The Internal Rate of Return (IRR) is the discount rate that makes all the cash flows of a Discounted Cash Flow Analysis (DCF) equal to zero. It can be understood as a startup’s average annual return. Its an overall measure of your startups return potential as it considers every cash flow from investment to growth period and exit, while reflecting time value of money. If your predicted IRR is high enough (>100%), your startup will have a high chance of being fund-able.
Most measures of return on investment are absolute and time dependent. Reflecting your startup’s performance by how much you could sell it for is relevant, but ignores how long it took and how much investment was needed (by you and by others along the way). The IRR is a neat way to combine the whole picture in one metric. Hence its more nuanced then just saying “I made 5x my money with ABC Ltd.” . In fact, as you can throw whatever cash flow pattern at it, it can even be used to determine an individual investor’s rate of return or that of an individual project within a company.
Calculating Startup IRR
How is IRR calculated? Isn’t it just an average of annual returns? Or can’t we use the CAGR (Compound Annual Growth Rate) formula from investment amount to exit price? Not exactly! These methods don’t correctly reflect time value of money or the cash flows in-between investment and exit.
Think of the IRR more as the discount rate that equates a startup’s initial investment with all of its future cash flows. This is where the Net Present Value (NPV) method comes in to play. The NPV discounts all the future cash flows to the initial investment date by a discount rate (required rate of return) and deducts the investment amount. Its result is your risk adjusted return in dollars.
If we wanted to manually calculate the IRR (which would be very tedious try-and-error kind of work), we would apply the Net Present Value formula to our startups cash flows and try to figure out a discount rate that would make the present value of all future cash flows be equal to the initial investment (a net present value of zero).
Using the NPV method to understand the IRR calcualtion
As you may recall from the discounted cash flow section, when determining a company’s net present value, we discounted back all future cash flows including the terminal value by our required rate of return, and then compared this figure against the initial investment needed to setup this company. If that figure was substantially positive one would invest in such a project.
NPV example for a startup with a rapid and a steady growth phase:
However, the net present value approach has one substantial pit fall: It’s result is absolute, meaning a dollar amount, which often is difficult to put into perspective.
For example, an investment in a power plant would likely render a high net present value, but it would also be a very lengthy and complex undertaking. Contrast starting an App company that could make first revenues in a few months. The IRR is a relative measure of return. It allows you to categorize your startup’s overall potential and measure it against other opportunities independent of duration until exit.
This is tremendously important for fund raising, as only startups with a sufficiently high enough IRR are generally considered “investable”. We discuss the entire topic of what is an investable project in a separate section of this course, but as a rule of thumb, a startup should offer a projected IRR of 100% per year or above to be attractive to investors.
Rule of thumb: A startup should offer a projected IRR of 100% per year or above to be attractive investors!
Of course, this is an arbitrary threshold and a much lower actual rate of return would still be attractive (e.g. public stock markets barely give you more than 10% return). But since we are talking about uncertain projections, an IRR of 100% at least guarantees that the company’s business model in theory has enough buffer to perform well enough, even if things don’t go according to plan.
How to set NPV to zero:
Again, to calculate the IRR we essentially need to achieve a NPV of zero, we can only use a trial and error approach. Even the IRR formula in Excel or your financial calculator essentially uses a trial and error approach. This is also why you sometimes see a small computation lag time even in Excel.
IRR – The Discount Rate that results in a NPV of Zero
In our example a Discount Rate of 153.7% discounts all future cash flows to match exactly the initial investment of $1,500. This means at this discount rate the Net Present Value is exactly $0.
IRR calculation by trial and error
Again, the only way to calculate this manually is by trial-and-error. Best is to use Excel’s “=IRR” formula for which you simply mark all projected cash flows from year zero to the final year of your model (remember the terminal value needs to be added to the last year) and hit enter.
Financial calculators or similar apps such as Texas Instruments BAII Plus App can do the same…but seriously, why even bother? Your model is in Excel anyways.
Calculating Startup IRR in Excel
As IRR calculations are such an iterative process and your inputs will come from your financial model, you should stick with Excel to calculate it. Our examples where calculated with the below spreadsheet:
The Excel =NPV() formula set to zero:
A couple things to remember: All amounts are calculated and rounded to the nearest dollar. Terminal Value is the projected price of this startup at the end of year 5. It is based on letting the cash flow of year 5 grow at 5% forever, assuming a required rate of return of 15%. In the case of IRR calculations, only the discounting of the amounts of the 5 years is done by applying IRR – the “r” in the terminal value formula however stays 15% (or whatever return rate you analyse to be fair in the far distant future). The above table shows, if you set the discount rate to IRR, your NPV will be zero!
If you would like to play around with this, you can download the spreadsheet here. Or if you would just want to understand the formulas take a look at this:
The Excel =IRR() formula:
And if you set the discount rate back to 15%, the NPV looks a little more normal again. You can also prove this by adding up the individual discounted cashflows like in the bottom half of the spreadheet.
The Excel =NPV() formula at 15% discount rate:
Pros and Cons of using IRR for Startups
The downside of IRR, is rooted in its advantage. It is relative! Hence you can have 100% IRR on a $100 investment which still is a nice IRR, but won’t make you a millionaire anytime soon. Also, it totally ignores the time until you reach break-even.
For example, a bio tech startup’s very high potential IRR might require years of research, passing of governmental approval processes and the binary potential of effectiveness or non-effectiveness of a new drug or medical device. In contrast, some consumer-focused tech startup might provide a similarly high IRR but generate cash much earlier. But don’t forget: Time and absolute numbers matter, too.
So, while a high IRR is an important threshold for investability and a key metric you will want to consider for your pitch documents, it has to be evaluated in conjunction with other metrics
Summary:
- IRR is great for analyzing a startups return prospects independent of time till exit
- Don’t make it your only metric – Your dollar return still needs to be high to get rich
- Calculate it with Excel
- …and don’t forget to calculate TV for the right period!
Table of Contents