While growth equity and venture capital (VC) both fall under the private equity umbrella, there are some important differences investors should be aware of.
More specifically, where venture capital invests in early-stage companies, growth equity selects businesses that have already solidified their position within their respective industry.
Further, growth equity invests in these more developed companies to mitigate their risk exposure; however, this also means lower expected returns.
Many investment firms invest in both venture capital and growth equity to build a diversified and risk-appropriate collection of portfolio companies.
Venture Capital Explained
In short, venture capital is a type of private equity that invests in high-growth companies. In exchange for funding, venture capitalists receive an equity stake in the business which they intend to sell at a later date for a profit.
Most venture capital investment is done by VC firms which, on top of supplying funding to growing businesses, provide industry connections, mentorship, and other resources to help founders grow their businesses.
Companies that raise venture capital are usually operating at a loss, as these younger firms are prioritizing growth over profitability. To further scale operations or develop new products, these businesses need the funding venture capital firms can provide. It is a good idea for new investors to familiarize themselves with the advantages and disadvantages of venture capital before they invest.
Benefits of Venture Capital
Obtaining venture capital funding can be game-changing for emerging companies that wish to scale yet lack the funds to do so properly. As well, venture capital firms offer more than just
- Expertise: Venture capitalists often have a wealth of experience and expertise in a particular industry or market. They can provide invaluable guidance and strategic advice to the management team of the companies they invest in.
- Network: VC firms often have extensive networks of industry contacts and resources that can help a startup succeed. Often venture capitalists will connect their portfolio companies with new potential customers, partners, or other investors.
- Personal Assets are Not Used for Collateral: In most cases, you won’t have to contribute your personal assets to secure funding. While many startup funding options will require founders to pledge some form of personal assets as collateral, most venture capital agreements won’t.
- Ability to Raise Large Amounts of Capital: Venture capital is one of the most efficient ways to raise large amounts of expansion capital. VC funding can range from as little as $100,000 for seed-stage startups to over $25 million for fast-growing companies. Additionally, startups have the potential to raise venture capital multiple times, potentially allowing them to access much larger sums of funding that might not be possible through other means.
- Potential for Exponential Returns: Because venture capital invests in early-stage growth companies, they have the opportunity for their original investment to double, triple, or even 10x in size.
6 Stages of VC Financing
One of the main attractions of venture capital to founders who need funding for their business is that VC is typically done in multiple rounds. Meaning as a business continues to grow and develop, founders can continuously raise capital to help fund the next stage of their business.
In total, there are six stages associated with venture capital investing, with each stage catering to companies at different points in their growth trajectory.
Pre-seed is the first round of VC funding and is defined as providing smaller amounts of capital to businesses that have only just begun to explore their potential. These companies typically don’t yet have a product to sell but want to pursue a potential business idea.
At this stage, founders may not have to give up equity in exchange for funding (depending on where the funding comes from) and may even provide this initial capital themselves or receive it from friends and families.
Seed funding is the second stage of VC financing and is usually the first time founders will have a formal meeting with venture capital investors. Businesses looking to secure seed funding have moved beyond the capital requirements of what founders could provide themselves and are looking to transition from a concept to selling an actual product.
3.) Series A
Series A funding still very much focuses on younger companies. However, at this point, the business has taken its product or service to market and is seeing some early success. Founders will be looking to VC firms to fund further operational improvements, advertising, and marketing campaigns, or even hiring new employees.
4.) Series B
Series B funding is reserved for businesses that are beginning to see consistent success and a clear path to a viable business model. At this point, founders will understand the high potential of their business and require capital to fund further expansion.
This expansion may come in the form of pushing their product into a new geographic region, setting up an online store, or taking on a large marketing campaign. Regardless, to develop further, founders will need additional capital from investors.
5.) Series C
When a founder reaches the series C funding stage, their business is no longer considered a startup. Rather they have successfully turned their emerging business into a full-fledged company.
At this stage, business owners are turning to VC funding to help finance large-scale growth initiatives. This may include expanding internationally, funding an acquisition, or developing a brand-new product.
6.) Series D & Beyond
Series D is the final stage of VC financing and is for businesses that need capital for a variety of different reasons. Founders may be looking to take their business public through an initial public offering (IPO) or fund new research and development.
At this point, the business has grown substantially, and the founders are looking to complete one final round of financing to help their business establish itself in its respective industry.
What is Growth Equity?
Growth equity (also known as growth capital) is a type of investment that targets established and mature businesses that are looking for additional financing to fund new growth initiatives.
Growth equity firms will look for startups who have already completed their first few rounds of financing and have a proven business model that’s continuing to grow. These emerging startups are willing to relinquish a certain level of ownership in exchange for the immediate funding a growth equity firm can provide.
Whereas venture capital investments focus on less developed firms and look for exponential returns, growth equity investors focus on more developed firms to reduce risk while still achieving a sizeable return.
What Makes a Good Growth Equity Investment?
Defining the perfect growth equity investment can be difficult, as different firms have varying criteria for the growth equity companies they invest in.
Nevertheless, some lasting qualities are universal across growth equity investing:
Reliable Revenue Growth
Growth equity firms invest in businesses that can show consistent revenue growth over an extended period. For a business to be considered a viable growth equity investment, the management team should be able to show investors a strong track record of improving revenue, as well as projections showing this trend is likely to continue.
Having an established R&D department helps show investors that improvement and future products are in the pipeline to generate more sales. Growth equity investors will be looking for tangible evidence that a company is working to grab additional market share or transition into new markets.
Evidence of Market Dominance
A growth equity investment firm will be looking for companies that can prove their product or service is superior to the competition. This evidence usually comes in the form of increased market share and a loyal customer base.
Clear Path to Profitability
To be considered as a growth equity investment, businesses won’t have to be consistently turning a profit. However, there should be a clear path as to when and how the business will become profitable.
Growth equity firms will expect to see financial projections and a well-thought-out plan as to how the company will be consistently profitable in the long term.
Growth Equity vs. Venture Capital
When comparing growth equity and venture capital, the most notable difference comes from selecting firms in different stages of the business lifecycle.
Venture capital should be viewed as a financing method that is provided to firms with unlimited potential that have yet to prove operationally that their business model can succeed. VC investors are willing to take on the extra risk of investing in these younger companies to achieve above-average returns.
Comparatively, growth equity will target established companies that have proven business models and a long history of financial success.
These companies are still growing significantly; however, they have built an established customer base with a clear path to profitability. Growth equity investments are slightly lower risk than venture capital, though this also means the potential return is lower.
Which type of investing style is best?
Truthfully, growth equity and venture capital both have their merits and downfalls, and as such, many private equity firms will invest in both. This allows them to simultaneously enjoy the high investment returns associated with venture capital while also limiting their risk through owning growth equity investments.
The split of how much growth equity or venture capital a private equity firm owns will depend on its investment strategy, risk tolerance, and available capital.
Similarities Between Venture Capital and Growth Equity
Although these two investment styles focus on different private equity investments, there are still some important similarities between the two:
Venture capitalists and growth equity investors both invest in privately held firms that have not yet gone public.
Growth Stage Companies Targeted
Both venture capital and growth equity funds aim to invest in firms that are well within their primary growth stage. Investors intend to leverage their expertise and resources to help their investments grow further.
Both growth equity and venture capital provide funding through non-debt transactions. Structuring deals using debt can be time-consuming and complicated – both investing styles support the simplicity and speed of all cash deals.
Venture capital and growth equity typically involve acquiring a significant yet non-controlling minority stake in a company (less than 50%).
Even though growth equity investments are usually lower risk than venture capital ones, both investing styles experience substantial volatility in the businesses they invest in.
Similar to public equity markets, variables like interest rates, industry trends, economic growth, inflation, and many other factors, greatly influences the valuations of growth equity and VC-backed companies.
How VC and Growth Equity are Different
There are also some important differences between VC and growth equity, including:
Return on Investment
Because venture capitalists are investing in businesses that have yet to prove they have a viable business model, these investments are at higher risk. However, this also means the expected return on investment is also higher. More risk = more reward.
Growth equity investments, on the other hand, are targeting businesses that have already experienced significant amounts of growth. For this reason, the expected return is smaller for growth equity investors. However, the risk they take on is also smaller.
Venture capitalists understand that it takes time for younger businesses to grow and develop and will stay invested in these firms for extended periods in hopes of realizing exponential returns.
Comparatively, growth equity investors will look to provide capital to help a business execute its next project and exit soon after.
As we talked about above, venture capital investors take on significantly more risk to try and achieve greater returns. Some estimates show 30-40% of VC-backed companies fail to transform into profitable businesses. Growth equity firms take on considerably less risk by investing in companies that have already proven they have viable business models.
Growth equity firms gravitate towards businesses that have a long operating history and a strong customer base to sell to.
Oppositely, venture capital firms usually focus their attention on businesses that haven’t been able to prove their business model is a success yet, but are instead still in the development stage of building a successful company.
VC and growth equity are both forms of private equity investing and are both crucial in providing funding to quickly emerging businesses.
While some investments in these areas can result in significant profits, the reality is that many new companies struggle to survive.
Growth equity attempts to mitigate this risk by investing in firms that have a long history of operating success, whereas venture capital accepts the risks associated with investing in early-stage companies.
The potential return on investment between these two investing styles is directly linked to the amount of risk they take on. Growth equity is typically lower risk, meaning it also brings lower returns. Comparatively, venture capital takes on higher-risk investments to earn a higher return.