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What is the Internal Rate of Return (IRR) and why does it matter when investing in startups?

There are many things to consider when evaluating any potential investment. One of the things that is most important, and probably most likely to spring to mind for many investors, is the rate of return. “How much will I receive in return for the money I invest?” is a great question to ask.

For traditional investments such as cash or bonds, the rate of return is simply the interest rate paid per annum. For stock investments, the rate of return is calculated by the dividend payments received, if any and the rise (appreciation)  in price upon selling the shares. But what about if you are investing in startup companies? Parameters that are used to assess returns in startups are a little more complex, but the underlying principle is the same, because they measure the return on your invested funds. 

As explained in this article, investing in startups can be facilitated by Angel Investing or Venture Capital, both of which are a form of Private Equity. In Private Equity investing, financial performance is often measured by the Internal Rate of Return (IRR) and the Investment Multiple (also known as the Multiple of Money).

What is the Internal Rate of Return (IRR)?

So, what is IRR? 

Simply put, the IRR can be considered to be the rate of return on an investment. Technically speaking, the IRR is the discount rate that makes the net present value of all cash flows of an investment equal to zero. 

But what does this actually mean? The two important terms here are discount rate and net present value, which are discussed below.

Discount rate 

The discount rate is a figure used to represent time and risk associated with an investment. 

Let us consider the time element first. Say you invest $100k and at maturity you receive a return of $100k on top of your original $100k investment, so your total return would be 100%. On the surface that sounds great, but to really understand the performance, you need to consider the time element. If the investment term was 5 years, the annual rate of return would be far better than if the investment had a term of 10 years. And remember that the value of money falls over time, so money will be worth less in the future than it is now. For example, if inflation were 5% per annum, then $100k today would only be worth $95k one year into the future, and only $78k five years into the future.

The second factor to take into account is risk. This considers the fact that some investments are less risky than others, and that higher risk investments should achieve higher returns. For example, putting your money in a bank or a US Treasury Bond is much less risky than investing in a tech startup. So, the discount rate generally increases for higher risk investments.

Net Present Value

Net Present Value (NPV) is the estimated total (positive and negative) future cash flows over an investment’s entire life, discounted to the current day, i.e. the present. It takes into account the decreased future value of money, as discussed above.

What is the Investment Multiple?

The Investment Multiple represents the total return on the capital invested, without considering the time element. Returning to our hypothetical $100k investment example above, the investment multiple on the $200k total return would be 2.0x.

What is the IRR Formula?

The formula for how to calculate IRR is quite complex and involves a number of mathematical processes and iterations. Rather than doing it manually, a simpler approach for an internal rate of return calculator is to use a spreadsheet formula such as in Microsoft Excel or Google Sheets

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The IRR is calculated by working out what discount rate makes the NPV zero at the end of the investment term. 

The higher the IRR, the better the rate of return of the investment.

What is a Good IRR?

An ideal way to evaluate the IRR of a startup investment is to compare it against the benchmark historical performance for angel investing returns. A good IRR for an investment in a startup would be one that is at or above the benchmark return.

The most recent  study on angel investing returns in North America  is the Angel Resource Institute’s 2016 Angel Returns Study.  This study showed an overall IRR of approximately 22% across multiple funds and investments. This indicates that a projected IRR of an angel investment that is at or above 22% would be considered a good IRR.

How to use IRR 

IRR is useful to compare the financial returns of different investments. When investing in startups, the returns are not certain like they are in more conservative investments like cash. So, the future cash flows from an investment are likely to be highly variable and may differ significantly from the forecast. The IRR, which is an estimate,  is a good way to “smooth out” the variation in the future cash flows to provide an easily understandable average rate of return to allow comparison against other investments.

It is important to remember that for investors, it is not just about getting your money back but also making a profit – IRR is a good way to quickly assess your potential returns.

Internal Rate of Return Example 

The following table provides a hypothetical example of calculating the IRR of an investment with a 6-year term, an initial investment of $100k, and variable forecast cash flows over the life of the investment. The IRR was calculated using the Microsoft Excel “IRR” formula. Note the initial $100k investment is shown as a negative number because it is a capital outlay. The undiscounted cash flows and the present value of the cash flows using the IRR as the discount rate are also shown to demonstrate the NPV reaching zero at the end of the investment, which is the underlying principle of how to calculate the IRR.

YearYear 0Year 1Year 2Year 3Year 4Year 5Year 6
Undiscounted future cash flows-$100,000$20,000$30,000$35,000$40,000$45,000$50,000
IRR (calculated by Excel’s IRR formula)24.0%
Cumulative undiscounted future cash flows-$100,000-$80,000-$50,000-$15,000$25,000$70,000$120,000
Discount factor from IRR1.000.810.650.520.420.340.27
Present value of future cash flows-$100,000$16,128$19,509$18,354$16,915$15,345$13,749
Net Present Value (NPV)-$100,000-$83,872-$64,363-$46,010-$29,095-$13,749$0
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The above is for illustrative purposes only and does not reflect any actual investment return.

Advantage of Internal Rate of Return vs. Multiples

In startup land, many investors focus on multiples, which is very important, but the timeframe must also be considered to truly evaluate the financial performance of an investment. It is important to also consider time and risk, which is where IRR is very useful. Simply judging an investment on whether it returned a multiple of 1.5x, or 2.0x, or 3.0x the original investment is missing part of the story if that return took 20 years to come in.

Limitations of Internal Rate of Return

All investments need to be considered as a whole, requiring due diligence and evaluation of a number of parameters. IRR is just part of the story, although  a very important and useful part. 

One limitation of IRR is that it does not consider the amount of the investment or the total return. This means that if you only look at the IRR, you might choose an investment with a higher rate of return but lower overall return. For example, an investment with a 35.0% IRR might seem a better choice than one with a 25.0% IRR, but if the former is only a $10k investment and the latter is a $100k investment, then the total return of the investment with 25.0% IRR will far exceed that of the 35.0% IRR.

Comparison Against Cost of Capital 

When researching IRR, you may come across the term “Cost of Capital” or “Weighted Average Cost of Capital” (WACC). This provides an indication of how much it costs a company to finance its operations including both debt and equity investments. When a company is considering an investment or capital outlay, they may compare the IRR against the WACC to evaluate whether the potential returns may be higher or lower than what acquiring the capital will cost them. 

Startups are rarely financed with debt (although that is changing too). So WACC is rarely, if ever, used in the context of startups. We might go so far as to say that WACC is usually irrelevant to startups. But we wanted to highlight this term as it is often thrown about in finance circles.

Key Takeaways for IRR

  • The IRR is a great way to evaluate and compare the returns of different investments.
  • The IRR provides an easy-to-understand average performance of variable cash flows over the life of an investment.
  • It is important to compare the IRR of an investment against appropriate performance benchmarks.
  • IRR is just part of the story – ensure you assess the investment as a whole.

You can find more information here on how to start angel investing and on how to find opportunities for angel investing on platforms such as Propel(x).

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