- By Aaron Kellner
- May 8, 2018
- 5 minute read
Venture capital is a unique asset class in that it typically represents long-term, illiquid investments in early-stage companies which are less established, predictable, and in most cases are not yet even profitable. To help make sense of investment performance in this context a handful of measures – including Return on Investment, Cash-on-Cash, and Net Present Value – have been proposed to help both fund managers and investors gauge the performance of not only their venture portfolios themselves but how those portfolios compare against different types of investments. While these varying performance measures each have their own strengths and weaknesses, one such measure – Internal Rate of Return (IRR) – has emerged as an industry standard. In large part this is due to the fact that IRR allows investors to make apples-to-apples comparisons across asset classes (i.e. leveling the playing field between the returns one has earned or expects to earn across publicly-traded stocks, bonds, real estate, annuities, venture capital, etc.).
Of equal, or perhaps greater, importance is that IRR allows for such comparisons on a standardized annual basis, which is crucial given the long-term, illiquid nature of early-stage investing versus the more traditional asset classes enumerated above. It is critical then that all early-stage investors have, at minimum, a baseline understanding of not only what the IRR represents and why it is used, but also its limitations.
What is Internal Rate of Return?
The textbook definition of Internal Rate of Return (courtesy of Investopedia) is “a discount [interest] rate that makes the Net Present Value (NPV) of all cash flows from a particular project equal to zero.” The underlying math itself comes courtesy of the Corporate Finance Institute:
For folk with a finance degree we’re sure these are helpful. But for those who chose a different major, IRR is far easier to understand once the underlying calculation is broken down to its core inputs:
- How much money did I invest?
- What is the current value of my investment (whether actual or estimated)?
- How much time has passed since my investment?
Although not always the case, venture capital IRRs are often easier to calculate (and understand) than stocks, bonds, or any other investment in which one may make multiple investments and receive multiple distributions (or returns) over a given period of time. In contrast, many early-stage investors opt to make one-off investments in as many companies as practical and then wait for a potential exit (e.g. acquisition or IPO) some years down the line. In this simplified scenario, it is easiest to think of the IRR as the annualized percent return one either has (or expects) to generate on the money they have invested.
As a simple example, let’s say that an investor invests $1,000 in a startup and that five years from now that company is acquired at a valuation that returns to that investor $10,000 (i.e. a 10X return on capital invested). Taking into account the five years that elapsed from the time of investment, that investor would have earned a 58% IRR. Granted, IRRs nowadays are almost exclusively calculated on spreadsheets, so it isn’t practical to walk through the underlying math of the IRR calculation itself. However, it’s actually fairly easy to spot check the underlying theory, as demonstrated by the table below which illustrates what happens when a $1,000 investment generates a 58% return per year for five years:
Why use Internal Rate of Return?
As discussed above, Internal Rate of Return has established itself as an industry standard for good reason:
- IRR is a fairly intuitive performance metric, especially when compared to competing methodologies such as Net Present Value.
- IRR takes into account the time value of money (i.e. the concept that $1 today is worth more than $1 five years from now due to factors such as inflation), which is extremely important in the context of early-stage investing since returns are typically neither periodic or predictable.
- IRR produces an annualized return regardless of the investment period (e.g. even if returns were realized in less than one year), which makes it possible to compare nearly any type of investment in a consistent, standardized fashion and compare not only competing investment opportunities within the same asset class, but across asset classes as well.
Internal Rate of Return Limitations and Considerations
Internal Rate Return is not without its limitations, however, and investors should bear these in mind when reviewing IRR data:
- IRR presents returns on a relative (percent-based) basis as opposed to actual dollars earned and is heavily impacted by timing, rewarding immediate returns. Although it might be nice to earn a 100% IRR on a one-year investment, a 50% IRR on a three-year investment would net you 70% more actual dollars.
- IRR data can be presented in “Gross” terms (representing the performance of the investment itself) or “Net” terms (which takes into account potential fees). Investors should confirm the basis upon which IRR data is being presented, as fees such as carried interest and management fees can have surprisingly large impacts.
- In the context of early-stage investing, the current value of the investment itself is only an estimate. Sometimes this is made subjectively but more often than not the most recent valuation at which a company raised money is used (as a side note: companies will either underperform or outperform relative to their last funding round, meaning that essentially every company will be overvalued or undervalued to some degree).
- The IRR calculations assumes that future cash flows/distributions are reinvested at the IRR, which is a near-impossible reality. Fortunately for early-stage investors, since there typically is only one cash flow/distribution (an acquisition or IPO) this has minimal impact.
- In the context of one’s venture portfolio, since startups that fail typically have shorter lives than those who don’t, it is often the case that a portfolio produces negative returns in the short-term and increasing thereafter (a concept known as the “J Curve”).
Don’t Forget: It’s Only An Estimate
There are many ways to measure the performance of an investment. This is especially true in venture investing where companies are much less established and less predictable. But for early-stage investors, returns will typically only be realized when a company gets acquired or goes public (i.e. IPOs on the NYSE, NASDAQ, or another public exchange). These realized IRRs can only be known after the fact and can vary from unrealized estimates. Still, unrealized IRRs maintain relevance as a legitimate benchmark of portfolio performance.
This post was written by aaronkellner on May 8, 2018