What Is Growth Equity? (With Definition, Pros, Cons And FAQs)
By Indeed Editorial Team
Published 11 May 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Most businesses may require external investment to expand their operations and accelerate growth. These investments can take different forms, like debt or equity, and each approach has its unique benefit. Learning about the importance of growth equity can help you understand how this type of investment can help businesses grow. In this article, we answer the question 'What is growth equity?', describe how it works, discuss how it differs from venture capitalism, private equity and leveraged buyouts, answer some common questions about growth equity and discuss its pros and cons.
What is growth equity?
Knowing the answer to 'What is growth equity?' can help you understand why it is crucial for business growth. Growth equity is a type of expansion capital investment made in late-stage companies through minority stakes like preferred stock. Investors make such types of capital investments in companies that have already found a product-market fit and are looking for new opportunities to expand and scale.
Growth equity investors typically enter right before the pre-profitability stages of a company's life cycle and can exit when there are slight indications of profitability. Growth investments usually have shorter holding periods, relatively moderate risks and greater returns.
How does growth equity work?
Growth equity investments serve to further the expansion and increase profits of companies that are already on a path towards profitability. It does so by subsidising the way in which a company carries out business operations and acquires customers, which positively influences the company's bottom line.
Expansion capital through growth equity typically allows companies to enter newer markets and make customer acquisitions through repeatable, efficient and scalable marketing practices. Late-stage investments can also help companies improve the allocation of capital and exploit unrealised growth opportunities due to lack of access or expertise. Companies can also use these funds to change the balance sheet structure and reduce the debt capital. The investors of growth equity earn a profit by leveraging the expansion potential of late-stage companies with moderate risk.
How is growth equity different from venture capitalism?
Here are some prominent differences between growth equity and venture capitalism:
Company life cycle: Venture capital is usually part of the earlier stages of a company's life cycle, whereas the requirement for growth equity comes in a company's later growth stages. This is because venture capitalists are concerned with top-line revenue expansion and not profits, whereas growth equity investors seek to increase profit margins while scaling up the business.
Holding period: The holding period of venture capital investments is typically longer, usually between five and 10 years, instead of growth equity, where the holding period typically varies between four to seven years. This is because establishing a company, finding product-marketing fit and acquiring customers requires more time in the nascent stage than expanding the scale of business.
Debt and risk: Venture capital rarely deals with debt or usage of leverage at all, whereas there can be a minimal amount of the same in growth equity investments. Similarly, venture capital usually has high levels of risk, while growth equity usually has moderate risk exposure.
How is growth equity different from private equity?
Growth equity is a subset of private equity, but there are clear differences with respect to the way investors approach the two:
Purpose: The clear purpose associated with growth equity investments is to leverage new opportunities and aid business expansion. While growth is also often on the agenda for private equity investors, there is no specific business area that gets more emphasis.
Stake: Growth equity typically takes the form of minority stakes like preferred stock. In contrast, private equity does not have stake limitations and can involve acquiring entire companies.
Risk**:** Investors usually consider private equity less risky as these investments take place in companies that show consistent profitability, exploit growth opportunities and have robust business practices. Growth equity investments are riskier since there is some level of uncertainty associated with whether companies can achieve growth targets or not.
How is growth equity different from leveraged buyouts?
Here are some differences between growth equity and leveraged buyouts:
Debt: Leveraged buyouts typically deal in debt investments, while growth equity investments take the form of minority investments.
Holding period: The holding periods associated with leveraged buyouts are usually shorter, between three and six years. In contrast, the holding period for growth equity can be from four to seven years.
Purpose: Leveraged buyouts occur when companies have matured and shown stable profit margins, and the focus is on deleveraging or the repayment of debt used to finance the investment. In contrast, growth equity investors bet on the unrealised growth potential of companies to get a high return on investment.
Pros and cons of growth equity
Here are the advantages and disadvantages of growth equity:
Pros of growth equity
Using growth equity to raise funds and investments can benefit businesses and investors in several ways:
Growth equity allows companies to eliminate operational inefficiencies. A crucial way that growth equity investments help the expansion of companies is by following clear and established business operation best practices. This is essential for any business to exploit growth potential and grow sustainably.
Growth equity offers lower risk. Growth capital enters at the middle stages of a company's life cycle. For the same reasons, they are neither too high nor low in risk compared to other forms of corporate investment, such as venture capitalism.
Growth equity can widen profit margins beyond growth forecasts. An essential component of growth equity is that it allows companies to realise growth potential that is otherwise unachievable. Apart from capital investments, growth equity can also give companies access to industry expertise and guidance.
Cons of growth equity
Here are some prominent disadvantages of using growth equity for investment purposes:
Growth equity investments are minor stakes. Although growth equity investments take place through preferred stock, the value of these investments is generally small. This implies that growth investors have little control over the decision-making in the company.
Growth equity investments require rigorous research. Since growth equity aims to leverage unrealised growth potential, there has to be adequate research to support this claim. This can be expensive and time-consuming for investors and growth equity firms.
Attracting investors to growth equity can be challenging. Investors tend to prefer other options given the minority stake and lesser opportunity to change business processes or product features in growth equity. From a business perspective, it can be challenging to convince investors to provide growth equity with a limited contribution in how to use the capital.
Frequently asked questions about growth equity
Here are the answers to some commonly asked questions about growth equity:
What do growth equity firms do?
Growth equity firms identify minority stakes investment opportunities in companies with a robust business model or plan and significant growth potential. They also usually have expertise in research and data collection to verify the claims made by these companies. Growth equity firms help investors allocate funds for specific expansion strategies or plans in companies with prospects of high returns.
Why do growth equity investors exit early and have short holding periods?
Growth equity holding periods are relatively small because such types of investments focus on specific and short-term expansion strategies or plans. Once this ‘growth potential' actualises, growth equity investors typically exit. Such strategies take shorter periods of time, such as four to seven years, to show results.
What are the characteristics of an ideal company that growth equity investors want to invest in?
Ideal companies for growth equity investors are businesses that have already seen validation of product-market fit and have a strong business model with a regular flow of revenue. These companies also usually show indications of future profitability. It is also essential for the company to have identified an appropriate target audience, create customer profiles and have a strong marketing campaign for customer acquisition.
What operational factors can a growth equity investor influence to ensure positive returns?
Growth equity investors try to ensure positive outcomes from their investment by conducting comprehensive research and having a good understanding and partnership with the company management. Most investors make such investments through dedicated financial firms that verify the financial health of the company. Investors can also provide valuable resources apart from the capital by way of access to industry networks and guidance from top leaders to ensure success.
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