Case 037Growth equity and softwareHard

A growth fund buys a minority stake in a fintech at 10x revenue and expects to exit at 5x revenue in five years. What revenue growth does it need for a 25% IRR, and is that believable?

The situation

Svarnim Fintech sells lending and collections software to small finance companies and cooperative banks. Revenue is Rs 120 crore and has grown 80% in the last year. A growth fund invests Rs 240 crore for 20% at a post-money valuation of Rs 1,200 crore, 10x revenue.

The fund's exit case assumes that by year 5 Svarnim is a mature, slower growing business that a buyer values at 5x revenue. The fund underwrites to a 25% IRR. Assume no net cash or debt at exit and, at first, no further dilution of the stake.

Your task

What revenue growth does the deal need, how much of it only repairs the falling multiple, and is that growth believable?

Quick check

Roughly what yearly revenue growth does Svarnim need over five years?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Revenue must grow about 6.1x in five years, 43.6% a year, to reach about Rs 732 crore. A 25% IRR is 3.05x the money; with the multiple halving from 10x to 5x, revenue has to double just to hold value and then grow 3.05x more. A path decaying from 70% to 25% a year only just reaches it. A 15% dilution from later rounds pushes the need near 48% a year.

Step 1How do you work backwards from the IRR?

Start from the money multiple the IRR implies, then ask what has to grow to deliver it. A 25% IRR over five years is 1.25 to the fifth, 3.05x, so the Rs 240 crore stake must be worth Rs 732 crore at exit, and with the stake held at 20% the company must be worth Rs 3,662 crore. At 5x revenue that needs revenue of Rs 732 crore, against Rs 120 crore today: 6.10x, which is 43.6% a year compounded.

The relationship

\frac{\text{Rev}_5}{\text{Rev}_0} = (1.25)^5 \times \frac{10}{5} = 3.052 \times 2 = 6.10 \qquad \text{CAGR} = 6.10^{1/5} - 1 = 43.6\%

(1.25)^5	the money multiple a 25% IRR needs over five years
10 / 5	entry multiple over exit multiple: the factor revenue must grow just to hold value
6.10	how many times revenue must multiply

What it says in wordsRevenue must grow by the target money multiple times the compression in the multiple: 3.05 x 2, about 6.1x, or 43.6% a year.

Revenue growing 6.10x at a constant 10x would take the Rs 240 crore stake to Rs 1,465 crore, but the multiple halving to 5x gives back Rs 732 crore and leaves Rs 732 crore, 3.05x, so half the growth only repairs the multiple.

Step 2Why does the falling multiple matter so much?

Think of buying a flat in a new locality at a premium because everyone expects it to boom: even if rents double, the premium fades as the locality matures, and the rent growth first has to make up for it. When the exit multiple halves, revenue has to double before the investor makes a single rupee, so growth does double duty: one part repairs the multiple, the other part is the return. On a log scale, about 38% of the required growth goes to repairing the multiple. The chart below shows how sharply the requirement moves with the exit assumption: at 7x it is 34.2% a year; at 3x, 59.0%.

For a 25% IRR from a 10x revenue entry, Svarnim needs 25% a year if the exit multiple holds, 34% at a 7x exit, 43.6% at the 5x the fund expects and 59% at 3x, so the exit multiple assumption moves the growth hurdle more than any other input.

Exit multiple of revenue	Revenue must grow	Yearly growth needed	Year 5 revenue, Rs crore
3x	10.17x	59.0%	1,221
5x (the case)	6.10x	43.6%	732
7x	4.36x	34.2%	523
10x	3.05x	25.0%	366
12x	2.54x	20.5%	305

Rs crore. From Rs 120 crore of revenue, a 25% IRR needs Rs 366 crore by year 5 if the 10x multiple holds and Rs 732 crore at the 5x the fund expects.

Step 3Is 43.6% a year believable?

Test it with a shape, not a single rate, because fast growers decay. A path of 70%, 55%, 40%, 30% and 25% multiplies revenue 5.99x, which at a 5x exit gives 3.00x and an IRR of 24.6%: the deal works only if Svarnim keeps growing faster than most software companies ever do for five straight years. Then add the things that make it harder. If later rounds dilute the stake by 15%, revenue must grow 7.2x, 48.3% a year. Diligence goes to what drives the 70%: new logos or larger contracts with existing ones, net revenue retention, sales cycle length with cooperative banks, and how much of last year's 80% came from a few large implementations.

The view: at 10x revenue with a 5x exit, the fund is paying for a near-perfect growth path and has no margin of safety on the multiple. A growth investor would either negotiate a lower entry, ask for a liquidation preference to protect the downside, or underwrite a 6x to 7x exit with evidence that the company will still be growing above 25% at exit. The limit of this maths is that it ignores the cash the business may generate or burn on the way, which changes the exit equity value as well.

Where candidates lose it

The usual loss is answering 25% a year, as if revenue growth equal to the target IRR were enough. That holds only at a constant multiple; with the multiple halving, the answer is nearly double.

The second miss is solving for one smooth growth rate and calling it reasonable. Fast growth decays, so test the requirement against a decaying path; the gap between the two is the real risk.

What the interviewer asks next

What exit multiple makes 30% a year of revenue growth enough for a 25% IRR?
How would a 1x liquidation preference change the fund's downside if Svarnim stalls at Rs 300 crore of revenue?
Svarnim turns cash positive in year 3 and builds Rs 200 crore of cash by exit. What does that do to the growth hurdle?

Company names and figures are illustrative.

1The situation

2Your task