Case 067Growth equity returnsCore
Tulavik Software can grow 40% a year while burning cash or 25% a year while making it. Which plan creates more equity value after four years, counting the cash burned or generated?
1The situation
Tulavik Software has ARR of Rs 200 crore. Its board is choosing between two plans for the next four years. Plan A grows ARR 40% a year at a free cash flow margin of minus 10%. Plan B grows ARR 25% a year at a free cash flow margin of plus 15%.
Assume the market values software like Tulavik at an EV to ARR multiple of 0.2 times its Rule of 40 score, growth plus free cash flow margin in percentage points, and that each plan's profile still holds in year four. Take each year's revenue as the average of opening and closing ARR.
2Your task
Which plan leaves more equity value at the end of year four, and what would change the answer?
Quick check
Plan A ends with 57% more ARR than plan B. By how much does it lead on equity value?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
Plan A leaves about Rs 4,439 crore of equity against Rs 4,101 crore for plan B, a lead of about Rs 339 crore, far smaller than its 57% ARR lead. Plan A ends with ARR of Rs 768 crore at 6x, less Rs 170 crore burned. Plan B ends with Rs 488 crore at 8x, plus Rs 195 crore of cash. If plan A's burn must be funded by new equity at today's value, existing owners do better under plan B.
Step 1How does the market price each plan?
Think of two shops: one doubles its floor space on borrowed money, the other grows slower and banks its profit. A buyer pays more per rupee of sales for the second, because it does not need a lender. Here the market pays 0.2 times the Rule of 40Growth rate plus free cash flow margin, both in percentage points; a software company scoring 40 or more is commonly treated as balancing growth and profit well. score per rupee of ARR, so plan A, scoring 40 minus 10, earns 6 times ARR, and plan B, scoring 25 plus 15, earns 8 times. Plan A's faster growth is partly paid back in a lower multiple.
Step 2What does each plan leave after four years?
Plan A compounds Rs 200 crore at 40% to Rs 768 crore; plan B at 25% reaches Rs 488 crore. Plan A's enterprise value is 6 times Rs 768 crore, Rs 4,610 crore, less Rs 170 crore of cash burned; plan B's is 8 times Rs 488 crore, Rs 3,906 crore, plus Rs 195 crore of cash generated. Equity value is Rs 4,439 crore against Rs 4,101 crore. Plan A wins by Rs 339 crore, about 8%, from 57% more ARR.
| Rs crore | Year 1 | Year 2 | Year 3 | Year 4 | Total |
|---|---|---|---|---|---|
| Plan A closing ARR | 280 | 392 | 549 | 768 | |
| Plan A free cash flow | (24.0) | (33.6) | (47.0) | (65.9) | (170.5) |
| Plan B closing ARR | 250 | 312 | 391 | 488 | |
| Plan B free cash flow | 33.8 | 42.2 | 52.7 | 65.9 | 194.6 |
Step 3Who pays for plan A's burn, and does that flip the answer?
The comparison above treats the burn as money the company already has. If Tulavik must raise it, the existing owners give up a share of the company. Raising Rs 170 crore today at plan A's Rs 1,200 crore value dilutes existing owners by 12.4%, leaving them Rs 4,036 crore of plan A's year-four value, less than the Rs 4,101 crore they keep under plan B. Plan A wins for existing owners only if the money can be raised above about Rs 1,373 crore pre-money. So the answer depends on the cash on the balance sheet and the price of new money, which is the point a partner will press on.
Step 4What would you tell the board?
Plan A creates more total value if the company can fund the burn from cash it already has, and if 40% growth is really available at minus 10%. The lead is small enough, about {TV_gap/TB['eq']*100:.0f}%, that a modest slip in plan A's growth or a lower multiple for burning companies would erase it. If growth came in at 35% instead of 40%, plan A's year-four ARR would be about Rs {TV_arr0*1.35**4:.0f} crore and its Rule of 40 score would drop to 25, a 5x multiple: about Rs {TV_A35:,.0f} crore of equity, now behind plan B. The limitation of the whole exercise is the pricing rule: the market's trade-off between growth and profit moves over time, and a plan chosen for today's rule is judged on the rule in year four.
Where candidates lose it
The common error is comparing ARR alone and picking plan A because it ends 57% bigger. The question says count the cash; a plan that burns Rs 170 crore and earns a lower multiple keeps far less of its ARR lead.
The opposite error is picking plan B because it is profitable. On the numbers given, plan A still leaves more total value; plan B wins only once the burn has to be bought with dilution.
What the interviewer asks next
- Plan A's growth slips to 35% with the same burn. Which plan wins now?
- How would you structure a plan between the two, and what Rule of 40 score would it target?
- Why might the market's pricing rule change by year four, and which plan is more exposed to that?
Company names and figures are illustrative.