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Overview of Venture Capital and Private Equity

So what exactly is venture capital and private equity? Venture capital and private equity are, in the most general terms, organizations that take in money from investors (pension funds, governments, insurance companies, wealthy individuals) and use that money to buy equity stakes in privately held companies. Venture capitalists typically invest in companies early in their life cycle, oftentimes even before the company has any substantial revenues, while leveraged buyout/private equity firms generally invest in companies that have a proven product and operating cash flows. Venture Capital While venture capital and private equity are similar, they do have some major differences. Venture capitalists generally invest in companies with no track record, while private equity firms tend to invest in mature businesses with positive cash flow. According to Michael Gorman (HBS ’94), a General Partner with St. Paul Venture Capital, “The typical venture-backed early-stage company often times has no revenue, no proven product, no proven management team, no clearly defined market statistics, and no realistic financial projections.” Venture capitalists must incorporate all of these risks into their investment decisions. Since venture capitalists tend to invest in companies with little or no internal infrastructure, they need to be actively involved in the operations of their portfolio companies, both at the board and management levels. This involvement typically includes helping a portfolio company recruit experienced managers and define its strategic vision. Due to the fact that venture capitalists tend to invest in companies with little operating history, there is not much need for significant company specific due diligence or complex financial modeling. As a result, venture capital firms typically look to hire professionals who have significant operating and industry experience and who can provide specific guidance to the management teams of their portfolio companies. Private Equity Private equity or leveraged buyout (LBO) firms are similar in some ways to venture capitalists in that they make equity investments in privately held companies. However, private equity firms differ in that they typically invest in more stable and mature companies with a proven product or service offering and a successful track record. Private equity investors generally look to invest in businesses with positive cash flow that can support a high degree of financial leverage (i.e. a high debt to equity ratio). By financing part of the investment with equity and the remainder with debt, private equity investors are able to leverage their equity investments to achieve high returns on capital. The average LBO in the late 1980’s was structured with approximately 90% debt and only 10% equity. Today, however, the average LBO transaction is capitalized with approximately 70% debt and 30% equity. Given the nature of investing in the private equity industry, financial modeling and company specific due diligence are extremely important aspects of the deal. Consequently, firms in this industry look to hire individuals with strong quantitative backgrounds. Life as an Associate A typical associate at a venture capital firm is responsible for performing industry research, searching for new deals, reviewing incoming business plans, working with the management team of existing portfolio companies, and performing due diligence. Associates in private equity can expect to perform similar duties to associates in venture capital. Their time will be allocated differently, however, in that they will probably spend more time performing financial modeling and due diligence tasks and less time searching for new deals as the typical private equity firm sources deals through its relationships with investment banks, among others.

December 3, 2001
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