Understanding Private Equity (PE), Venture Capital (VC), and Angel Investing

All businesses have a journey, and each step of the journey requires capital to grow. This starts with the initial funding round, called the seed round, where you have investors who invest a relatively small amount, these are called angel investors. At the next step, as the capital requirement increases, the company looks towards sources like venture capital & private equity funds. In this chapter, we’ll look at these sources as alternative investments and try to understand the differences and similarities between Venture Capital, Private Equity and Angel investing. 

Venture Capital 

What is Venture Capital?

Venture capital (VC) is the term used for financing provided to early-stage, private companies that have high growth prospects. Venture capitalists finance start-ups and small companies that do not have access to public capital markets or bank lending. The typical companies of VCs are those with innovative technologies, products, or business models that have yet to have a history of successful operations and positive cash flows. Therefore, they are not able to raise funds through public debt and equity offers.

Venture capital is essential in financing entrepreneurship and technological innovation. The VC hand is over the start of some of the biggest companies nowadays, like Apple, Amazon, Facebook, Google, Starbucks, and FedEx.

VC investors expose themselves to substantial risks when they invest in fledgling ventures. 60% of VC investments are lost, and only 1% are huge winners. Nonetheless, the minority of very successful investments leads to the overall returns being attractive. According to Cambridge Associates, venture capital has provided an average annual return of 15.1% over the last 20 years, which is better than most other asset classes.

Stages of Venture Capital Financing

Venture capital investments are made across various stages of a startup’s growth. The riskiness and financing needs vary at each stage:

1. Seed Stage: The earliest stage when a business still defines its product or service. Seed capital is used for product development, market research, management team building, etc. Investors include angel investors, friends and family, incubators, and VC firms. The amount raised is usually under $1 million.
2. Early Stage: The startup has developed an MVP (minimum viable product) but is still pre-revenue or generating minimal revenue. Capital is used to complete product development, recruit an entire team, and conduct initial marketing efforts. Prominent VC firms start actively investing at this stage. The amount raised ranges from $1-10 million.
3. Later Stage: The startup has an established product in the market and is seeing accelerating growth. Capital is used for expansion needs like increasing inventory, hiring sales and marketing personnel, geographic expansion, etc. Investors include VC firms and PE firms. The amount raised ranges from $10-100 million.
4. Bridge/Pre-IPO Stage: The mature startup is gearing up for an IPO but needs capital to sustain operating expenses in the interim. Investors include PE firms and hedge funds. The amount raised is over $100 million.

VC investors invest in all these stages depending on their risk tolerance and expected returns. Early-stage investments bring the opportunity for fabulous profits; nevertheless, they carry a high risk, while late-stage investments pose less risk but provide very modest returns.

VC Ecosystem Stakeholders

1. Venture Capital Firms: Managed firms are professional operators that raise money from a group that could be likened to a limited partner, such as a pension fund or an endowment. The general partners then invest the funds in companies, managing the investments. Sequoia Capital, Accel Partners, and Andreessen Horowitz are some of the leading VC firms.
2. Angel Investors: Generous people who put their funds in startups at the earliest stage. They are usually ex-entrepreneurs or possess an industry background.
3. Accelerators/Incubators: Angels that support startups at the very early stage through capital, mentorship, and other resources. Y Combinator, for example, is an influential startup accelerator.
4. Corporate VCs: VC arms of large corporations that make strategic investments. Google Ventures is Alphabet’s corporate venture capital arm.
5. Government VC Programs: Some governments have specific funds or incentives to invest in startups, e.g., the Small Business Innovation Research (SBIR) program in the U.S.

Unique Features of VC Investments

Some unique attributes characterise venture capital investments:

1. High-Risk, High-Return: Investing in startups with no revenue or track record is extremely risky. However, VC portfolios target extraordinary returns of at least 3-5 times the capital invested.
2. Long Investment Horizon: VC investments are illiquid and usually have an investment timeframe of 5-10 years before an exit is possible. Patience is critical.
3. Hands-On Involvement: VCs do not just provide capital; they actively guide and mentor the startups they invest in. They often take board seats and voting rights.
4. Staged Financing: Instead of investing all the committed capital upfront, VCs release funds in stages linked to the startup achieving predetermined milestones. 
5. Preferred Stock: VCs receive convertible preferred stock rather than common stock in exchange for investment. This grants them liquidation preferences, anti-dilution protections, voting rights, etc.
6. Full Ratchet Anti-Dilution: A down round triggers full dilution protection for VC preferred stock versus the more founder-friendly weighted average protection.

Private Equity

What is Private Equity?

Private equity (PE) involves equity investments in private companies, i.e. companies not listed on public stock exchanges. PE provides long-term capital in exchange for a share of ownership in private companies. These companies can be startups or small businesses, typically backed by venture capital and angel investors. However, PE more commonly refers to acquiring mature, established companies.

A private equity firm raises capital from institutional investors like pension funds, insurers, and endowments. The PE firm then invests this capital to acquire private companies - either outright or a controlling stake. They look to enhance the value of these companies over 3-7 years through operational improvements, expansion, industry consolidation, etc. Finally, the PE firm sells its stake for profit through a strategic sale, IPO, or secondary buyout.  

PE firms generate returns by improving the financial performance and valuation of the companies they acquire. A key way they do this is by applying leverage, i.e. significant debt financing, to maximise equity returns. The debt is serviced through the cash flows of the acquired companies. The use of leverage amplifies returns but also increases risk.

Major Types of Private Equity Deals

1. Buyouts: This accounts for most PE deals by value. It involves acquiring a controlling stake or the entire share capital of a mature company. Buyouts allow PE firms to implement major changes. 
2. Growth Capital: Minority investments in established companies looking to expand or restructure operations. The existing owners still hold a controlling stake.
3. Turnaround Capital: Investing in distressed or undervalued companies with the potential for a financial turnaround. Operational overhaul and balance sheet restructuring feature prominently here.
4. PIPEs: Private investment in public equity involves acquiring a stake in a publicly listed company by issuing new shares directly to the PE firm.
5. Going Private: Taking a publicly listed company private by acquiring all outstanding shares and delisting it from the stock exchange.
6. Distressed Debt: Acquiring discounted debt securities of firms in financial distress and then converting them into equity during restructuring.

Key Players in Private Equity 

1. Private Equity Firms: Professionally managed investment firms that raise funds from institutional investors, invest in portfolio companies, and manage the holdings. Leading PE firms include The Blackstone Group, KKR, The Carlyle Group, Vista Equity Partners, etc.
2. Institutional Investors: Provide the bulk of the capital in PE funds, including pension funds, sovereign wealth funds, insurers, endowments, etc.
3. Investment Banks: Help identify acquisition targets, conduct valuations, arrange debt financing, manage the sales process, and facilitate IPOs.
4. Management Teams: Existing management teams play a crucial role in executing the PE-backed business plan. Top executives are often given equity incentives. 
5. Operating Partners: PE firms maintain networks of industry and functional experts who work actively with portfolio companies.

Unique Features of PE Deals

Some typical characteristics of private equity deals:

1. Control-Oriented: PE firms acquire complete or majority control in portfolio companies, unlike minority VC stakes.
2. Leverage: Debt financing is used extensively to fund acquisitions and boost equity returns through financial engineering.  
3. Longer Hold Periods: On average, PE investments are held for around 5-7 years to realise operational improvements.
4. Active Governance: PE firms closely oversee strategy and operations through board roles, management incentives, operating expertise, etc.
5. Alignment with Management: Management incentives like co-investment and bonuses seek to closely align interests with the PE fund.
6. Value Creation Levers: PE firms use levers like strategy repositioning, expansion, add-on acquisitions, technology upgrades, etc., to enhance portfolio company value.  

Angel Investing 

What Is Angel Investing?

Angel investors are wealthy individuals who offer funding to start-ups, usually at the earliest stages. They put in their own money, contrary to venture capitalists who control funds collected from institutions. Angel money is financial aid for start-up companies, enabling them to convert their ideas into working businesses. Good angels are successful entrepreneurs or executives within the same industry as the startups in which they invest.

Angels bridge a funding void faced by very early-stage businesses that cannot get VC funding because of small check sizes and untested concepts. The seed capital and mentoring to enable these early-stage startups to be VC-ready firms in 18-24 months is deposited by the angel ecosystem. Angels are higher risk takers than usual VC firms in exchange for the potential maximum returns.

Angel investors do not only bring funds but also useful industry knowledge, business sense, and powerful connections to assist new entrepreneurs. They often play an active mentoring role, providing strategic advice and operational assistance alongside monitoring through regular reviews and reporting. Angels aim for high returns but derive satisfaction and networking benefits from working with young startups.

Stages of Angel Investing 

Angel investors target the earliest stages of startup financing, which are too risky for most professional VCs:

1. Pre-Seed Stage: The entrepreneur may have a business concept or prototype at this idea stage. Angels help turn the concept into a business plan and product design. The amount invested is up to $500,000.
2. Seed Stage: The startup has a business plan and is working on an MVP (minimum viable product). Angels facilitate the creation of the founding team, product development, trials, etc. The amount invested ranges from $500,000 to $2 million.  
3. Early Stage: The startup has some initial traction and proof-of-concept for its product in early sales, pilots, user feedback, etc. Angels provide capital to begin commercialisation and enter the growth phase. The amount invested ranges from $2-5 million. 

Angel investing is especially critical for capital-intensive startups working on emerging technologies like cleantech, biotech, etc., where larger amounts are needed to fund R&D and testing before VC interest picks up.

Key Players in the Angel Ecosystem

Active individual angels who invest their own money as well as emerging angel groups and networks, including:

1. Experienced Entrepreneurs: Those who have built and exited startups make for active angels in their domains of expertise.
2. Corporate Executives: Former or current senior executives from large companies also provide valuable experience.
3. Finance Veterans: Retired investment bankers, VC/PE investors, etc., bring financial acumen.  
4. Service Providers: Successful lawyers, advisors, and consultants who have worked with startups. 
5. Angel Groups: Semi-formal groups that allow angels to pool capital into larger investments. Help expand the professionalism of angel investing.  
6. Equity Crowdfunding: Online regulated platforms are opening up angel investing to smaller accredited investors. 
7. Super Angels: Prominent individual angels who actively invest and support dozens of startups.

Unique Aspects of Angel Investing

Some key attributes of angel investments in startups:

1. High-Risk Appetite: Angels invest before most institutional VC funds are ready to take risks. Thus, startup survival rates are low at the angel stage.
2. Informal Agreements: Typical investments use lightweight term sheets and common stock instead of detailed contracts.
3. Smaller Deals: Check sizes are lower than VC deals, usually from $25,000 to $2 million.
4. Active Involvement: Angels engage much more closely with entrepreneurs than typical VC fund managers through frequent meetings, mentoring, networking, reviews, etc. 
5. Portfolio Diversification: Given the high failure rate, angels mitigate risk by building a portfolio of 15-25 startups across sectors and stages. 
6. Follow-On Rights: Angels negotiate pro-rata rights to invest in subsequent rounds to build their stake.

Comparing VC, PE and Angel Investing

While VC, PE and angels provide equity financing to private companies, there are some key differences:

Feature	VC	PE	Angels
Stage Focus	Early-stage companies (Idea, MVP, Commercialization)	Mature companies (Established products, model)	Pre-seed, Seed stages
Company Profile	High-growth startups (Tech, Life Sciences)	Stable/Mature companies (Attractive cash flow)	Entrepreneurs (Idea stage, Promising potential)
Deal Types	Minority stakes in portfolios	Controlling stakes/Full ownership (Buyouts)	Small investments in return for equity
Deal Size	$500K - $100M+	$100M - Billions	$10K - $2M
Use of Leverage	Minimal	High (70-80%)	Only their capital
Hold Period	7-10 years	3-5 years	5-8 years
Governance	Oversight through board seats	Complete control (Majority equity ownership)	Limited rights (Active mentors)
Returns Profile	High multiples (3-5x)	Lower IRRs (~20-25%) (Operational improvement)	High returns & Social rewards
Risk Tolerance	Very high (Unproven ideas)	Stable, mature companies (Lower risk)	Early-stage risk (New concepts, teams)
Exit Avenues	IPOs	Sales (Strategic, IPOs, Secondary buyouts)	Piggyback on VC exits/Distribution rounds

In summary, VC, PE and angels cater to different segments of the corporate lifecycle with their risk-return profiles. But they play a complementary role in supplying capital to the private enterprise economy. Their funding enables innovation and growth at various stages of the evolution of companies.