Question

ReadMyMind Inc is a Silicon-valley startup that is expected to revolutionize social interaction in the 21^st century. The only equity investor in the startup is Sequoia, a well-known private equity firm. Free cash flow at ReadMyMind is forecasted to be zero from Year 1 to Year 9, but positive thereafter. The firm currently has a cash balance of $5mn. In year 10, free cash flow will be $10mn. In that year, Sequoia will use a ratio (“exit multiple”) based on free cash flow to calculate terminal value. If Sequoia requires a return of 9% on its equity and ReadMyMind has no debt, what is the equity value of the firm if Sequoia wants to exit its investment at a multiple of 15?

Answer 1

Solution:-

The private equity firm wants to sell at the beginning of year 10. The current value of equity should include the current levels of cash and the expected value of future cash flows. So, the value of equity can be calculated as follows:

Value of equity= Current cash balance + present value of terminal value

Cash balance= $5m

Terminal value at the beginning of year 10= free cash flow year 10*Exit multiple = $10m*15= $150m

Present value of terminal value= $150m*present value factor (Year 10 beginning)= $150m*(1/1.09)9 = $69m

Therefore, using the formula described above, we calculated the value of equity as follows:-

Value of equity= Current cash balance + present value of terminal value = $5m + $69m= $74 million