15. Difference between growth equity and venture capital
I speak with a lot of software company founders, and one of the most common misunderstandings for folks looking to raise money is the type of investor they should raise from. Most people have heard of venture capital, but not many know about growth equity. Should they look into that?
To be clear, this problem doesn’t apply to everyone. On one side of the spectrum, there are software companies that were built for venture capital. These are often founded by highly ambitious and intense people who previously worked at VC-backed businesses. They have a clear vision to raise several rounds of capital and not stop until they’ve gone public.
On the other side of the spectrum are companies that have never considered venture capital. These software businesses were often founded by a person or two solving a problem for a small number of customers. Often the company takes years (or decades) to grow into something much larger, but once it’s there, the founders and employees own the whole thing. The end of this game usually looks like selling the whole company to private equity.
But what about in the middle? What about companies that aren’t on the venture path but don’t want to give up control of their company?
This is where growth equity comes in.
Growth equity is a form of financing that looks sort of like private equity and sort of like venture capital. It’s like venture capital because growth equity investors typically take a minority stake in the business (10-40%). But it looks like private equity in that they invest in profitable, mid-growth, often years-in-the-making companies. A few examples of growth equity investors are JMI Equity, Spectrum Equity, and Level Equity, though there are literally hundreds of these kinds of funds.
Even though they are both minority investors, the distinctions between growth equity and venture capital can be fuzzy.
Part of this is definitional. A venture capitalist might tell you they are giving you “growth capital”, and a growth equity investor might call themselves a “software investor”. Neither of these things is wrong, per se.
Another part of the confusion is how they act. Sometimes growth equity investors will invest in companies that have raised lots of money before. Or they invest in companies that are on track to become a billion dollar company. Even worse, sometimes a brand name (like Vista Equity Partners, or Insight Partners) might have multiple funds with different strategies or sizes. Or a single fund might have a lot of flexibility in the types of investments they make.
If you’re confused, you’re not alone. This whole thing is kinda like asking if Lightning McQueen should buy life insurance or car insurance.
So why does this all matter? Because taking the wrong capital can really screw up your business, and taking the right capital can really accelerate it.
Taking venture capital can often be the wrong move. Venture capitalists make their returns based on a power law. Most of their investments go to zero, but their winners are BIG winners and carry the rest of the portfolio. This means that if they invest in your company, they won’t be thrilled about getting 1-3x return on their money. It doesn’t make sense for their portfolio. They need 100-1000x
Growth equity is different. In their portfolio, they don’t want any of their companies to go to zero. Most of them try to find companies that will have a reasonable chance to return 3-5x in a few years (with a small possibility of generating a much higher outcome).
Growth equity can earn this return because of the types of companies they focus on.
Here’s a typical growth equity profile: a company started in 2013 that sells software to event management departments of large enterprises (think the software to manage user group events and company offsites). The software might build and track attendee lists, pre-event communication, event logistics, a mobile app for speaker lists, and payment processing technology for the tickets. Maybe it’s doing $15m in annual recurring revenue (ARR) and growing 35% per year. It’s profitable. The only outside capital they’ve raised was $1.5m from the founders when they started the business.
Growth equity would be a perfect fit here. They would like this business for the following reasons:
It’s a software business that should have recurring revenue and high gross margins.
The company isn’t too small ($15m in ARR).
It’s in a large market with plenty of room to expand.
The company is profitable.
The company is growing 35% per year.
The CEO and other key executives are capable and excited to keep running the business.
The biggest bottleneck for further growth is A) capital, B) board member-level expertise, C) customer introductions, or D) all of the above.
A growth equity investor might invest $20m. Half of this investment might be sold to existing shareholders to take chips off the tables as secondary. The other half would be added to the balance sheet to grow the company. The fund might now own 25% ownership of the business and have 1-3 board seats. They would try to help you take the business to, say $60m in ARR in a few years and sell the business to a private equity fund.
Growth equity has been quite profitable, and the amount of funds has expanded recently. This also means the types of companies eligible for growth equity has expanded, too. I know several funds that will invest in companies as small as $3m in ARR and as large as several hundred in ARR. They’ve expanded sector focus, too. It’s not just software (though that is the most popular), but healthcare, tech-enabled business services and a few other high-growth categories.
If you run a business that looks like our example here, growth equity might just be the right option for you.