Case 077Growth equity returnsHard

Dhaarvik Infratech is offered its Rs 4,000 crore pre-money headline only with a 1.5x liquidation preference and an IPO ratchet that guarantees the fund a 20% IRR. What do the fund and the founders get if the year-four IPO values the company at Rs 3,500, Rs 5,000 or Rs 10,000 crore?

The situation

Dhaarvik Infratech builds and runs toll roads and transmission lines. It wants Rs 400 crore at a Rs 4,000 crore pre-money valuation. Existing holders own 40 crore shares, so the round prices shares at Rs 100 and the fund buys 4 crore shares.

One growth fund will pay that headline price only with two protections. First, a 1.5x liquidation preference that applies in any sale of the company. Second, an IPO ratchet: if the company lists in year four at a valuation that leaves the fund's stake worth less than a 20% IRR on its Rs 400 crore, the company issues the fund extra shares just before listing until its stake is worth exactly that much. Preferences convert to ordinary shares at the IPO. Treat everyone other than the fund as the founders.

Your task

Work out the fund's stake, value and IRR, and the founders' ownership, if the IPO values the company at Rs 3,500, Rs 5,000 and Rs 10,000 crore. Is the headline price real?

Quick check

Above what IPO valuation does the ratchet stop topping up the fund?

Worked solution

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

30-second answerThe answer to give first

The headline price is real only if Dhaarvik lists above about Rs 9,124 crore. The fund needs Rs 829 crore for a 20% IRR. At Rs 3,500 crore the ratchet lifts its stake from 9.1% to 23.7% and founders fall to 76.3%; at Rs 5,000 crore to 16.6%. Only at Rs 10,000 crore does the fund keep 9.1%, worth Rs 909 crore, a 22.8% IRR.

Step 1What does a ratchet do to the headline price?

Imagine selling your flat at the asking price, but signing a side letter that promises to hand the buyer cash if the flat is worth less than a set amount in four years. The asking price is in the newspaper; the side letter decides what you really received. An IPO ratchetA term that issues an investor extra shares before listing if the IPO price would leave its stake worth less than an agreed return. works the same way: the fund's return is fixed, and the founders absorb any shortfall in extra shares. So the question is never whether Rs 4,000 crore is a good price. It is at what IPO value the side letter stops paying out.

Step 2At what IPO value does the ratchet stop binding?

The fund owns 4 crore of 44 crore shares, 9.09%. A 20% IRR for four years multiplies Rs 400 crore by 1.2 to the fourth power, 2.0736, which is Rs 829.44 crore. The fund's 9.09% is worth Rs 829 crore only when the company is worth Rs 9,124 crore, 2.07 times the post-money, so every IPO below that triggers the ratchet. Most candidates assume the protection only matters if the IPO is below the Rs 4,400 crore post-money. It matters far above it.

The relationship
4+n44+n×V=400×1.24=829.4\frac{4 + n}{44 + n} \times V = 400 \times 1.2^4 = 829.4
4crore shares the fund bought at Rs 100
44crore shares after the round
ncrore top-up shares issued to the fund
VIPO valuation of the whole company, Rs crore
What it says in wordsIssue the fund enough new shares that its slice of the IPO valuation equals a 20% a year return on Rs 400 crore.
Who owns Dhaarvik at listing: the red slice is the ratchetIPO at Rs 3,500 crore76.3%Fund stake23.7%Fund valueRs 829 crFund IRR20.0%Ratchet shares14.6 ptsFoundersIPO at Rs 5,000 crore83.4%Fund stake16.6%Fund valueRs 829 crFund IRR20.0%Ratchet shares7.5 ptsFoundersIPO at Rs 10,000 crore90.9%Fund stake9.1%Fund valueRs 909 crFund IRR22.8%Ratchet sharesnoneFounderstop-up shares issued to the fundfund's original 9.1%founders and other holdersThe ratchet binds for any IPO below Rs 9,124 crore, 2.07x the post-money
At a Rs 3,500 crore IPO the ratchet lifts the fund from 9.1% to 23.7% and the founders fall to 76.3%; at Rs 5,000 crore the fund reaches 16.6%; only at Rs 10,000 crore does no top-up happen, and the fund earns 22.8% on its original 9.1%.
Step 3What do the three scenarios cost the founders?

Solve for the top-up shares in each case. At Rs 3,500 crore the fund needs 23.7% of the company, so it receives 8.42 crore new shares and the founders' 90.9% falls to 76.3%, a transfer of about Rs 511 crore of value. At Rs 5,000 crore the transfer is Rs 375 crore. At Rs 10,000 crore the fund's 9.1% is worth Rs 909 crore on its own and nothing moves.

IPO valueFund stake worth, no ratchetIRR, no ratchetTop-up shares, croreFund stake afterFund IRRFounders afterValue moved to fund
3,500318-5.6%8.4223.7%20.0%76.3%511
5,0004553.2%3.9616.6%20.0%83.4%375
10,00090922.8%0.009.1%22.8%90.9%0
Rs crore. Without the ratchet the fund would earn -5.6% at a Rs 3,500 crore IPO and 3.2% at Rs 5,000 crore; the ratchet lifts both to 20.0% by moving Rs 511 crore and Rs 375 crore of value from the founders.
Step 4What valuation did the fund really pay?

Divide the Rs 400 crore by the stake the fund ends up with. At a Rs 3,500 crore IPO the fund paid Rs 400 crore for 23.7%, which is an effective pre-money of Rs 1,288 crore, less than a third of the headline. The 1.5x preference does the same job in a sale: sold for Rs 3,500 crore, the fund would take Rs 600 crore rather than its Rs 318 crore share. Between the two terms the fund is protected on every exit route.

The price the fund really paid depends on the IPO it getsHeadline pre-moneyRs 4,000 croreIf IPO at Rs 3,500 croreRs 1,288 croreIf IPO at Rs 5,000 croreRs 2,011 croreIf IPO at Rs 10,000 croreRs 4,000 cr, no top-upheadline
The fund's effective pre-money is Rs 4,000 crore only if the IPO clears the threshold; at a Rs 3,500 crore IPO it falls to Rs 1,288 crore and at Rs 5,000 crore to Rs 2,011 crore.
Step 5What should the founders compare this with?

Compare it with a clean term sheet at a lower headline, say Rs 2,500 crore pre-money with no ratchet, where the fund takes 13.8%. The founders are better off with the ratchet only if they believe the IPO will be above about Rs 6,013 crore; below that, the clean lower price leaves them owning more. That is the judgement: a headline valuation bought with a ratchet is a bet by the founders on their own IPO. It suits founders who are confident and want the headline for hiring or signalling, and it punishes founders whose listing slips.

Where candidates lose it

The usual miss is testing the ratchet only against the Rs 4,400 crore post-money. A return-based ratchet binds until the stake earns its target, here up to about Rs 9,100 crore, so it is live in almost every realistic outcome.

The second is forgetting that the top-up shares dilute the fund's own denominator. Setting n equal to the shortfall divided by the IPO price per share undercounts, because every new share also enlarges the total.

What the interviewer asks next

  • The ratchet targets a 15% IRR instead of 20%. Where does it stop binding?
  • The company is sold at Rs 3,500 crore instead of listing. What does the 1.5x preference give the fund?
  • How would you cap the ratchet if you advised the founders?
  • Why might a fund accept a lower IRR guarantee in exchange for a lower headline?

Company names and figures are illustrative.