What is IRR and Why Does It Matter

Posted in Finance by Ben Worsley

As a founder, you don’t have to be a finance whiz. However, it is crucial to the success of your company (and your business plan!) that you have a baseline understanding of finance concepts, especially when you’re pitching investors.

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 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:

IRR Formula From Investopedia
Source: Investopedia

 

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:

Simple IRR Example

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:

Chart Showing IRR

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.

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

Investor Proposition From 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.

Investor Prop from Masterplans business plan

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:

Investor Prop from Masterplans Business Plan

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.

--

Ben Worsley is Marketing and Creative Director for Masterplans. But he is a former Financial Modeler!

Tagged: IRR, funding, investors
Most Popular
Articles
8 Funding Options for Startups - Plan Friday
Immigration
Can You Get an E2 Visa with Less Than $50,000?
Articles
Bus Transport Business Plan
Articles
Fried Chicken Business Plan
Read Previous
News Startups Led by Women Entrepreneurs Increase Read more >
Up Next
News Startups Direct New Products at Younger Customers Read more >