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Growth Equity

Updated on May 28, 2024
Article byWallstreetmojo Team
Edited byAaron Crowe
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Growth Equity?

Growth equity is, also known as expansion capital, is a form of capital investment usually undertaken in the form of minority investment in relatively mature and large corporates that are looking forward to some structural and transformational change or a large growth prospect in future or business operation expansion or for acquisition or entering a new market.

Growth Equity

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Growth equity is interchangeably used with growth capital or expansion capital, which deals in minority investments and generally in preferred shares. The risk involved in such an investment is minimal, whereas the return on investment is very high. Therefore, this is the preferable form of investment.

Key Takeaways

  1. Growth equity is undertaken to push expansion capital for small investments made by mostly large corporates to bring about a structural change in their company proceedings. 
  2. Such a type of equity is very different from asset classes and leveraged buyouts and is done by investors requiring minimum risk. 
  3. Growth equity provides various benefits, such as it helps subsidize business operations, has higher growth potential, and restructuring the company’s balances. 
  4. Growth equity has certain pitfalls, such as it is a long, tiring process and requires extensive research methodologies, including outsider selling, that can cause conflicts. 

Growth Equity Explained

Growth equity is private equity asset class segment that is very distinct and separate from venture capital or leveraged buyouts. It works to provide ventures like providing high returns with minimum risk. The risk of capital loss is moderate as compared to other growth equity firms. The holding period is three to seven years, and the target for the internal rate of return is around 30-40 percent. The capital invested can be targeted to multiple 3 to 7 times. The investors keep evaluating the risk-adjusted return profile of various investment alternatives. The companies involved in investment are already operating in an established market with proven products. The risk involved is only the execution and management risk.

It is preferred by businesses to enter into a new market, expand their business in new operations, and boost the company’s revenue and acquisitions. Investors choose companies without debt history and low leverage policies as the risk potential is very low in such companies. Investors who invest in such companies are usually large investment firms such as mutual firms and hedge funds, private equity firms, venture capitalists, etc.

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Why Growth Equity?

Growth equity investment is one of the best options for companies looking for capital for their business expansion or operation restructure. It provides an easy way of venturing into new markets and acquiring a significant position. Also, it helps to bring a transformational event in the life span of the businesses.

Growth Equity

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  1. Restructuring the Balance of a Company: It is used to restructuring the balance sheet of a company reduce the debt capital.
  2. Subsidize Business Operations: Most business houses use this investment to expand and subsidize their business operations, boost the company’s profitability and revenue expansion, and enter into a new market for further enhancement of the profit.
  3. High Growth Potential: Investors of growth equity benefit from high growth with moderate investment risk. The investment is very nominal and executed with preferred shares. Companies chosen for investments are generally debt-free or at low leverage.

Examples

Let us consider the following examples to understand how growth equity investment works:

Example 1

Company A has been a consistently growing company in its region. Business X, which aspires to have some additional income to boost financing for its business operations, decides to invest in growth equity vehicles. It owns 20% shares of company A to ensure it has its own share of profits in whatever company A makes.

Example 2

Mentioned below are the profits of a stabilized business and its chart showing net profits for different years:

Profits of stabilized business

The Excel chart for the above profits figures is as follows:

Net profits chart

This is what the growing company’s statistics look like. Studying the chart can help any entity have a minority interest in it.

Advantages

  • This investment helps in facility expansion, equipment purchases, product development, sales, and marketing initiatives.
  • Apart from higher financial growth, equity investment also provides access to business expertise by adding a valuable source of guidance and consultation to the business.
  • Since the funding is based upon the choice and level of interest investors have in the business, there is no limit to the capital to be raised.
  • It is not required to make monthly payments to investors; hence the sole focus shifts to the needs of the business and its rate of growth.

Disadvantages

  • It may be a frustrating and time-consuming process to attract potential investors.
  • A rigorous research exercise must be carried out beforehand, investing in new business.
  • The investors may sell shares of the company to someone outside the business, which leads to opposing views and a lack of sufficient experience getting involved in the business.

Growth Equity Vs Venture Capital

Although both venture capital and growth equity investors assume the risk involved while investing, these investments vary greatly in different aspects like the extent of risk, cash flow perspectives, growth, etc. In comparison, venture capital investment does not include debt in its capital structure. Venture capital generally targets businesses at initial stages with less historical financials.

Companies have a high level of market, funding, technology risk, etc., in venture capital investment compared to growth equity investment. Also, a high risk of company failure is involved in venture capital, whereas in growth equity investment, a limited risk is involved. Companies usually have low revenue and usually negative cash flow in venture capital compared to growth equity, where there are sustainable revenues and positive cash flow.

In growth equity investment funds are based on growth, revenue, and cash flows, while venture capital returns are based on growth in the addressable market and company market share.

Frequently Asked Questions (FAQs)

What is private equity? How is it different from growth equity?

Growth equity is a sort of extra capital required by corporates, so they purchase huge holdings in some other firms. However, private equity is when a large corporation buys out entire businesses, mainly small companies, to increase their assets.

Why is growth equity better than buyouts?

Growth equity funds pitch to companies with higher growth potential and business prospects. Their goal is to stay in stock until profits are claimed, which is not true in buyouts.

When do companies choose to go for growth equity?

Companies choose to invest in growth equity because it is an attractive tool with low risks, with major returns, as it means investing in highly potent businesses.

This has been a guide to what is Growth Equity. Here we explain it vs venture capital, reasons why choose it along with examples. You may learn more about financing from the following articles –