What is Growth Equity?

Growth equity is an investment strategy where you acquire minority stakes in late-stage companies with high-growth potential. Growth equity investors typically invest in established companies that plan on expanding further. They typically invest during the pre-profit phase and often exit as soon as the company starts seeing signs of profitability.

This way, growth equity aims to maximize exits with lower risk and shorter holding periods.

What are Growth Equity Investments?

Although growth is the main indicator of such investments, there’s are other criteria to look for when using a growth equity investment strategy. For growth equity investments, some or all of the following conditions must be met:

• Product-fit validation

• Notable customer traction and popularity

• High growth in revenue (30% or more)

• Positive or nearly positive profitability

• Established business model

• Shares include a minority stake (less than 50% ownership)

• Growth and revenue are the main drivers of returns

This should give you a general guideline on what growth equity investment is. Still, growth is the main focus.

Unfortunately, it can be difficult at times to determine a company's potential growth, so how do you determine whether a certain growth equity investment is worth your time and money?

There are primarily three things you should look for in every company you plan to invest in as a growth equity investor:

• Growing market - Where there’s demand, there are customers. If the company has a large market that it wishes to break into with expansion capital, it’s usually a good sign that the product/service will have significant demand.

• Strong business model - Does the company have a strong business model that, once delivered, can provide durable margins to shareholders?

• Good management - Even if you have the best plans in place, they won’t succeed until executed effectively. Consider how the company is managed and whether the management is determined to help it grow and meet its goals.

A good real-life example to learn from is OpenAI. When OpenAI started developing its technology, it was mainly funded by its founders, who pledged a billion dollars for venture capital. After it was unable to generate the needed funds, mainly due to major donors not contributing anything, it transitioned to a for-profit organization.

OpenAI started to attract significant investments due to its innovative artificial intelligence systems, with its biggest partner being Microsoft. Microsoft injected one-billion dollars into the company and granted them access to their Azure-based supercomputing platform to run their systems.

With the funds from Microsoft, OpenAI was able to execute its expansion plans and develop its AI systems, which were released to the public in the form of GPT-3 and DALL-E.

Microsoft is an independent firm that invested in OpenAI, but there are firms that specifically invest in growth equity.

What is a Growth Equity Firm and What Do They Do?

When a company is in its development phase, it’ll soon realize that to uptick production, it needs additional financial assistance. Do growth equity firms invest in companies that are still in development?

Growth equity firms don’t invest in companies in the early stages of development, rather, they mainly invest in already established companies. These firms typically invest in companies that have a proven business model, value proposition, and are gaining significant customer traction.

Growth equity funds are used for a company’s expansion plans and give them the extra push to extend to broader markets and take product development further.

Many growth equity firms are built to invest in companies that have developed an innovative product/service they believe may disrupt existing markets.

Investing isn’t as simple as putting money into every shiny new thing you see.

Growth equity investors evaluate the company’s existing status and identify whether the product is feasible and successful among potential customers. Investing in every company with potential is unfeasible, so they have to take the time to research when choosing which companies to invest in.

Some popular examples of growth equity firms include:

• Insight Partners

• General Atlantic

• Tiger Global

• TPG Growth

• Sequoia Capital

Advantages and Disadvantages of Growth Equity

As with anything in life, there is always a balance between positive and negative. Growth equity is no exception.

Advantages:

• Allows investors to exploit growth opportunities and improve operational efficiency: Growth equity firms invest in established businesses and help a company grow sustainably, which, in turn, improves the sustainability of the firm’s portfolio earnings.

• Lower risk as compared to other investment strategies: Investing in a startup that is still figuring out how to be successful comes with a lot more risk than investing in a company in its growth stage. These companies likely have survived stages of growing pains and now have a promising business model.

• Provides higher returns on investment: Equity growth firms invest in companies with high growth potential. This means your investment grows as the company grows, generating higher returns as you support a company’s expansion plans.

Disadvantages of Growth Equity

• Growth equity investors seek minor interest in a company: Growth equity investors are interested mainly in facilitating the expansion plans of a company and hold ‘non-controlling’ shares. This means that growth investors usually have little say in how the company runs its affairs.

• Requires extensive research: For growth equity to be successful, you need to be able to evaluate the company’s prospects. This includes reviewing a company’s financial records, looking at its business models, and evaluating its growth potential.

Now that you have a better understanding of growth equity, let’s compare it to other types of investing.

Growth Equity VS Private Equity (PE)

The main difference between private equity and growth equity is that they each have different drivers for investments. In private equity, the main driver is debt reduction, whereas growth investments focus on an increase in revenue resulting from a company’s organic growth.

There are other differences that may make the distinction clearer. We break those down further below.

Purpose

For private equity investors, the main aim is to maximize returns. This implies that such investors aren’t necessarily supporting a cause or looking to capitalize on a particular area of the business.

On the other hand, growth equity investors invest in companies that show promising signs of growth. This might be because of the introduction of an innovative product or service they believe can disrupt existing markets. To aid the development of such projects, growth investors provide expansion capital to these firms and generate higher returns through the company's growth.

Involved Risk

Private equity investments may be considered less risky than growth equity investments as there isn’t a surefire way to determine whether or not a company would be able to achieve its growth targets.

Private equity investors also typically invest in firms that are already growing and achieving high profitability rates. Compare this to growth equity investors who usually invest in a company in its pre-profit stages.

Preferred Stakes

Stakes refer to the number of stocks a person holds in a company. Growth equity investors prefer to have minority stakes, which is less than 50% ownership of the company. Private equity investors don’t have any set rule as to what stake they hold and can range anywhere from having a small share to acquiring entire companies.

Growth Equity VS Venture Capital

The immediate distinction of venture capital from growth equity is that venture capitalists often invest in the initial stages of the company to get it off the ground and running.

Life Cycle

Venture capitalists are often interested in the initial stages of a company’s life cycle. On the other hand, growth equity investors are more interested in the later stages of a company before it manages to increase profitability. This is mainly because growth equity is concerned with gaining higher returns based on the ability of a company to achieve its growth targets. With venture capital, the primary purpose is to improve the company’s revenue.

Holding Period

Because of the nature of each investment strategy, venture capitals typically have a longer holding period as it’s harder to judge or evaluate a business’s direction in its early stages of development. This means that before considering investing in a company, venture capitalists would have to give the company a long time to show some progress for it to be a worthwhile investment. The usual holding period for venture capital investments is around five to ten years.

Given that growth equity investors invest in already established companies, it would be easier, at least compared to earlier-stage companies, to predict a company's potential growth. The typical holding period for growth equity is thus lower than venture capitalists, with an average holding period of four to seven years.

Debt and Risk

Venture capital firms don’t often deal with companies that acquire high amounts of debt but have generally riskier business models. As venture capitalists invest in companies at the early stages, they carry higher risk as there is less foresight in the company’s direction.

Growth equity investors carry low to moderate risk when investing in established companies with strong business models.

Make Your Earnings Grow by Helping Other Companies Grow

Growth equity is an excellent strategy for exploiting growth opportunities. By investing in companies with high growth potential, investors typically get higher returns from a company’s organic growth. There are firms that specialize in growth equity strategies called growth equity firms.

Like any other investment approach, it has its pros and cons. Due to its efficiency in generating higher ROIs with moderate risk, it might be the best investment strategy for you.

If you’re feeling more adventurous, you might be interested in learning more about investing in startups!

If you want to break further into growth equity investing and create an effective investment roadmap, book a call with Invested Mom today!