What’s in a Growth Equity Case Study?
The pot of gold at the end of the rainbow.
Why else would you suffer through investment banking?
This ancient post from Leveraged Sellout sums up how most bankers used to think about exit opportunities:
“Before I became so fervent about Private Equity, I thoroughly considered all my other career options: hedge funds and VC.”
But that’s not quite true anymore: corporate exits are looking better and better… tech startups are hot… and even putting aside those recent trends, the author forgot about growth equity.
Which is a shame – because if you can’t decide between traditional private equity and venture capital / tech startups, it might be right up your alley.
In this article, you’ll learn what growth equity funds do, what to expect in case studies, and you’ll get a full growth equity case study with a video tutorial, 18-page solution, and Excel file.
You just have to keep reading:
What is Growth Equity, and What Do Growth Equity Funds Do?
“Growth Equity” funds invest in companies that are somewhere between “brand new startup” and “established, boring company” on the maturity scale.
Pure-play growth equity firms will generally:
- Only take minority stakes in companies – very different from traditional leveraged buyouts where the PE firm acquires 50% to 100% of the company.
- Invest in revenue-generating and cash flow-positive companies – very different from venture capitalists, who often pour money into pre-revenue companies.
- Aim for a money-on-money (MoM) multiple (also called a cash-on-cash multiple or multiple of invested capital), perhaps around 2.5 – 3.0x, in addition to a targeted IRR.
- Earn returns via business growth, via organic EBITDA growth, acquisitions, partnerships, regional expansion, or some other strategy.
- Not use debt… since they are only making minority investments in companies.
You can see the implications of these differences:
- There is less emphasis on modeling / pure technical skills because the deals you work on will generally not involve debt.
- Since the companies are more mature and since no debt is involved, there’s generally less risk of a complete disaster on any investment. So the question is “Can we achieve the IRR or multiple that we’re targeting?” rather than “Could we lose our shirts on this deal?”
- You need to know a lot more about the market – how else could you decide if there’s enough growth to justify the returns your firm is targeting?
The recruiting process for growth equity firms could be a multi-part series, so we’re going to focus on one smaller part of that process here: the case study.
Yes, you’ll almost certainly get case studies in growth equity interviews, just like you’ll get them in any other type of buy-side interview.
Growth Equity Case Studies: What to Expect
As promised in the beginning, here it is: a complete 6-page case study on Atlassian, a software company based in Australia.
- Case Study – Description (Word)
- Case Study – Description (PDF)
- Case Study – Supplemental Files and Data (ZIP)
- Atlassian 3-Statement Model – Blank File (Excel)
- Atlassian 3-Statement Model – Completed File (Excel)
- Case Study – Discussion and Answers (Word)
- Case Study – Discussion and Answers (PDF)
As always, I strongly recommend clicking through and/or viewing this in 720p and full screen mode to properly see everything.
This is one of the many case studies in the new Financial Modeling Fundamentals course set for release on December 19th, 2014.
And yes, I am giving away this case study, the Excel file, and the 18-page written solution for free (minus the video tutorials and transcripts).
Before you read the rest of this article, I strongly suggest reading the first few pages of the case study document above.
What is This Deal / Investment Case Study All About?
In mid-2010, Accel invested $60 million USD into Atlassian at a valuation of $400 million.
Then in April 2014, T. Rowe Price announced a $150 million USD investment in Atlassian, at a… slightly higher valuation of $3.3 billion.
Your job is to decide whether or not you would invest the same amount at the same valuation that T. Rowe Price did, assuming your fund is targeting a 20% IRR on its investment.
You can read all about the company itself on its website, but here’s the short version:
- Product: It sells software products to other software developers: tools for project management (JIRA), collaboration (Confluence), source code control, peer code review, and release management. In short, it makes programmers more efficient.
- Financials: It recorded ~$200 million AUD in revenue in FY 2014 (ending June 30th), with a revenue CAGR of 25% over the past 3 years. Its EBITDA margin was ~16%, with heavy spending on R&D (40% of revenue) but very light spending on sales & marketing (20% of revenue).
- Why It Was “Hot”: High growth, profitable and cash flow-positive, relatively little capital raised for a business of this size, and a red-hot tech market.
If you look at press releases and commentary on this company, most reporters were ogling over the low sales & marketing spending due to the lack of commissioned sales reps.
As usual, though, most of the mainstream commentary missed what’s really important when evaluating this company from the perspective of an investor:
- Business Model Shift – Atlassian is shifting from one-time purchase (“Download”) to a subscription-based model (“OnDemand”), similar to Salesforce.com. But the average product price is lower when purchased as a subscription, so the financial impact might be negative at first.
- Sales & Marketing – Most enterprise software companies – the likes of Oracle – spend ~40% of their revenue on sales & marketing, mostly due to their commissioned sales reps. Atlassian only spends ~20% on sales & marketing, but at some point, that spending will have to increase and it will have to use sales reps to win bigger accounts.
- Valuation – T. Rowe Price invested $150 million at a valuation of $3.3 billion USD, which equates to a 110x EBITDA multiple. No, that’s not a typo. So can they actually invest at that sky-high valuation and still earn the returns they’re targeting?
Step 1: Gathering Data
You’ve probably noticed by now that Atlassian is a private company, so how do you get all the required data?
I pieced together the numbers here from interviews, press releases, PrivCo.com, and other sources:
- Annual Revenue: This was easy to find via in press releases (see the files above).
- OnDemand vs. Download Revenue Split: I found customer count estimates via PrivCo.com and news stories; the revenue split is guesswork, but OnDemand revenue was minimal until the 2 most recent years, so my numbers aren’t that much of a stretch.
- Annual Expenses: Similarly, a few press releases give estimates for the % of revenue that the company spends on different categories, so I combined that with guesstimates on the others.
- Other Items: For the Balance Sheet and Cash Flow Statement items, I looked at other Australian software companies and applied similar percentages to Atlassian (e.g., median Accounts Receivable as a % of Revenue * Atlassian’s Revenue = Atlassian’s Accounts Receivable each year).
The Punchline: After spending hours backing into these numbers, an Australian reader wrote to inform me that you can actually get the company’s financial statements on this site:
I might eventually go back and revise this case study using the real numbers.
(Interestingly, my own guesstimates were not that far off – I mainly got the Deferred Revenue balance wrong since it was much higher in real life.)
In a real case study, they will almost always give you the financial statements and other relevant information, so “data gathering” is less of a concern.
Step 2: Building the 3-Statement Model
The case study document provides very detailed guidance on certain points, but almost no guidance on other points.
Here’s what we came up with:
Historically, the # of Download customers has grown at between 17% and 28% per year; going forward, we make a conservative estimate of 20% growth next year, falling to 8% by the final year.
OnDemand is growing more quickly (147% decreasing to 44%), but even there, we assume 35% growth declining to 10% by the end.
Average customer value is tricky because it’s different from average product prices.
Yes, the company dropped its prices across the board in 2011, but that only caused a temporary drop in the average customer value figures in FY 2012.
If lower prices result in more users at each company, the average customer value might actually increase.
In the absence of solid guidance, and in light of the historical growth rates of 3% to 10%, we use 3% for the average customer value growth rate going forward:
Expenses and Cash Flow / Balance Sheet Line Items
The case study instructions spell out most of what we need in this section. The main points:
The Gross Margin improves over time, partially because of more OnDemand customers and partially because of economies of scale; the company already has a ~90% Gross Margin, though, so this doesn’t make a huge difference.
We don’t think it’s reasonable to assume that R&D as a % of revenue declines just because Atlassian “can” afford to spend less on it.
That high R&D spending is baked into the culture of the company: you can’t just say, “Sorry, we’re going to fire a bunch of people because we don’t need that many engineers anymore.”
We also strongly believe that sales & marketing spending will increase over time, up from 20% of revenue to 25% of revenue by FY 2019.
The press glossed over this point, but there is a distinction between sales & marketing spending and spending on commissioned sales reps.
Even if a company doesn’t employ sales reps, it still spends something to market and sell its products.
Atlassian operates in a competitive market with a huge range of free and paid solutions, and at this stage the company has already grabbed most of the “low-hanging fruit” (e.g., word-of-mouth sales to fellow developers).
So it seems likely that its sales & marketing spending on both new and existing customers will increase over time:
The rest of these items are straightforward: CapEx and D&A are not that important for most high-growth software companies, and the other BS/CFS items mostly use historical averages as percentages of the relevant Income Statement line items.
We are assuming that Receivables as a % of revenue and Deferred Revenue as a % of revenue both increase over time, primarily to reflect the historical trends and the shift to subscription-based software.
Step 3: Calculating the Returns
At the end, we calculate the IRR and MoM multiples:
The conclusion is that this is a great investment for Accel, which got in much earlier at a much lower valuation, but a not-so-great deal for T. Rowe Price, which falls far short of the targeted 20% IRR.
Yes, we’re ignoring Equity Value vs. Enterprise Value in the exit calculation because this case study comes before those lessons in the new course.
But that doesn’t make a huge difference anyway: even if you factored in the cash build-up, it would be tough for T. Rowe Price to achieve its targeted returns.
Step 4: Answering the Case Study Questions
So what does all this analysis tell you about the case study questions posed in the beginning?
You should look at the case study document to see the answers firsthand, but in short:
We would NOT do the deal if we were T. Rowe Price because there’s a very low chance of achieving a 20% IRR over 5 years.
If they’re aiming for a 10-15% IRR instead, then the deal may be reasonable.
But to achieve a 20% IRR, the exit multiple would have to increase to 140-150x EBITDA if they wait until year 4 or 5 to sell.
How likely is it for a $459 million company growing sales at 12% to be valued more highly than a $200 million company growing at 34%?
Even if you vary other assumptions, such as the total customer count, sales & marketing spending, or the exit multiple, a 20% IRR is unlikely.
To achieve a 20% IRR:
- The company’s customer base has to triple over 5 years.
- Its average sales & marketing expense per new customer also has to increase by 50% less than expected; and
- The exit multiple has to remain the same as the purchase multiple – even though Atlassian’s growth rate and margins are both lower by Year 5.
In terms of qualitative factors, some points are positive and some are negative:
- Growth / Market Size: Other companies such as Box, Dropbox, and Square were growing at faster rates and serving much broader markets. There are ~11 million professional software developers worldwide, but that’s still a much lower number than the total potential customers for those other services.
- Competition: All these markets are highly competitive, but one advantage Atlassian has is that fewer huge tech companies pay attention to its market because it’s relatively niche.
- Substitute Products/Services: Very few of these companies have much of a “moat,” but as a direct comparison Github is better-positioned than Atlassian because of the social aspect: it’s arguably more like a social network for developers than a true enterprise software company.
- Pricing Pressure: While Atlassian’s market isn’t as competitive as cloud file storage, there is still downward pricing pressure due to the sheer number of very similar tools; the company already dropped its prices once, and it may do so again.
Overall, the market / qualitative factors aren’t positive enough to outweigh the negative financial analysis, so they further support our “No” recommendation.
Whither Growth Equity?
So that’s the point of a growth equity case study: you’re typically looking at “solid” companies, but are they solid enough?
It’s not so much about “Does this deal work? Or will we lose all our money?” as it is about “Could we achieve our targeted IRR or MoM multiple under reasonable assumptions?”
Here, Atlassian is clearly a great company that has done extremely well without raising much outside capital.
This one falls just short of being a “great investment” – assuming that T. Rowe Price really is aiming for a 2.5x multiple and a 20% IRR over 5 years.
For Further Reading
Make sure you check out all our previous coverage of case studies and interviews in private equity, hedge funds, and other industries to compare and contrast:
Private Equity, Growth Equity, and Venture Capital:
- Series on Dell Leveraged Buyout Case Study
- Private Equity Case Studies in 3,017 Words
- Private Equity Strategies 101
- Private Equity Interviews
- Private Equity vs. Venture Capital
Hedge Funds and Asset Management:
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