Note: This article is the tenth in an ongoing series for Angel Investors. To learn more about developing the key skills needed to make great investments, download this free eBook today Angel 201: The 4 Critical Skills Every Angel Should Master or purchase our books at Amazon.com.
A lot of angels bandy the term IRR about, but its actual meaning and use sometimes feels like the question people are too embarrassed to ask. So to save everyone any awkwardness I’ve asked Christopher to take us through a quick review of the concept of Internal Rate of Return.
Q: What does IRR stand for?
IRR stands for “internal rate of return” and is a more complicated way of looking at your returns which takes elapsed time into account as one of the factors. It is actually a concept that originated in the bond markets and was adopted by corporate finance professionals in the large enterprise context for planning capital budgeting (and in that context is sometimes called the discounted cash flow rate of return or DCFROR). Pure finance theory says the project with the higher IRR should be prioritized over the project with the lower IRR. Closed-end funds such as a typical venture capital fund have adopted IRR for their own purposes as a standard measure of performance, and so, as with many other things, angels have inherited the IRR habit from VCs. In the context of a patient angel who does not have to repay limited partners at a fixed point in time (e.g. the end of a ten year fund), IRR may be less meaningful than a simple exit multiple, but Seraf includes it because many investors find it helpful.
Q: Is IRR important? If so, why?
IRR is not important, per se. It is just one way of looking at your investments which is a bit more complicated than exit multiple, because IRR takes that element of elapsed time into account. Think of it as a harsher grade for your investments. If you think in pure exit multiples, then you are inclined to think of your investments as having overly rosy returns. A 2X is “wow, 200% return!” A 2X in 6 years is an IRR of 12.2%. Not quite as rosy because your money was tied up a pretty long time and bore a fair amount of risk to merely double. (And if you really want to grade yourself harshly, subtract the nominal returns the money would have gotten in your favorite market index. The net after that subtraction is the true internal rate of return you earned over what you would have otherwise.)
Q: How are Exit Multiple and IRR calculated?
Exit multiple is a very simple calculation. It is the total cash out divided by the total cash in. So if you put $50,000 in and got $150,000 back, your exit multiple would be 3X.
To calculate IRR, think of it as follows: the internal rate of return on an investment is the annualized effective compounded return rate that would be required to make the net present value of the investment’s cash flows (whether they be cash in or cash out) equal out to a perfect ZERO. The actual equation is sometimes expressed like this: NPV = NET*1/(1+IRR)^year). IRR can also be thought of as that particular discount rate at which the present value of future cash flows become equal to the original investment (or put another way, the rate of return necessary for the investment to break even). In the investment context, the IRR of your investment is the discount rate at which the net present value of your investment’s costs (the negative cash flows) is equal to the net present value of your investment’s returns (the positive cash flows).
Q: Why do the Exit Multiples and IRRs vary so much from round to round in a single company?
The variation is entirely due to the time element. A second investment round immediately prior to the sale of the company, which as a result generates a return almost immediately, can have a much higher IRR than an earlier investment, even if the earlier investment was at a much lower valuation and had a higher exit multiple. This illustrates the time element of the IRR calculation - finance theory punishes projects which tie up cash longer.
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