Note: This article is part of a broader series on how to prepare for growth equity interviews
Growth equity definition
Growth equity is an investing style that involves purchasing significant minority ownership stakes (less than 50%) in privately-held companies that are experiencing rapid growth and have demonstrated traction with a viable business model.
Companies that take on growth equity investors usually have strong revenue growth and business momentum. Although not always, usually the funds from a growth equity investment round are used to fuel additional growth.
Though not every transaction follows this pattern, it can be instructive to think of growth equity investment rounds as being pre-IPO and post-venture capital. That said, this distinction has become less helpful in recent years as many traditional venture firms have raised large growth funds to participate in investment rounds that would otherwise be considered growth equity rounds (so-called “late-stage venture” rounds).
Growth equity investment criteria
Growth equity investments usually exhibit many, if not all, of these attributes:
- Significant revenue that is growing quickly (e.g. 30% or higher)
- Strong bias toward tech-enabled products and services, given high growth
- Proven business model (established offerings with customers)
- Positive (or near-positive) cash flow or profitability; usually, no further fundraising rounds or dilution are forecasted until after exit
- Owned and/or managed by founder(s)
- Usually, a purchase of a significant yet minority ownership position (less than 50%)
- Investment dollars are usually used to fuel growth, although it can also provide shareholder liquidity
- Do not involve use of significant leverage (debt)
- Growth (not leverage) is expected to drive investment returns
History of the term “growth equity”
Growth equity pioneers General Atlantic, TA Associates, and Summit Partners are often credited with popularizing the term “growth equity” to mean private investment rounds to provide expansion capital to companies.
In today’s environment, the term “growth equity” can be somewhat confusing because, for many, it is assumed to simply mean “private equity firms who are investing in the growth stage.”
In reality, given the ubiquity of technology and the attractiveness of growth stage returns, a diverse set of firms beyond just the traditional firms now invest at the growth stage. Therefore, the term had evolved to capture all investment activity at the growth stage.
How growth equity works
Most growth investors would agree that their primary job is “to identify the fastest growing markets and to invest in the best companies that are leaders in that space.”
While there are diverse philosophies among firms on how to best to do this, many growth equity funds would describe the ideal process as:
- Firm develops a “thesis” about why a market is attractive or poised for growth
- Firm becomes expert on this industry through research and meeting with companies
- Firm identifies the market-leading companies within that industry
- Firm invest in the best one
Of course, every process and every firm is different. The reality is that, given the competition within growth stage investing, many firms operate more opportunistically, frequently evaluating markets and prospective deals reactively after being notified by sell-side bankers.
How growth equity makes money
At the deal level, growth equity generates returns primarily through growth. Unlike private equity firms, they do not typically generate returns through leverage. Further, unlike value investors, they do not typically seek to make money through multiple expansion or pricing inefficiencies.
At the fund level, growth equity firms make money by investing the funds of limited partners and charging fees for doing so. Like other investment funds, growth funds charge a management fee (assessed as a percentage of assets under management — usually 2%) plus investment carry (assessed as a percentage of investment gains — usually 20%).
Which “stage” is growth equity
There are no strict cutoffs for which investment round (e.g. Series A, B, etc.) constitutes the “growth” round. Instead, it’s more instructive to think of any round as potentially qualifying as a growth round so long as it meets the characteristics laid out above.
Given that proviso, a given startup today would likely start to meet the “growth” qualifications above in the Series C or later. While this Series C cutoff is debatable, this is when many investors start looking to approach profitability while still taking on expansion capital.
That said, a company may have never taken any outside investment previously (so-called “bootstrap”), and still have reached a level of traction and de-risking to attract growth stage investors.
What makes a good growth equity investment
An attractive growth equity investment usually meets many or all of the core criteria of strong growth, minority stake, low debt, proven business model, and positive or near-positive profitability.
However, it’s important to remember that one factor is usually most important — growth. As the name implies, “growth” equity investments generate returns through growth. This means that the rate of revenue (or EBITDA) growth for any prospective deal is of utmost importance. There’s not usually a hard-and-fast rule, but many growth investment firms target companies that have a higher rate of growth than the fund’s return target (say, 25%+).
Every investor has his or her own framework for assessing companies. At General Atlantic — a top growth fund where I worked — a Managing Director once taught me his favorite mental model for what makes an attractive growth investment. It’s called the “3Ms”:
- Market – Large and growing market that provides strong tailwinds
- Business Model – Company has a strong business model that, once at scale, can provide durable margins and defensibility for the company
- Management – A visionary management team that will drive and execute against ambitious growth opportunities
Above provides a simple and easy framework to assess the key merits of growth equity investments quickly. Just note, however, these are just a few of the criteria. There are several other considerations one must take into account when actually determining the merit of a deal. For instance, here are a few more considerations related to the transaction itself:
- Competitive Deal Dynamics – Are there many firms competing to do this deal, or is the opportunity “proprietary” to your firm?
- Sector Fit – Does your company invest in companies within this industry?
- Investment Size & Ownership – How large of an investment is the firm looking for, and given your desired ownership stake, does this fit into your firm’s investment parameters?
- Governance – Is the company looking to add board seats as part of the transaction, and does your firm require this as a condition for investment?
- Firm Value Add – Can your firm provide expertise or services that will help the company with strategic initiatives (e.g. hiring, geographical expansion, etc.)?
Growth equity vs. private equity
Many ask: is growth equity “private equity”? Given the similarity in names, “growth equity” and “private equity” are often confused or conflated, and although they are both investment strategies, they are NOT the same and have many key differences.
Growth equity and private equity tend to invest in different stages of a company, with different transaction structures and level of operational involvement. Another factor that has increased the confusion is the fact that in recent years many large private equity firms have launched dedicated “growth” funds to compete within the growth investment stage.
While both invest large stakes in companies and have similar return expectations (~25% IRR or above), the differences between growth equity and private equity firms can be bucketed into these main areas:
- Company growth rate – Relative to growth equity, private equity firms target more mature companies, who tend to be older in lifespan and have slower growth
- Company profitability – Because they are in the growth stage, companies receiving growth equity investment tend to have low (or even negative) overall profit since they are investing in growth; private equity firms target companies with stable profitability and cash flow, so they can support debt repayment
- Investment in public companies – It is very rare that a growth equity investment would target a company that is already publicly-traded due to concerns among LPs; meanwhile, private equity firms regularly target publicly-traded companies for so-called “take private” transactions
- Ownership stake – Growth equity investments tend to be minority, non-controlling stakes (e.g. less than 50% ownership), whereas LBO buyout transactions of private equity firms involves a majority controlling stake
- Amount of debt used – Growth equity investments typically target companies with low or no debt, while leveraged buyout transactions of private equity firms require large amounts of debt financing (often a majority amount)
- Levers for influence – Given their minority stakes, most growth equity firms influence the company’s operations either by taking a seat(s) on the company’s board or by influencing management through unofficial channels; given their majority stakes, private equity firms often have total control over governance and management
- Degree of operational involvement – Given their minority stake, growth equity firms are limited in the amount of control they can exert on portfolio companies, while private equity firms tend to purchase a majority stakes so they can be much more involved; that said, this is not typically a problem for growth equity firms, since these investments target fast growing companies that are thriving already. Therefore, there is less need to take control and change the direction of the company, in order to generate returns.
Growth equity vs. venture capital
While both growth equity and traditional venture capital target rapidly growing businesses, they differ in several important respects.
Venture firms invest as early as the very beginning of a company’s development without any customers or proof of positive unit economics. Meanwhile, growth investment rounds typically occur after a company has proven its business models, established positive unit economics, and has a significant customer base. In this way, venture capital firms take “market” and “product” risk (will this work at all?), while growth investment firms take “management” or “execution” risk (can we scale what’s working?).
The return expectations also differ significantly between growth equity and venture capital. Given the high failure rate of companies at the early stage, venture investors seek investments that can “return their fund” (e.g. 50-100x return). Meanwhile, growth stage investments do not fail with the same frequency and most firms target a more normal return of 3-5x. See more resources in my blog to learn more.
Growth equity vs. late-stage venture capital
Whereas the difference between growth equity and traditional venture capital is relatively easy to define, the difference between growth equity and venture capital is more subtle and less obvious.
Indeed, the two types of investments seemingly have lots in common. They both involve taking minority stakes in high growth, relatively young private companies. Both investment styles aim to generate their returns from growth.
In practice, “growth equity” and “late-stage venture” are used somewhat interchangeably, making any discussion of the distinction between them somewhat academic. Many growth equity firms have even marketed themselves as “late-stage venture capital.” Interview candidates interested in growth investing should certainly target both growth equity firms and late-stage venture firms (Series B/C or later).
That said, if one HAD TO draw distinctions between the growth equity and late-stage venture, it’d likely be along the following vectors:
- Degree of profitability – while both late-stage venture and growth equity focus on positive unit economics, some might distinguish the two by the fact that companies receiving a growth equity investment may be more likely to be profitable overall, whereas late-stage venture capital companies may still be operating with large losses
- Expectation of future dilution – since growth equity investments are at or near profitability, there is an expectation that they will not require additional fundraisings in the future and therefore investors will avoid future dilution
- Use of proceeds – venture capital investors tend to focus on primary transactions and have traditionally had a strong aversion to providing founder liquidity via secondary share purchases; meanwhile, growth equity investors are usually less averse to deal structures involving secondary purchases, in part because the trajectory of the business is more secure so a potential loss in motivation among founders is less of a concern (note, this is situation dependent)
In summary, here’s what we’ve learned:
- Growth firms seek to acquire minority stakes in high growth, private companies with proven business models
- There’s no strict definition for which investment round corresponds to a “growth round,” but in most cases startups raise growth rounds in Series C or later
- Growth equity differs from private equity in that it targets high growth companies seeking minority investors with low or no debt, while private equity firms target more stable, high cash flow businesses in control transactions that use lots of debt
- The lines between growth investing and venture capital have started to blur as many venture capital firms have raise “late-stage” funds that target similar deals as growth equity firms
If you’d like to learn more, check out other free resources about growth equity. Also, if you’re preparing for an interview with a firm that invests at the growth stage, check out my comprehensive interview guide.