IRR: What Is It and Why Founders Need to Understand It (Part 1)
Part 1 of Our Primer for Founders on Internal Rate of Return (IRR) and Investor Expectations
This is Part 1 of our “Finance in Focus” article on IRR. Click here for Part 2.
As a founder, you don’t have to be a finance whiz. However, it is crucial to the success of your company that you have a baseline understanding of financial concepts, especially when you’re pitching for investment. If you’re intimated at the very notion of finance, don’t worry, many entrepreneurs are. Wading into the world of finance may seem daunting, but hopefully we can help make it a little less scary.
Any entrepreneur who has sought investment has come across the term Internal Rate of Return (IRR). In today’s post, I will try to explain what IRR is, how to derive it for your business, and what IRR an investor expects to see in a potential investment.
ROI vs IRR
Most people are familiar with the concept of Return on Investment (ROI). If you invest $50,000 in a rare stamp and sell it for $100,000, that’s a $50,000 gain on investment, resulting in a 100% (1x) ROI. Simple and straightforward.
But ROI is missing one critical piece of information. If you doubled your money in 3 years, it’s a much better investment than if it took 6 years to mature, since your capital is tied up for a shorter period of time. However, ROI is unable to account for the length of time.
To solve that problem, investors prefer to evaluate investments by using IRR. The formula to calculate IRR is as follows:
Okay, thanks for reading our post on IRR.
Just kidding! Even the most seasoned finance experts don’t have this formula memorized. Fortunately we have Excel to help us calculate it.
The easiest way for me to wrap my head around the concept of IRR is to think of a credit card and compounding interest. Every month, the credit card’s interest rate is applied to the account’s principal, creating a new balance. The following month, the interest rate is applied to that new principal balance, compounding the debt. Similarly, an IRR is accounting for compounding interest, but we’re doing it backwards (in finance terms, we call that “discounting”).
Let’s return to our stamp example to understand the difference. The tables below show what your IRR would be if you realized the gain after 3 years:
Each year, the stamp’s internal rate of return is 26%. At the end of the first year, it would be worth $63K, after the second, it would be worth $79.4K, and finally the end of year three, we hit the 100K sales price (I rounded here, but you get the point.) Simply, the IRR lets us figure out what that average annual rate of return is based on the amount and length of time the investment is held.
Now let’s look at the IRR if we sold it after 6 years:
If you held onto it for 6 years, the IRR would be only 12.2%! When evaluating IRR, the higher the IRR, the better the investment performed. If 3 years IRR is 26.0, why isn’t 6 years 13.0? Because of compounding interest!
Risk vs Reward
An investor is going to look at an investment opportunity broadly in order to ascertain whether its potential reward is worth the risk they will incur. First, an investor will compare it to other investments. Over the last 20 years, the S&P500 has averaged 5.9% per year. Since the S&P500 comprises large-cap companies with long histories, it’s a relatively safe investment. If you were to look at the stock market as a whole and factor in riskier companies, the average annual return increases to just shy of 10%.
I mention the stock market for two reasons.
- First, it’s a clear example of risk versus reward. S&P500 stocks are stable but not fast-growing. Low risk, low reward. Investing in smaller cap stocks is riskier, but the potential reward is higher. If you seek high reward in the stock market, you have to incur greater risk.
- Second, investing in a startup is FAR riskier than investing in publicly traded company. An investor can average just shy of 10% a year trading stocks, and maintain asset liquidity since it’s easy to sell a publicly traded stock. So you’re going to have to make it worth their while to invest in your risky (at least as far as they are concerned) and less-liquid startup.
Thus, we definitely need to hit at least an IRR of 10% to make it even worth considering. More on what an investor expects later.
Deriving the IRR
The only way we can compute IRR is by first deriving an enterprise valuation. Since a company is worth precisely what someone is willing to pay for it at that time, we’re going to have to rely on assumptions based on industry comparables. In other words, when dealing with a startup’s enterprise value, we generate a hypothetical forward-looking value rather than base it on present value. (Note: Rather than a future valuation, investors will also use pre- and post-money valuation to address investment risk, which I will address in a future article.)
There are several ways a company is valued, and I could write a series of posts about valuations (and maybe I will!). However, for equity investments, the most common way to determine an enterprise valuation is by using an earnings multiple. (Note that I’m using the terms “profit,” “net profit,” and “earnings” interchangeably in this post. There are some nuanced differences between the three terms, mostly having to do with corporate taxes and amortization, but for today, we’ll keep it simple.)
In short, the earnings multiple is the money investors are willing to spend to acquire shares relative to profit. In stock trading parlance, this is the P/E (Price to Earnings) ratio. Multipliers are relative to industry and based on recent equity transactions. You can search the web to find earnings multipliers by industry or sector.
The average P/E ratio across all publicly traded companies is around 13. If your valuation comparables are publicly traded companies, you might want to add a liquidity discount of 30%. A common number I’ve seen VCs use is 5–6x earnings, so be prepared for that.
In Part 2, we’ll put IRR into action so you can see it in context.
Click here for Part 2.
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