The overlooked strategy beating venture capital for growth

Most entrepreneurs assume the only way to fund serious growth is by raising venture capital. But that route isn’t the only option. For founders who can’t land a VC check or don’t want to give up equity in early rounds, partnering with private equity to acquire an already established business can move a company forward faster than building from scratch.

On today’s episode of Business Trends Today, George Deeb, Managing Partner at Red Rocket Ventures and author of 101 Startup Lessons: An Entrepreneur’s Handbook, joins us to break down why buying a business with private equity backing can outperform venture capital as a growth strategy, and what they need to understand about the tradeoffs before they pursue it.

Venture capital and private equity fund different stages of growth

Venture capital and private equity get lumped together, but they fund businesses at very different stages. Venture capital targets early-stage companies with limited cash flow that are trying to scale revenue as fast as possible. Private equity targets later-stage businesses already generating millions of dollars in cash flow, where the priority shifts from growth speed to cash flow scale.

"Owning a smaller piece of a bigger company could be worth more value than a bigger piece of a smaller company."

A failed VC pitch doesn’t mean a business is unfundable, according to Deeb. It usually means the founder pitched the wrong deal to the wrong investor. A private equity pitch is built around a high cash flow business the founder has already acquired or plans to roll up, not a low cash flow startup with growth potential, which can make it the easier pitch to land once a founder has the right target in hand.

Small companies can acquire much larger ones

Founders often assume acquisitions only flow one direction, from large companies down to smaller ones. Deeb said that assumption holds businesses back more than any lack of capital does. A common scenario involves a retiring CEO with no heirs who needs to sell for estate planning purposes and has no succession plan in place. The target doesn’t have to be a single acquisition, either, since founders can roll up several smaller businesses to reach the same goal.

Cash flow, not deal size, is what ultimately matters to a private equity firm. Businesses landing in the $3 million to $5 million cash flow range are generally well positioned to attract private equity interest, whether that comes from one acquisition or several combined.

Giving up more equity can still mean a bigger payout

Founders often hear that private equity demands a larger ownership stake than venture capital, and that’s typically true. Deeb said the size of the stake matters less than the size of the company behind it. Venture capital rounds usually cost a founder roughly 25% of the company with each raise, while private equity firms funding a $5 million cash flow acquisition might bring $30 million to $50 million in capital to the table and expect a meaningful stake in return.

That could leave a founder with just 20% of the business. But 20% of a much larger company can be worth significantly more than a majority stake in a smaller one built through multiple venture capital rounds, a tradeoff many founders overlook when they fixate on dilution instead of total company value.

Acquiring an established business means moving faster with less risk

Capital isn’t the only advantage an acquisition provides. There’s also speed, Deeb said.  Since a founder acquiring a business with $30 million in revenue gains in a single transaction what could otherwise take years to build organically.

"It isn't about where you are today, it's where you're gonna be in the future." 

An established acquisition also comes with existing sales relationships and brand credibility. The challenges that typically slow down a startup, proving the concept works and building a track record, carry far less weight when the business being acquired is already a proven player in its industry.

What private equity firms want to see before backing a deal

Private equity firms expect a level of preparation many founders underestimate. Running a $30 million revenue business requires a different skill set than running a $1 million revenue business, and founders need to be honest about whether they have it. If they don’t, private equity firms will want to see an experienced CEO or executive on the team who does.

Founders shouldn’t approach a private equity firm with a broad idea to roll up an industry and no groundwork done, he said. Instead, they should already have conversations underway with acquisition targets, know their revenue and cash flow figures, and understand whether sellers want cash or equity.

Founders fixated on venture capital as their only path to growth should widen the view, Deeb said. Mergers, acquisitions and roll-ups offer another route to the same outcome, often faster, as long as the founder understands the complexities involved and goes in with a well thought out plan.