The stock market is an important source of funding for many companies, but it's far from the only one. Especially for small and medium-sized companies that aren't yet large enough to go public, working with private-equity firms or venture capital firms can often be a good alternative to going through an initial public offering. Venture capital firms focus on start-ups, investing in companies that they see having maximum growth potential. Private-equity firms have a broader universe of investments to choose from, often taking full control of target companies to capitalize on the difference between the market's assessment of their value and the value the private-equity firm sees in businesses. The net result is the same: to help foster companies in a way that makes them grow and produce profit for the investors in the private-equity or venture capital firm itself.

How private equity works

At its most basic level, a private-equity investment is any investment in a privately held company. That makes all venture capital firms also private-equity firms. However, private equity encompasses a much larger set of companies than just the start-ups that are venture capital firms' focus.

Private-equity firms raise capital by creating investment pools and soliciting qualified investors to buy into private-equity funds. Those funds then seek to buy promising companies, taking them private and then working to unlock undiscovered value in their underlying businesses. After spending enough time to unlock the businesses' value, the private-equity fund will often sell off their stakes, either by taking the company public or by making a private sale to another private-equity firm.

Private equity airport sign.

Image source: Getty Images.

Private-equity deals are often highly leveraged in order to minimize the amount of capital that the private-equity firm has to raise. These leveraged buyouts can be risky, but they also tend to maximize the potential reward when deals go well. The challenge for private-equity firms is figuring out the right strategy to reshape privately held companies in an effort to give them greater success in their respective industries. Unlike publicly traded companies, which have to be accountable to their shareholders quarter after quarter, private-equity firms can take a longer-term view toward reinventing their holdings, and that can lead to enhanced returns when they're successful.

How venture capital works

Venture capital focuses on getting start-ups the funding they need to get off the ground. Typically, venture capital firms provide financing to new companies in exchange for equity stakes, either directly through shares or indirectly through special securities like convertible bonds or a combination of debt and warrants to purchase equity at a future date. Because many start-up businesses fail, the ones that succeed have to produce enough profit to make up for all the losses from the failures.

Once a venture capital firm takes a stake in a start-up company, it works together with the company's founders to drive the business forward. The leaders of the venture capital firm provide both money and other valuable assets like contacts, industry expertise, and reputation. Multiple rounds of venture capital funding can occur over time; some firms specialize in early-stage start-ups, while others prefer to wait for a proof of concept and invest at later stages in the process.

As with private-equity firms, the exit strategy for venture capital firms involves an eventual sale of their stake in their companies. That can happen either through an IPO or through a private sale of the business, and the best-known success stories in the venture capital world become the hot stocks of the market years down the road.

High risk, high reward

Venture capital and private-equity investments are different, but they have one thing in common: They are high-risk ventures with potentially huge returns. Only those who can afford to lose everything should look more closely at venture capital and private equity as an option for their portfolios.

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