Core to the traditional model of Venture Capital (VC) is the assumption that, through investment in a large number of disparate, disruptive technologies, losses can be limited to the initial investment, while gains can be ridden out and, ultimately, the significance of the winners will far outweigh the losers. By their nature, VCs are looking for a big win on some and cutting losses of most. Accordingly, their investment timeframe is typically shorter. The model is built on momentum in the broader market generated by demand for more, newer ways to do things, thus requiring rapid adoption of disruptive technology by consumers (read: willingness to accept risk). This entire cycle, from inception to completion, is based on the broad willingness to assume larger risk positions. From inventor to consumer, demand for risk tends to be higher.
Private Equity investments tend to concentrate more on going concerns in established markets that may be in a down cycle, or depressed state. They are based on longer investment cycles that align with the business’s strategic objectives. Because of these characteristics, the focus tends to be on maintaining and building behind existing management structures, multiple investments in similar sectors, and a more balanced combination of financial fundamentals and growth, as opposed to purely explosive growth. The strategy tends to embrace fewer opportunities with larger investments and results in more of a "buy and hold" philosophy.
The recent collapse of capital markets, stock indices globally, and massive contraction in consumer spending all decidedly represent a cycle favoring healthy fundamentals, longer investment cycles, and a more guarded approach to risk (note the historically high volatility levels). The price-earnings ratio will tend to rule the roost in this environment, on both the supply and the demand side. Given the outlook for a slow, grinding bottom to this recovery, disruptive technologies are going to take a back seat to clean, solid, healthy technologies that represent lower risk for the purchasing agent and consumer.
As with many things in life, one size certainly doesn’t fit all. A company’s funding strategy needs to take into account many things, including its stage of development, target market, customer adoption, balance sheet, and cash flow, among others. For startups, especially technology companies focused on innovation, venture capital funding is the way to go.
Venture Capitals make money by investing in companies poised for growth and striving to fill unmet needs with innovative products and solutions. They often start working with an entrepreneur at the business plan stage, nurturing along promising technology or ideas and putting the right management team in place to scale the business. VCs continue to invest in promising companies and manage their risk by making additional funding contingent on specific milestones. This also is highly motivating and provides discipline to the management team.
Private equity firms, by contrast, make money through financial engineering and generally participate at a much more mature stage of a company’s development cycle. Investment is often accompanied by leverage to increase returns and provide strict discipline for the management team.
In times of economic trouble, lending slows, thus contracting private equity firms’ ability to invest; good VCs invest throughout the cycles. Further, companies with excessive leverage can’t fund growth as much because they tend to hoard cash to service debt—this doesn’t serve the needs of a growth-oriented entrepreneur.
Many tremendous success stories started with VC funding—including Google (GOOG), Apple (AAPL), Microsoft (MSFT), and Amazon (AMZN)—and many started in down economic cycles. Sybase and CommerceOne, two successful companies I had the privilege to lead, both started and thrived with VC funding. No private equity firm would consider investing in such risky propositions. Smart investment from VC partners during those early, critical stages makes it all possible.
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