Venture Capital (VC) tends to invest into people while Private Equity (PE) tends to invest into companies. This fundamental difference may seem simple, almost obvious, but in practice leads to completely different approaches. It is easy to gloss over these differences or not even fully appreciate them. However, understanding these differences, understanding what you are investing into, how you are investing and then being coherent in approach, structure and style is crucial to maximize chances of positive investment outcomes.
Playing the Venture Capital game
Startups are organizations in search for a repeatable business model. The team and in particular the founders are the key drivers tasked with finding such business model, realising “a vision”.
If they fail, then the money used to fund this journey is lost – typically a combination of savings, FFF (friends, family and fools) money, angels and Venture Capital. If they succeed, then everybody is supposed to win. And win big. Returns, especially for early investors, hereby are measured in multiples not just percentages, such is their scale.
In such companies, founders and early-stage senior hires typically have a highly dominant role. These people are the key asset which make or break the company. The so-called “bus-factor”, the number of team members who, if run over by a bus, would put the startup in jeopardy is therefore very low. If 1 or 2 key people were hit by a bus, the entire company will flounder. Consequently, if you don’t really believe in those people, why invest – there is little else that can be backed in those companies.
Private Equity: Models not People
Private Equity investors tend to look at things the opposite way. They look at a business and assess the current model searching for optimization potential. The goal commonly is to either massively accelerate company profits or transition to a different, well-established but more profitable business model.
Management/leadership are not the spiritual parents or single most important asset of the business, they rather are stewards and custodians. As such, they receive a clear mandate on what needs to be done. If they then happen to not be “up to the job” of executing the overall plan, management can simply be replaced.
Having established the key hypothesis on the differing perspectives of investing into people or businesses, the remainder of this article will look at two specific ramifications.
The role of the board
As mentioned, founders are key in a startup and their success pretty directly correlates with company success. Boards therefore tend to take on more of a coaching role for founders. They serve as sounding boards, they provide access to potentially value-adding resources and try and support the entrepreneur throughout their journey.
It is highly uncommon for startup boards and VCs to actively remove founders/top management. This does not mean top management composition is stale or even founders are CEOs for life. It does quite regularly happen that founders, in consultation with their board, decide the business has reached a stage where somebody else may be better to execute the vision. But such decision is usually mutually agreed upon and “board coups” to remove management are very rare.
In short, as ultimately for startups/VC it is an investment into people, the board’s role is to make sure that the team builds the best possible business according to their overall vision.
Boards of more mature, PE-backed businesses tend to follow a different approach. Management executes and implements a relatively clearly predefined plan. This plan was either actively developed in cooperation with the board/PE investor beforehand or at minimum been fully communicated and elaborated at investment. Little major deviations are expected.
Progress monitoring against such plan becomes key with a prominent role for measuring and minimizing risk. Such risks include the risk of missing overall goals, wrongly investing, key people not being up for the job etc. It is not realizing the founders vision that is key but rather implementing a business plan/model.
People incentivization and “upside”
With venture capital investing into people and founders specifically, “keeping them happy” is crucial. The people “doing the work”, i.e. founders, their management teams and early-stage employees hence typically hold a major chunk of equity. Such allocations often remain above 50% for the first few years despite multiple investment rounds.
Successful founders are rare – globally only very few people manage to create a so-called unicorns (billion dollar valuation company). And as startup life is extremely stressful with plenty of anxiety. Early-stage companies live and die with their founders/senior teams who are willing to give up 5-8 years of their life at significantly lower pay but the perspective of immediate potential retirement if it works out. Low(er) salary, high equity potential is the formula. And if you believe you can be one of the few success cases, why would you settle for anything less?
VC funds have come to accept this viewpoint as the rare home-runs still make up for the failures and lower shareholding percentages. Preferred share classes are well established in VC rounds and offer further protection.
The opposing PE viewpoint is that there are plenty of people in leadership positions around the world. If a particular CEO or CTO does not work out, ample alternatives exist to lead and implement the company vision.
Cash tends to be less tight in these businesses too, hence, lesser salary sacrifices need to be made. This opens up a broader potential talent pool including candidates with significant ongoing financial commitments for family, existing property etc.
Talent becomes much less of a limiting factor, hence, deserving much less of the potential equity upside. Typically, for PE, capital and models, not founders, are the scarcest factor, hence, these earn and deserve the greatest returns.
Putting things together
The lines between VC and PE are increasingly blurring. More and more VC funds place very late-stage investments closer to the traditional PE sweet spot. PE funds meanwhile move to earlier stages in search of the spectacular returns of individual VC bets, especially in the tech sector. Both types of investing surely have their upsides and place and historically have proven that they can produce returns. Whether one really is “better” than the other therefore is rather questionable.
Additionally, even corporates with their historically low risk appetite are entering the game through Corporate Venture Capital funds. It is therefore more important than ever today to ensure awareness of what type of investment is being made and manage appropriately.
Making early-stage VC-style bets into unproven models without strong founders in place is a recipe for disaster. Corporate/PE-backed early-stage businesses who hold 100% shares in a new entity and then search for top talent willing to build a huge business in return for receiving 2-3% ESOP are another worrying current trend. The same person may end with 15-30% when going down the independent route. So why would top talent accept such a deal? Just because these entities find somebody willing to forego millions in potential exit proceeds in exchange for a few thousand dollars monthly salary difference, does not mean such person is able or even likely to succeed. And actual success cases of such setups for early-stage/new venture creation are exceedingly rare to our knowledge.
The challenges are real not just for later stage/lower risk investors moving to early stage. Also for VCs moving to later stage, the risks associated with playing a different game are significant. When investing into 5 late-stage businesses, each with a maximum potential upside of doubling, write-offs are not acceptable. The much-celebrated Silicon Valley “culture of celebrating failures” is not appropriate here. And once enough “substance” in the company has been created, it may be time to put more emphasis on the model/underlying business instead of mainly being “coaches & cheerleaders” for the founders.
In conclusion, not all investing is equal. Therefore, it is paramount to understand the type of investment and what the rules of the game are.