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January 12, 2017

The Difference Between Venture Capital and Private Equity

A Whole New Ballgame

Once NG Advantage LLC, our compressed natural gas trucking business, started to grow, we needed a lot more capital. Moving into a new region requires at least a $5 million investment to build a station to compress gas from a pipeline into the trailers which deliver it to customers. Adding even one new customer can require a million dollars or more in new trailers and equipment. Even though we were EBITA-positive, we were still new so banks still couldn’t lend to us because of Dodd-Frank (thank you, Senators Dodd and Frank). We could now borrow from non-banks (at high rates) but we still needed cash for down payments on all this equipment.

So we had to sell some equity. “Been there, done that,” I thought. Knew we were too small to go public but didn’t know what I didn’t know. Last time I ran a pre-IPO startup we raised money from venture capitalists (VCs). I quickly learned that VCs don’t do investments as big as we needed, in fact don’t do capital intensive businesses at all. It’s private equity firms, which tend to have much bigger pools of money than VCs, who provide early stage financing for businesses like ours. Just like VCs, I thought, but more zeroes on the check.

Because I didn’t know any private equity firms, we hired an investment banker to manage the process. Together we did a five-year plan (as if anyone knows what’s going to happen in five years). We put together the “book” which described our successes, our market, our competitors, and our plan. Anyone could plainly see they’d make a lot of money by investing in us.

The investment bankers shopped a teaser to private equity firms and lined up thirty of them for us to present to in New York City during a three-day period. It was intense although not as intense as the IPO road show I’d done fifteen years before. At least I didn’t have to travel somewhere new every night although we did walk around midtown New York. I got sick of the sound of my voice making the same pitch ten times a day but answering questions was fun. The bankers were gentle when they pointed out after the first presentation one morning that I was somehow wearing one brown shoe and one black one.

About ten firms had enough interest to come up to Vermont to see our first compressor station and meet the team. One snowy day, a delegation’s return flight was delayed for a few hours so we took them to dinner near the airport.

“What’s the downside risk?” one of the partners from the investment firm asked me.

“What do you mean?” I asked, surprised by the question.

“I mean, in the worst case, what would happen to our investment?” he asked surprised that I was surprised by the question.

“Well, we’re a startup. You could lose all of your investment,” I said. trying not to sound like I thought I was talking to an idiot. The conversation abruptly switched to sports.

“Why did he ask me that question?” I asked our investment bankers once the private equity guys were gone.

“He wanted to know the answer.”

“No venture capitalist ever asked me that and I’ve talked to hundreds of them. They understand that most startups fail. That’s obvious.”

“You don’t understand the difference between venture capital and private equity,” the banker said.

“That’s obvious, too,” I said. “Please tell me.”

“Venture capitalists do well if they have a batter’s average; private equity needs a fielder’s average.” [note to anyone who didn’t grow up with baseball statistics: players do well when they get a hit more than 30% of the time they bat (.300 average in baseball talk); in the field they are playing poorly if they make an error more than 5% of the time they are involved in a play (.950 average).]

Venture capitalists make a large number of small bets relative to the size of the fund they are investing. If five of them are complete losses, four of them return the investment money, one returns 5 times the investment money, and one returns twenty times or more, the fund is a success from investors’ PoV. This, of course, is what I was used to. It’s why VCs don’t look at investments that don’t have huge potential returns. They only need a few winners but they need them to be big. They swing for the fences, to go back to baseball talk.

Private equity firms make relatively few investments from each fund but each investment is big. If one of them goes down the tubes, ALL of the rest have to do very well in order for the fund to perform reasonably. The capital-intensive companies which private equity firms invest in don’t have products that “go viral” like software or social media. If they grow (like NG Advantage) they require even more capital. When they go public, it is not an astronomical multiple of the early investment. If they fail to make it big, the hope is that they can sell assets or themselves and that the investors will break even or avoid losses.

Lesson learned. We did raise the capital we needed but that’s another story for another day.

For much more on the difference between venture capital and private equity firms, see What VC Can Learn From Private Equity by my friend and super-VC Fred Wilson (aka @AVC). If you are a CEO or CFO talking to both types of firm, you really want to read Fred's post.

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