Venture Things E01: The Internal Rate of Return
The Internal Rate of Return (IRR) is a wide-spread measure for the return of investment projects — also in Venture Capital. It has very good properties, but also a very critical assumption. In Venture Things we try to give short explanatory views on terms & KPIs used in the VC life!
The IRR is the interest rate which yields a Net Present Value (NPV) of Zero for an investment project. So what about the Net Present Value and the Zero? When deciding over investment projects a NPV > Zero is a clear “GO!” and a NPV < Zero is “Nope!”. Therefore, the IRR is the interest rate which represents the break-even between “GO!” and “Nope!”. After calculating the IRR of a project you can benchmark this value — e.g. against other risk-adjusted interest rates which are annualized and derived from other comparable investment projects.
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The main assumption of the IRR is that temporal cash-inflows can be re-invested at the very IRR. Decisions based on NPV and IRR can differ because of this assumption. However, finance practitioners still love this measure and especially in VC this is actually okay: The timing and amounts of temporal cash-inflows is limited in Venture Capital — thus, the main assumption does not inflate results too much. Additionally, you can modify the IRR by actually modelling the re-investment process and assume other (more realistic) interest rates for re-investing the temporal cash inflows until the maturity of the project.
The existence and use of the IRR should be enjoyed — carefully. To measure performance and overall returns of longterm-high-risk investment projects is not that easy and should include different measures and KPIs as a modified IRR or a detailed comparison of Money-Multiples.
Sources:
https://www.investopedia.com/terms/n/npv.asp
http://www.chegg.com/homework-help/definitions/internal-rate-of-return-irr-11
