Scale-Stage Entrepreneurs Increasingly Must Navigate Both Venture Capital and Private Equity Expectations

‍Challenging Funding Markets Precipitating a Change in Growth Strategy

To put it mildly, the last few years have been challenging ones for both the venture capital and private equity funding markets. Companies that raised capital in 2020 and 2021 often did so at a favorable valuation, and with the expectation that they could tap additional rounds of funding a year or so down the line. As we have all discovered, that has not necessarily been the case.

With capital markets functionally closed for two years, investor expectations have changed, forcing many entrepreneurs to make tough choices on how to continue to grow their business. In this environment, the strategy of ‘growth at any cost’ has evolved to one focused on cash burn discipline, and EBITDA growth. While this makes business sense, it can actually be a fairly disruptive shift in strategy for companies undergoing rapid growth and needing capital to do so.

Many entrepreneurs feel that they have been unwittingly pushed from a venture capital philosophy into a private equity one. While this shift in strategy can present a challenge, the truth is that the distinction between venture capital and private equity has been blurring at the scale-stage for more than a decade now, and will likely get even blurrier as we rebound from the current lull in funding.

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The Blurring Line Between Venture Capital and Private Equity

Scale-stage entrepreneurs always need to keep an eye on the funding horizon, engaging and building relationships with the appropriate investor community for the next stage of growth. In the past, if a company was backed by venture capital, keeping an eye on the horizon primarily meant knowing which venture funds could write a larger check for the next round of growth.

While that can still be true, the investment community has become much more complex. For decades, venture capital and private equity investors each had their own lane. Rarely did those two meet. Not so anymore. In many sectors - notably tech - the distinction between private equity and venture capital has blurred, and in some cases, no longer exists. Case in point, Pitchbook reported that “In 2020, PE firms participated in more than 800 VC transactions worth a combined $48.3 billion in the US”.

Those numbers have likely decreased in the last few years as interest rates skyrocketed, and capital deployment pulled back significantly. However, as we work our way out of the current market correction, expect the trend of private equity mingling with venture capital at the scale-stage to only increase.

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Institutional Investors Seeking Scale-Stage Returns Have Altered the Funding Landscape

Private equity and venture capital have both always been a part of the investment landscape. However, they traditionally resided at different ends of the spectrum. Venture capital played in the startup and early-stage sandbox. While private equity limited its attention to more mature companies - primarily in the lower-middle market/middle market space.

However, over the last two decades, both investor categories have experienced a generational ‘explosion’ in capital. Large institutional investors such as pension funds, endowments, sovereign wealth funds, and large family offices have increasingly come to believe that they can drive more investment alpha by holding on longer to private companies that are experiencing rapid scale. They simply could not ignore the outsized portfolio returns that companies at this stage of growth could provide. Therefore, over time, these global institutions have steadily increased their exposure to this stage of the market.

“VC-backed companies are staying private for longer before conducting an IPO or finding another path to exit. This has led to an overall increase in the number of companies seeking to raise late-stage fundings, deals that can often closely resemble the growth-stage financings with which many PE firms are already more familiar”

— PITCHBOOK

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Scale-Stage Companies Can Now Opt to Stay Private Much Longer

The end result of this significant shift in institutional asset allocation is not surprising. The venture capital and private equity communities simply followed the money, and gave these large institutional players more opportunities to invest at the scale stage. Gone are the days of companies going public within three to five years of their founding. Companies now regularly remain in private hands (private equity and venture capital) for eight to ten years before they debut in the public markets. That is if they ever go public at all.

With access to larger pools of private capital, leaders of scale-stage companies now have the opportunity to completely fund their growth without having to tap the public equity markets. Two decades ago, the only place an entrepreneur could credibly raise a capital round of $50M to $100M was via an initial public offering. While that was a viable option, it came with great cost and regulatory complexity. Now, scale-stage companies can easily raise those amounts in a Series A or B round - at far lower cost and hassle.

These changes may sound small and insignificant, but they have caused disruptive ripple effects throughout global capital markets. Taken together, these behavioral changes continue to drive ever larger amounts of capital out of public stock markets and into private markets. The lasting effects of this shift from public to private markets are unlikely to reverse any time in the near future, regardless of other macro factors such as interest rate levels.

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Understanding and Engaging the Entire Capital Ecosystem is Now More Important Than Ever

In down markets like the one we have recently experienced, it is always a challenge to separate short-term fluctuations from longer-term trends. Without question, the recent short-term move has been away from private market funding. However, large institutional investors will continue to need access to the outsized returns that only rapidly-scaling companies can provide. Therefore, don’t be too surprised if the longer-term trend of higher allocations to privately-held, scale-stage companies increases. In other words, expect the line delineating venture capital from private equity only to blur further.

If you are a scale-stage entrepreneur, chances are that your company will remain private for nearly ten years or more. In the past, many entrepreneurs were able to grow their business without ever having to meet with or engage the private equity community. That is no longer the case. Today, entrepreneurs must understand that it will be vital to engage a more diverse set of private market investors, including larger portions of the private equity community.

While private equity and venture capital are now meeting more at the scale-stage, they still often have very different return expectations. The challenge is that this new dynamic will require every entrepreneur to have a greater understanding of the differing set of needs and expectations, unique to each investor group. This will undoubtedly lead to a level of disruption and discomfort.

However, the good news is that if you are able to do that successfully, your company will have access to a far larger pool of capital that can fund your company’s future growth.

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@ Copyright September 2024. Marc Patterson. All Rights Reserved.

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