Business 101: What Is the Difference Between Private Equity, Venture Capital, and Debt Capital?
When a business finds they need funds to start, continue, or expand business operations, where should they turn? Individuals often don’t fully understand the similarities and differences between private equity, venture capital, and debt capital. However, this information is critical to ensure the right funding source is selected.
Equity that isn’t publicly traded or listed is private equity or shares that represent an interest in an entity and demonstrate ownership. Used for investment capital, the funds come from either an individual with a high net worth or a firm that secures shares of a private company. In addition, this equity may be used to gain control of a public company with the goal of taking the organization private while removing the business from the public stock exchanges. Pension funds are one source of private equity with large equity firms that generate their money from accredited investors being another.
Private equity investments are actually direct investments in a business. The goal of the investors is usually to secure a major level of influence over the daily operations of the organization. As a result, the capital outlay is significant, and only those with deep pockets can gain a dominant foothold in the industry. Before taking part in one of these opportunities, understanding private equity and its risks and rewards is essential.
Venture capital, in contrast, is often secured at the early stages of a company’s formation. Some venture capitalists provide seed money for a company looking to get off the ground, but others choose to work with a company that has already proven that is has a product or idea with merit. Those who work with these companies help them boost sales and marketing efforts. When a company has already achieved success but needs an influx of cash, venture capitalists may step in to provide the funds and help the company move even farther.
Investors look at a start-up company’s cash burn rate and measure it against future revenues of the company to decide if the company is a worthwhile investment. They typically choose one of two methods of reimbursement for providing funds to the company in need of venture capital. Some investors opt to secure equity in the business being funded, and the funds provided to the growing company don’t need to be repaid. Others, however, decide convertible debt is a better option. This debt does need to be repaid in the future, and the two parties determine how best this should be accomplished. This type of investment does come with more risk than private equity opportunities.
When a company borrows money from outside sources for their business operations, this is considered debt capital. The funds are usually provided for a fixed time period and come with a fixed interest rate. The lenders in this financial arrangement don’t benefit from the profits of the borrower, as they are compensated in the form of the interest paid. The borrower, however, can write off the interest payments as a business expense and must include the payments in any listing of the company’s revenues and expenses on their balance sheet. Doing so could have a negative impact on the business in certain situations.
When securing funding, consider all options. Know the benefits and drawbacks of each to ensure the right choice is made. This depends on many factors, so what works for one organization might not be appropriate for another. There can also be the option to use a robo advisor. If questions still remain, seek outside guidance. One can never be too careful when it comes to the business they have put time and effort into building.