Differences Between Venture Capital and LBOs

The differences between venture capital investing and LBO investing are obvious to those in the business, but many outside the business are unclear about the distinctions. Here are eight differences:

1. Sources of Funds — When LBO firms bring money to the closing, it typically comes from at least two sources. First, the equity is provided by the LBO firm’s investors. In addition, senior debt is provided, most likely from a bank or commercial finance company. In many cases, there is a mezzanine layer of subordinated debt in addition to the senior debt and equity.Venture capital investments almost always have just one source of funds: the investors in the venture capital fund. Although such funds are often invested as convertible subordinated debentures, in reality this money has equity risk and demands equity returns. (Sometimes the portfolio company is able to use that equity cushion to raise some senior debt, but in most cases at best they are going to raise an asset based loan (based on accounts receivable and perhaps inventory) and perhaps lease some equipment.)
2. Uses of Funds — Venture capital is invested into the company. VCs go to great length to make certain that shareholders are not being cashed out. All or almost all of the funds in a buyout are distributed to shareholders.
3. Maturity of Business — LBO firms almost always acquire mature business with excess cash flow. Venture capitalists invest in business that are much earlier in their life cycle; many VCs, for example, invest in start-ups.
4. Technology Focus — Although many venture capitalists are willing to consider investing in non-technology businesses, the fact is that almost all venture capital investments are in high technology companies. In order to generate the high returns VCs require, a potential company must offer the possibility of very high growth and a high exit multiple. Few non-technology businesses offer such potential. LBO firms, on the other hand, rarely invest in high technology companies, due to their high business risk. Combining high business risk with high financial risk (i.e., a leveraged balance sheet) is very risky. LBO firms acquire no-technology and low-technology companies. Some, like Kensington, will acquire medium-technology companies.
5. Profitability — LBO firms usually acquire companies with excess cash flow that need little or no capital for expansion. Venture capitalists almost always invest in companies with negative cash flow and which need capital for expansion (even if such companies are reporting accounting profits); otherwise, why would the company be raising venture capital?
6. Participating With Other Firms — Venture capitalists typically invest only in deals where other VC firms have also agreed to invest. A typical proposal to an entrepreneur is: “You need $4 million to start. I’ll give you $1.5 million, and you have to raise the other $2.5 million from at least two other venture capital firms.” The VCs want other VC firms to invest in order to obtain a second opinion on the desirability of the investment, and to share risk. Buyout firms rarely share deals with other buyout firms.
7. Emphasis on Management — VC and buyout firms are extremely concerned about the quality of the management team, but VCs are even more focused on this than buyout firms are. For a VC, an idea is just an idea; what really matters is who is going to execute. For a VC, the management team is usually the most important factor in whether to invest. General Doriot (who founded American Research & Development) said: “I much prefer Grade A men with grade B ideas than vice versa.” Buyout firms also care about management, but typically look first at the business. Many buyout firms are willing to consider purchasing companies where the owner/manager will leave a year after closing, figuring they can find a replacement manager. Some buyout firms, such as Kensington, have several partners with substantial CEO experience who can run an acquired company for the first year.
8. Control — VCs are less focused on control (defined as choosing the Board of Directors) than buyout firms are. VCs figure if the management team has to be replaced, the investment is probably worthless. Buyout firms almost always insist on control of the Board of Directors and the right to replace management if things are not working out. VC typically have negative control over majority decision through covenants that are included in the Investment Agreement. Buyout firms typically don’t have such covenants because they know they are going to control the Board of Directors anyway, so they don’t need the contractual protection.

Read James’ essay on how to write your own LBO model.

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Cite as “Differences Between Venture Capital and LBOs ” by James Mitchell. May 14, 2009, version 1.1. www.jmitchell.me/essays/differences-between-venture-capital-lbos.