IRR: What Is It and Why Founders Need to Understand It (Part 2)

Part 2 of Our Primer for Founders on Internal Rate of Return (IRR) and Investor Expectations

This is Part 2 of our “Finance in Focus” article on IRR. Click here for Part 1.

In Part 1, we looked at what IRR was and why investors used it. Now let’s put IRR into action so you can see it in context.

This is the Investor Proposition table you would see in a Masterplans business plan:

Let’s walk through this table one line at a time. The top line here is the investment amount. In this example, I used $1 million.

The second is the equity position an investor would receive in exchange for the $1 million investment. This is a variable, and the equity position you offer determines the IRR. For this example, the company is offering 40% equity share in exchange for the investment of $1 million.

Since we are using earnings to derive the company’s valuation, the next line shows the company’s profit, which will be driven directly by your financial model. In this case I’m showing a net profit of $1 million in year 5. This is not accumulated profit. It goes without saying that this is a pretty hefty profit. If you were looking at an average business’ profit margin (~10%), your year 5 revenue would need to be $10 million! Growing a company from $0 in revenue to $10 million in revenue in just 5 years is incredible growth, and gives you an idea just how aggressive your revenue potential needs to be to entice a sizable investment.

The next line is the earnings multiplier; for this example, I set the multiple at 10.. This is another variable that is typically based on industry.

With $1 million in earnings and an earnings valuations multiple of 10, the next line on the chart indicates the company valued at $10 million at the end of the fifth year. Returning back to the investor share, the value of the investor’s equity is 40% of that $10 million valuation, or $4 million. Finally, we have enough information to compute an IRR for our example: 32%.

What IRR Does an Investor Expect?

Another question we often get is how to decide how much equity position to offer. The answer, is that it really depends.

What we don’t want to do is give away controlling stake (more than 50%), but we still need to offer a reasonable IRR. In the case we’re working with here, an investor may want a higher IRR while you, as the owner, may not want to give 40% of the company away.

In general, an investor is looking for around 40–60% IRR when investing in a startup. Typically, a VC group is going to come in on the higher end of that amount, while angels may look for less.

When I’m working through a financial projection, I typically shoot for 50% unless my client can offer a reason as to why their investors would be willing to accept less. (An example might be a vanity project such as a brewery.)

One way a founder can increase the investor’s return without adding additional equity is by adding an annual distribution of earnings, also known as a dividend. This payment from the company’s cash flow allows for the investor to earn an annual distribution that increases their IRR.

It should also be noted that investors may not always be interested in dividends. For example, with a tech company, the investor is most likely looking for an exit event to realize the gains on their investment, and would rather see profits re-invested into the company rather than distributed.

I’ve recast the same example as above, assuming a baseline 10% annual growth in profit in order to calculate the dividend.

As you can see here, by adding a distribution commensurate with the equity position, the proposed equity share is lowered to 30% and gets us to a more-than-40% IRR. Most of the time, we try and get the IRR to 50% so let’s try returning to a 40% equity share:

As you can see, everything increases despite earnings staying the same. Now the investor has an equity position worth $4 million, and an annual dividend of 40% of earnings, resulting in a 52% IRR.

Conclusion

There’s a lot to digest here, but from a founder’s perspective, here is what you really need to know.

First, that IRR is a formula to compute the average annual return on an investment as a function of the length of the investment. Second, since startups are risky, most investors are looking for 40–60% IRR over 5 years, typically on the higher end. Third, the IRR is directly impacted by the equity share that the investor receives. Fourth, as a startup or early stage business, you’re going to use assumptions to forecast an enterprise valuation. And finally, IRR can be boosted by offering the investor a dividend.

Founders, please don’t hesitate to comment below if you have questions or feedback based on your capital raises. And investors, I’d love to hear from you about IRR in the comments as well. What IRR do you expect from a start-up? How do you compute startup valuations?

Masterplans is a veteran-owned business that specializes in providing the highest-level business development consulting located in Portland, Oregon. For over 18 years we have helped thousands of entrepreneurs develop compelling business plans and pitch decks. Learn more about how we can help you.