The development of a private equity or venture capital roadmap begins when the developer or entrepreneur realizes that he needs to be funded by external investors to support the expansion or transformation of his firm or project. Therefore, equity investment provides a firm or developer’s financial needs or the finances to create a project or enterprise.
What is the difference between corporate finance and private equity finance (or entrepreneurial finance)? This is a very interesting question an is addressed from a different perspective in the previous post. The question therefore can be answered in two different ways: institutionally and environmentally.
Corporate finance which is the most traditional way to fund projects or firms. Is more standardized, less flexible, and focused on debt. Expected returns are lower and linked to the costs that financial institutions incur while collecting money from savers. The reference point for the valuation (i.e., costs, feasibility, etc.) is the whole company, independent of sources. Another interesting point is the financial institution’s unwillingness to participate in the company’s or project’s decision structure.
The institutional approach, even though it is able to distinguish between corporate and entrepreneurial finance, does not consider the environment companies face when they contemplate private equity as a finance option. The environment approach does consider the environment and the situation faced by entrepreneurs during the financial selection process. Some aspects of the environmental approach are the same as the institutional approach, whereas some aspects better explain the consequences of entrepreneurial finance.
The elements in the following list distinguish private equity finance from corporate finance using the environmental approach
- Interdependence between investment and finance decision
- Managerial involvement of outside investors
- Information problem and contract design
- Value to the entrepreneur
- Legal and fiscal ad hoc rules
With the institutional approach, private equity financing does not fund the whole company. In this scheme of financial and non-financial support, a specific project the entrepreneur needs to finance is targeted. Because of this, a strong and effective interdependence between the firm’s investment and financing must exist and must continue during the entire length of the deal.
Private equity operators and venture capitalists provide financial and non-financial sources. This generates the involvement of third parties (external investors) in the decision process and/or company management. It must be emphasized that only in private equity finance is there a decisive participation in the firm’s administration.
The third issue seen in the environmental approach is that private equity operators support firms on risky projects. This increases conventional information problem occurring in all firm financing schemes. These problems lead to a lack of standardized agreements, so a special settlement is design for every funded project.
The special legal and fiscal framework for the investor and/or vehicle used to realize the deal is the last factor that sets private equity finance apart from venture capital. It is quite common throughout the private equity industry, because it simultaneously acts as entrepreneur/shareholder and financier, needs special treatment regarding exits, valuation, taxes and legal framework to develop and carry out investments.
Characteristic drivers in a company’s or developer’s life cycle stage
Firms need funding during revenue development, which occurs during different stages of for each project or company. The drivers that measure the venture’s need for funding are investment, profitability, cash flow and revenue growth. These four variables are strictly linked together, and should be evaluatedform a long term perspective. These four variables/drivers represent the stage the firm is in, which helps financiers define their strategy.
- Start up
- Early growth
- Rapid growth
- Mature age
- Crisis and decline.
These stages impact the four drivers – investment, profitability, cash flow and revenue growth – used when analyzing financial needs and equity capital demand of a firm as can be seen in the table above.