Quick quiz:

  • If your startup is seeking investors, will you have more success with private equity or venture capital firms?
  • How about when you’re looking to sell that company?

Businessman giving Vulcan greeting from Star TrekThe answers are (1) venture capital and (2) private equity.  If you weren’t sure, you’re not alone; the terms are often confused or used interchangeably.  However, PE and VC firms generally have very different investment strategies.  Understanding the distinctions may help save time and money and…perhaps…save face (i.e., not everyone will judge you for confusing Star Wars and Star Trek, but others will never forget).

Like most either/or categorizations, the distinctions blur in the middle, making generalization dangerous.  But in basic terms, here is what you need to know to avoid that awkward Han Sulu moment.

Characteristics of a PE investment (or, investing by Vulcan rationality)

PE firms typically invest in existing companies with a quantifiable track record (including proven cash flow), existing products or services, and potential for value creation.  PE investors may also consider businesses that complement their existing constellation of portfolio companies.  Therefore, whether or not PE firms invest in a company is a highly data-driven decision.  PE firms purchase a majority stake (often 100%) in their target investments.  This permits them to take an active role in their portfolio companies and to create value through financial engineering and restructuring.  In broad brush terms, this investment strategy focuses on value.  PE firms purchase underperforming or undervalued companies intending to guide them to optimal performance, increase their value, and sell them for a profit.  In other words, PE firms help existing companies realize their potential and boldly go where they have not gone before.  Because this strategy applies in many circumstances, PE investments are made across a wide set of industries.

Characteristics of a VC investment (or, investing by Dagobah ecosystem)

VC firms typically invest in emerging companies, which may have no or a limited operating history, but potential for light speed growth.  Therefore, whether or not VCs invest in a company is a holistic decision involving analyzing ideas and people (i.e., the business plan and the founders’ and management team’s ability to execute it).  To mitigate risk, VCs diversify their investments by making minority investments across a universe of startups.  Because they purchase smaller stakes, VCs have less control than PE firms over the day-to-day operations of their portfolio companies; however, VC’s often retain veto rights over certain major decisions.  In broad brush terms, this investment strategy focuses on growth.  VC firms invest early in the hopes of sharing in the upside upon exit or IPO.  These criteria keeps many VC investments industry-specific (e.g. technology and life sciences).  Although startups often fail, VCs can earn attractive returns if even one rebellious company blows up and disrupts an existing empire.

Of course, PE and VC investments have similarities, not the least of which is seeking above market returns.  The primary difference is how they arrive there.  From a company’s perspective, VC and PE firms serve distinct purposes and are appropriate at different stages of a company’s life cycle.  Entrepreneurs must understand the differences between VC and PE firms and their investing philosophies to ensure they’re approaching the appropriate investors at the right time.  Of course, there is much more to consider.  This is just a high level overview intended to demonstrate that there is a difference.  In a critical moment, remembering that PE firms invest like Vulcans and VCs invest like Jedis might remind you of the key distinctions.