Private equity firms typically believe that venture capitalists invest in lossmaking businesses with a view to extraordinary growth (risky). Whereas venture capitalists typically believe that private equiteers invest in traditional businesses (boring) with a view to value creation through means other than just revenue growth (over-gearing). In practice though, there can be an overlap between the two.
With that in mind, I thought it would be helpful to understand some of the venture capital lexicon and the different stages in venture capital and privat equity investing.
- Pre-seed stage: this is the stage of idea inception. Capital is used to create the legal business structure, research the market, register patents and initiate prototyping. Providers of this capital are usually friends, families and fools (the “3Fs”), or sometimes angel investors.
- Seed stage: this involves the commercialisation of products and services. Typical uses of funds include bolstering the management team and moving from prototype to production. Investors at this stage are usually angel investors and incubator programmes.
- First stage: this stage is about establishing real revenue, opposed to revenue from trials and grants. From a corporate perspective, the business should be fully operational and able to scale to meet demand. This is where true venture capitalists enter a business and look to fund subsequent stages as part of a syndicate.
- Second stage: at this stage, revenue is about to take off. Capital is required to increase production, fund large marketing campaigns and enter new markets. Later stage venture capital specialists may invest at this point, or the original early stage firm will consider a second round of funding.
- Third stage: the business is highly profitable now. Funding for working capital, increasing plant size, product diversification, more marketing, quality improvement and further revisions is required. For a high growth business, later stage venture capitalists will dominate funding. For lower growth and more traditional businesses, private equity firms will enter the fray.
- Pre-IPO stage: funding at this stage is called mezzanine or bridge finance. It cleans up the share register, pays down debt, prepares the company for IPO and ensures top quality management are at the helm. There are specialist funds that will come in at this stage, but private equity funds will also make an appearance. Often convertible debt will fund this round as the business will have the income to support the coupon payments.
The stages of private equity clearly overlap with the stages of venture capital financing. It helps to think of them both as private investment, but venture capital as earlier growth stage and private equity as a later more traditional growth stage.