Venture Capital vs Growth Equity
Venture capital and growth equity are two related asset classes that are sometimes difficult to distinguish from one another due to inconsistent definitions. Like many investment topics, different definitions are used by different people when comparing venture capital vs growth equity. I hope that the below can help investors as they think about how they want to differentiate between the two asset classes.
Simple Definitions of Venture Capital and Growth Equity
Venture capital focuses on early-stage companies that possess strong growth potential that may also carry heightened risks (due to the unproven nature of their products or services). Traditionally, venture capital firms take a minority stake in these startups and provide guidance to help them achieve success.
Growth equity typically refers to investments made in companies that are further along in their development with a proven business model and more stable revenues. Growth equity investments often facilitate accelerated growth through expanding operations, entering new markets, or consummating strategic acquisitions.
In short, both venture capital and growth equity represent investments into private companies, but at different stages of growth. Venture capital generally focuses on earlier-stage companies and growth equity generally focused on later-stage or mature companies.
Understanding Venture Capital and Growth Equity
Venture capital (VC) generally refers to equity financing provided to early-stage, high-potential companies. VC firms have traditionally invested in startups at the beginning of their developmental stage (although many companies are staying private for longer and accepting venture funding at more mature stages), seeking to capitalize on their potential for high growth and profitability. It is important to note that VC investments carry a relatively higher risk compared to other investments.
Some key features of venture capital investments include:
- High-risk, high-reward strategy
- Focus on early-stage companies with high growth potential (early stage venture)
- Involvement of the investor in company operations
- Typically longer holding periods (5-10+ years)
Growth equity typically targets companies that are beyond the early stages of their development but still have significant growth potential. The purpose of growth equity investments is often to accelerate the growth of the firms, such as helping them expand into new markets or support strategic acquisitions.
Compared to venture capital, growth equity investments have some unique characteristics:
- Lower risk, as the companies have already passed the early developmental stage (“late stage” companies)
- Less potential reward (at the individual company level) compared to VC due to the lower risk profile (although a diversified growth portfolio may outperform a venture portfolio in many cases)
- Focus on expanding existing operations, entering new markets, or making strategic acquisitions
- Generally shorter holding periods
Key Differences: Venture Capital vs Growth Equity
Venture capital (VC) firms typically invest in early-stage companies, often during their startup phase, while growth equity focuses on later-stage companies that have established a product-market fit and are seeking additional funding to scale.
VC investments tend to be riskier, with a high failure rate, as they invest at the early stages of a company’s development. Growth equity investments are less risky, as companies are already established and generating revenue.
VC firms often invest alongside other VC firms, while growth equity investors often invest alone. VC’s often exert some control over the company’s decision-making process in the form of financial leverage and/or board seats. Growth equity investors may exert more or less control depending on the terms, conditions, and size of investment.
Majority vs Minority Stake
VC investments often result in minority ownership stakes, with the firm holding a significant but non-controlling interest in the company. Growth equity investments can result in minority or majority ownership stakes, depending on the size of the investment and the investor’s objectives.
Venture capital firms are the primary investors in VC rounds, while growth equity investments can come from a variety of sources, including private equity firms, “crossover funds,” institutional investors, and strategic corporate investors.
Growth equity investments generally have a shorter holding period, compared to venture capital investments, which can span over 10 years due to the longer development process of early-stage companies.
Use of Proceeds
VC funds are often used for product development, initial marketing efforts, and team expansion. Growth equity investments are used for scaling the business, expanding operations, entering new markets, or completing strategic acquisitions.
VC investments typically seek higher return potentials, as they compensate for the increased risk associated with early-stage investments. Growth equity investments, on the other hand, tend to have lower return expectations, reflecting their lower risk profile.
Pros & Cons: Venture Capital vs Growth Equity
Pros of Venture Capital
- High growth potential: Venture capital firms typically invest in early-stage startups with innovative ideas and high growth potential, leading to significant returns if the company is successful.
- Support and guidance: Venture capital firms often provide valuable industry connections, mentorship, and strategic advice to help startups navigate through the challenges of growing their business.
- Funding for risky ventures: Startups with unproven business models and uncertain revenue streams may have difficulty obtaining funding from traditional sources, making venture capital an important source of funding for these companies.
- Exit opportunities: Successful venture capital-backed startups may lead to lucrative exit opportunities through acquisitions or initial public offerings (IPOs), which can generate significant wealth for both founders and investors.
Cons of Venture Capital
- Risky investments: Due to the nature of investing in startups, venture capital investments entail high risk, with a significant number of startups failing to realize their potential or even cease operations.
- Loss of control: In exchange for funding, venture capital firms typically require equity stakes and may influence strategic decisions, leading to potential conflicts between founders and investors.
- Pressure to grow: Venture capital-backed startups often face significant pressure to grow quickly and achieve high valuations, potentially leading to founders making unsustainable decisions or neglecting long-term goals.
- Dilution of ownership: Raising funds through venture capital results in the dilution of ownership for existing shareholders, including founders and early employees.
Pros of Growth Equity
- Lower risk profile: Growth equity investments usually target companies with a proven business model and established revenue streams, resulting in a lower risk profile compared to venture capital investments.
- Accelerated expansion: Growth equity can provide the necessary funding for companies to scale up their operations, enter new markets or pursue strategic acquisitions, facilitating accelerated growth.
- Longer investment horizon: Growth equity investments typically have a shorter holding period compared to venture capital, providing investors with a quick return of capital.
Cons of Growth Equity
- Lower potential returns: Due to the lower risk profile of growth equity investments, the potential returns may be lower compared to the high-growth potential associated with successful venture capital investments. However, this downside may be mitigated by diversification.
- Minority stakes: Growth equity investments often involve taking minority stakes in companies, potentially limiting the influence and control exerted by the investor.
- Limited availability: Growth equity funding may be limited to companies that have achieved certain milestones in terms of revenue, profitability, or market presence, making it a less accessible source of funding for early-stage companies.
The Bottom Line
Both venture capital and growth equity play pivotal roles in supporting and fueling the growth of companies at different stages of their life cycles. Having a clear understanding of these two types of investments can provide valuable insights when comparing venture capital vs growth equity.
VC investments primarily focus on early-stage, pre-revenue companies with potential high growth. These companies typically have unproven business models and require a significant amount of risk capital to develop their products or services. Growth equity investments target more mature operating companies that have established end markets and are at an inflection point where the growth capital can fuel expansion.
It is important to note that these two forms of investments are not mutually exclusive. There is a fair amount of overlap between venture capital and growth equity. Venture capital and growth equity investments each have their specific characteristics, risks, and rewards. As investors navigate the ever-evolving landscape of private company financing, understanding and employing the appropriate investment strategy aligned with their objectives and risk tolerance is as important as ever.