What is the Difference Between Private Equity and Venture Capital
What are the differences between private equity and venture capital?
Two terms in finance are often misused and confused. These terms are private equity and venture capital. So, what are the differences between private equity and venture capital? The answer to this question will be answered concisely in this article. If you are also confused about these terms, well, not to worry, the differences will be clear soon. Read on.
These terms are confused because they both have similar representations in business. Both forms invest in third-party companies and exit the agreement through the sale of their investments in equity financing. However, despite the similarities, there are still disparities in the way that both businesses are conducted.
Although both operations involve investment and equity financing, their modes of operation differ. Also, their goals differ largely and these will be discussed shortly. Before progressing into these details, what is equity capital?
What is equity capital?
Private equity is the capital invested in a company but is not traded or listed publicly. Private equity represents equity that is owned in a business by an individual that may share no public relations with the business.
This sort of investment is mostly from individuals with high net worth. This is because the investment requires a lot and will not be possible for a regular earner. These individuals and firm investors tend to invest in top private companies or public firms. They invest in public establishments to enlist them as private trading establishments by gaining control of the public companies.
Since the goal of this investment is to directly invest, a lot of capital is required. Hence, why high net worth investors and rich business individuals are involved.
Now, what is venture capital?
What is Venture capital?
However, venture capital is the capital invested in a startup business that shows positive growth potentials in the long run. Hence, while private equity may have no long-term interest, venture capital does.
The investment for these businesses arises from investment companies, wealthy business enthusiasts, and other financial institutions. The investments provided to these organizations and startups are not necessarily financial. They can be expertise investment either technically or in managerial terms
How this works is that the companies and investors take a share in the company’s equity. This provides the companies with a right to partake in the startup business decisions. Therefore, it is a way of providing growing businesses with alternatives based on their growth potentials.
However, the risk of losing their investments if the company does no deliver the expected profit remains on the investors. Above is information on venture capital and private equity. Now let’s consider the differences between private equity and venture capital.
Differences Between Private Equity and Venture Capital
The first difference to be aware of is their target businesses. Private equity investors aim to fundraise only for mature companies. That is, companies that are already established and known, however, having lower output than expected makes them perfect for these investors.
When these private investors acquire these businesses, they try to take over the business and make it profit-oriented. They focus the resources on driving productivity in the company.
Venture capital investors on the other hand prefer to invest in startups with growth potentials. Hence, unlike the former that focus on ready-made companies, these investors look for growing businesses.
Another difference is the equity obtained. Although venture capital investors take more risks in their investments, they take lesser portions of the companies.
However, in these fundraising schemes, there is a measure of dividend that is expected by each investor. These investors are a part of the company’s ownership and can demand regular dividends. However, how will this be calculated? Read further.
How to calculate the cost of equity capital?
The cost of equity capital is usually assumed to be cost-free but it is not. Investors that have gained a place in the ownership structure of a company demand dividends. The cost of equity can also be described as a market compensation to investors for the risks of ownership.
The cost of equity can be defined in two separate ways depending on the subject. For a company, the cost of equity is the returns that are required for an investment. While for an Investor, it is the returns required for an investment.
The cost of equity capital is usually calculated using either CAPM or the Dividend Capitalization Model. CAPM is an acronym for Capital Asset Pricing Model; it shows the threshold of returns to be given to investors. Using a formula calculation, CAPM considers the market rate of return, and other variables.
It is represented as;
Cost of Equity = Risk-Free Rate of Return + Beta × (Market Rate of Return – Risk-Free Rate of Return)
Beta is a factor that compares the risk of an unlevered company to the market risk.
Risk-Free Rate of Return is the return expected from a risk-free investment made by the company
Market Rate of Return is the expected rate of return based on the market returns over a period
Another method that is used to calculate the cost of equity as highlighted above is the Dividend Capitalization Model. Using this model, the cost of equity capital calculation is as follows:
Cost of Equity = DPS/CMV+GRI
Where: DPS is the dividends per share for next year
CMV is the current market value of a company’s stocks
GRD is the growth rate of dividends
Conclusion
What is the difference between private equity and venture capital is a question this article has answered.
There is a wide difference between private equity and venture capital investments. Although in both cases, there are external sources of financing by investors. Also, the company avoids bad debts such as loans using assets as collateral.
However, the variation in the goals of both ideas stands as one of the major differences noticeable in both cases. Also, the point of interest is something to also consider. While private equity investors look for already established companies facing inefficiency, venture capital investors go for startups.
Nevertheless, they have similarities such as claiming equity and part ownership with the companies. Although venture capital investors claim equity lesser than private equity investors do.