Venture capital provides financing for innovative companies, often generating enormous profits and serving as an engine for U.S. economic growth. But such investments come with formidable risk. Growth equity, a form of venture capital, aims to temper that risk by investing in a private start-up company’s last stretch before it goes public or sells itself. The lower risk entails lower profit.
Often the same private equity firms do both traditional venture-capital and growth-equity investing.
What is venture capital?
Venture-capital funds finance young, private companies that the VCs hope will prosper.
VCs and their limited partners, as well as their growth equity counterparts, harvest profits in one of two ways: when the startup is bought by an established company or when the VC sells shares on the public market after the startup does an initial public offering, or IPO. Prominent traditional VC firms include Kleiner Perkins, Silver Lake Partners, Union Square Ventures and Sequoia Capital.
What keeps the money flowing into venture capital is the prospect of huge returns. In 2007, Union Square Ventures (USV) invested less than $5 million in Twitter’s series A funding round. Others steered clear, wary of the social messaging company’s ability to monetize the service.
USV later participated in some, but not all, funding rounds. When Twitter raised $1.8 billion in its 2013 IPO, earning a $14.2 billion valuation, that series A round was worth $863 million, generating a gain of 17,160% on USV’s investment, or an increase of about 136% annualized.
The stages of VC investing
The traditional VC funding route follows a road map of successive rounds of funding for the startup, labeled by the letters of the alphabet. They often are timed to coincide with following benchmarks in a startup’s development.
- Pre-seed or seed funding. This typically takes place as the start-up performs initial market research, drafts a business plan, and lays out its legal and ownership framework. Funding at this stage tends to come from company management itself, friends and families, and angel investors. In the past, traditional VC firms did not finance the earliest stages of a start-up’s life but that has evolved and many VCs now invest in such early stage companies.
- Series A funding. The startup is selling products and services, and generating revenue, though it’s losing money and needs more capital. Management should be able to articulate a pathway to profitability.
- Series B funding. This typically occurs when the startup, having demonstrated management skill, a viable business model and market demand, is expanding production or services. The business must prove its ability to scale.
- Series C funding. This round takes place when the young company is no longer really a startup, and has established a record of sales growth. It may expand product or service offerings, push into new markets and make acquisitions.
- Series D funding and beyond. Some companies may require additional financing, especially if growth hasn’t followed a smooth trajectory. That may entail series D or more funding.
Potential risks and benefits of venture capital
Venture capital comes with a number of potential risks and benefits, including:
- Low liquidity. It’s not easy for an institution to enter or exit a VC investment. A venture-capital fund typically has a lifespan of seven to 10 years from when it’s founded until it sunsets, distributing any profits, though sometimes gains may be disbursed along the way. During that time an investor’s money is locked up. Investors may unload their stakes in the fund to another investor, if covenants and stipulations permit.
- The potential for huge losses. There is a substantial risk of loss in individual VC investments because most startups fail, costing backers much or all of their money. The National Venture Capital Association estimates that 25% to 30% of all VC investments fail, while up to 40% only return their investors’ original capital. Another estimate puts the failure rate at 75%.
- The potential for huge returns. Some venture-capital firms have recognized huge returns from successes like Apple, Intel, and Amazon. Nevertheless, average overall returns are about the same as those in the stock market. Research firm Cambridge Associates calculated that U.S. venture-capital returns averaged 10.9% annualized for the 20-year span ended Sept. 30, 2021. That is only slightly more than the roughly 10% average annual historical return of the Standard & Poor’s 500 Index.
What is growth equity?
Growth-equity firms target companies that have already completed series A, B, and C funding rounds but may not want to do an IPO or sell to a buyer for any number of reasons—including volatile public markets or major business developments like a new product or acquisition.
Traditionally, VC-funded start-ups expect to be ready for an exit—a corporate sale or IPO—soon after a series C funding round. So when a company seeks to drum up more capital in a series D round, it may signal a problem—a strategy miscue, unexpected competition, or operating issues.
Series E, F, and even G rounds raise more eyebrows. A company’s need for additional funding may force it to sell shares at a lower valuation—a scenario known as a down round, which will entail further dilution for earlier investors.
But many later-stage investment rounds are not due to problems. Enter growth equity. Growth-equity investors generally target maturing start-ups that have these characteristics:
- Revenue growth. A growth-equity firm looks for demonstrable revenue growth in a start-up. With several financing rounds behind the company and an operating history, it should have several quarters or more of rising sales.
- Profitability path. It’s unlikely that the start-up is generating positive free cash flows at this stage, much less earnings, but negative profit margins should be narrowing.
- Market penetration. Whether the start-up provides products or services, it should be gaining market share, or show evidence that the market it is addressing is growing rapidly and is scalable.
- Growing customer base. The new company should have a growing roster of customers, hopefully deep-pocketed ones that can generate more sales.
- Product development. The start-up should be in the process of expanding its product or service offerings. Again, this bodes well for future sales—and profits.
Potential risks and benefits of growth equity
Many of the potential risks and benefits of growth equity are similar to venture capital, including:
- Potential for substantial profits. Growth equity has the potential to be highly profitable, although not to the same degree as traditional, earlier-stage venture capital investing. Growth equity investors target an internal rate of return of up to 40%, or about half that of other VCs.
- Potential for large losses. Though less risky than traditional VC investments, growth equity still carries the risk of substantial losses.
- Limited liquidity. Investors’ capital is generally tied up until a growth-equity firm unwinds the investments in a particular fund. The good news is that rather than seven or more years that traditional venture capital investments require, growth equity can be ready to return capital in three years or less.
Similarities and differences between venture capital and growth equity
Growth equity is part of venture capital and shares identical compensation, legal, and ownership structures with VC as a whole. There are several differences between the two, though.
How VC and growth equity are similar
The two investing styles have a number of similarities, including:
- The fund that invests. Many venture capital firms operate as both traditional and growth-equity investors. But some firms concentrate on the latter, including TPG, General Atlantic, TA Associates, and Technology Crossover Ventures.
- Potential for volatility. Growth-equity investments are generally lower risk than VC ones, but they can nevertheless be volatile. In 2018, Manhattan Venture Partners, a late stage-focused firm, was one of several investors including to invest in Coinbase’s series E funding round, which valued the cryptocurrency exchange at $36.19 a share. The shares closed at $328 on the first day of trading as a public company in April 2021. Amidst the tech stock bear market of 2022, Coinbase’s shares plummeted to less than $50 each.
How VC and growth equity are different
There are some critical difference between the two, including:
- Investment time frame. Growth equity has a shorter time frame between the initial investment and exit. That can be just two to three years versus seven to 10 years for traditional VC investments. For this reason, illiquidity is less of an issue for growth equity.
- What it funds. Unlike with early stage VC investments, in which investors are essentially financing company-wide initiatives, like operations, R&D, and compensation, growth equity tends to focus on financing particular initiatives. These efforts may include geographic expansion, acquisitions, new products or services, or sales force expansion.
- Riskiness. Growth equity is somewhat less risky than traditional VC. While traditional venture capital has a failure rate of 75%, according to one estimate, for growth equity the figure is believed to be lower, although there is little reliable data to verify that.
- Potential reward. Less risk also means less reward. Traditional VC aims for an internal rate of return (IRR) of 60% to 80%. By contrast, growth equity shoots for an IRR of 30% to 40%.
The bottom line
Traditional venture capital and growth equity play formative roles in the life cycles of important startups—from inception to growth to a sale or IPO. Some VC and growth-equity investments yield huge profits, yet most new companies struggle, and many don’t survive.
Growth equity carries lower risk than traditional VC investing because it usually targets more mature companies, often just before they do an IPO or sell to a corporate buyer. The lower risk also entails lower profit.