Private markets control approximately 98 percent of all companies and a full quarter of the American economy, so it is important to understand how they work. In the private markets, both venture capital and private equity are funding options for companies.

The terms venture capital and private equity are sometimes used interchangeably, but they are actually distinct processes. Understanding the differences between them provides important insight into private markets.

The goal of both processes is the same. Investors want to increase the value of a businesses and thereby increase the worth of their stake in it. However, the two approaches differ in terms of amount invested and types of companies targeted, as well as the point in a company’s lifecycle during which they get involved.

Venture capital firms tend to get involved with young companies, especially tech-focused startups. With venture capital deals, firms generally receive a minority stake in equity in exchange for funding.

Private equity firms, on the other hand, frequently take a majority stake and tend to seek mature companies in a variety of different industries. Through private equity deals, businesses that are struggling are bought out and revitalized. However, these firms may also seek out tech companies that have been previously backed by venture capitalists.

Of course, these generalizations are not rules, and some overlap can exist between the two different approaches to funding. Also, firms rooted in these two different philosophies can often collaborate and support each other in unique ways.

Understanding the Basic Strategies of Each Approach

The basic approach to funding is quite different between venture capital and private equity. Venture capital firms will open a fund and then solicit financial commitments from a limited number of partners to invest in companies. These firms thus create a pool of money that they can use to invest in private companies with the promise and potential for quick growth.

Most venture capital firms focus on a particular stage of growth in the lifecycle of a startup, or potentially two different stages. The specific stages that a venture capital firm targets will influence its investment style.

If a company that a firm has invested in is acquired or goes public, the firm makes a profit and distributes it among the partners that contributed to the pool. Venture capital firms may also sell shares to other investors in the secondary market.

Private equity firms also create pools of capital from limited partners and form a fund that can be used to invest capital in promising private companies. The companies that these firms target may be tech startups, but often include a variety of other types of organizations. Private equity investors often look for companies that have become stagnant or even distressed despite still having the potential for growth.

There are different types of private equity deals, with the most popular being the leveraged buyout. With this type of deal, the firm purchases a controlling stake in the company through both equity and debt which the company will ultimately repay. The investing firm works to improve profitability after the purchase. Private equity firms generally try to sell companies for a profit, although the investment may also end up going public.

Teasing out the Main Differences in Investment Approach

Both venture capital and private equity firms have similar goals, but their strategies for achieving them can be quite different. One of the biggest differences is in terms of the size of the investment. Often, private equity firms spend hundreds of millions of dollars, or even billions, to acquire a company while venture capitalists make smaller and sometimes incremental investments in a company.

The usual venture capital investment ranges from $1-$10 million, although it can be even less in the earliest funding rounds. Venture capital firms often invest more money as the companies they support grow. However, they will almost never acquire a company in the same way that a private equity firm does. Also, venture capital often involves numerous co-investors, whereas private equity typically consists of one firm making the investment.

The different approaches to investment also have an effect on risk and reward. Since venture capital firms make smaller investments, they will often look at hundreds or thousands of potential deals and choose a handful each year. In that handful, a few companies will likely fail. The firm may break even with some. A few will do quite well and bring a large return.

Since private equity firms invest more money and focus on fewer companies, they often have a much more structured approach to investing. Private equity firms may choose a single company to invest in and then dedicate a significant amount of time and resources into turning it around so that it can be sold at a profit. In other words, private equity firms do not accept the same risk of failure that venture capitalists do.