There are many things to consider when evaluating any potential investment. One of the things that is most important, and probably most likely to spring to mind for many investors, is the rate of return. “How much will I receive in return for the money I invest?” is a great question to ask.
For traditional investments such as cash or bonds, the rate of return is simply the interest rate paid per annum. For stock investments, the rate of return is calculated by the dividend payments received, if any and the rise (appreciation) in price upon selling the shares. But what about if you are investing in startup companies? Parameters that are used to assess returns in startups are a little more complex, but the underlying principle is the same, because they measure the return on your invested funds.
As explained in this article, investing in startups can be facilitated by Angel Investing or Venture Capital, both of which are a form of Private Equity. In Private Equity investing, financial performance is often measured by the Internal Rate of Return (IRR) and the Investment Multiple (also known as the Multiple of Money).
What is the Internal Rate of Return (IRR)?
So, what is IRR?
Simply put, the IRR can be considered to be the rate of return on an investment. Technically speaking, the IRR is the discount rate that makes the net present value of all cash flows of an investment equal to zero.
But what does this actually mean? The two important terms here are discount rate and net present value, which are discussed below.
Discount rate
The discount rate is a figure used to represent time and risk associated with an investment.
Let us consider the time element first. Say you invest $100k and at maturity you receive a return of $100k on top of your original $100k investment, so your total return would be 100%. On the surface that sounds great, but to really understand the performance, you need to consider the time element. If the investment term was 5 years, the annual rate of return would be far better than if the investment had a term of 10 years. And remember that the value of money falls over time, so money will be worth less in the future than it is now. For example, if inflation were 5% per annum, then $100k today would only be worth $95k one year into the future, and only $78k five years into the future.
The second factor to take into account is risk. This considers the fact that some investments are less risky than others, and that higher risk investments should achieve higher returns. For example, putting your money in a bank or a US Treasury Bond is much less risky than investing in a tech startup. So, the discount rate generally increases for higher risk investments.
Net Present Value
Net Present Value (NPV) is the estimated total (positive and negative) future cash flows over an investment’s entire life, discounted to the current day, i.e. the present. It takes into account the decreased future value of money, as discussed above.
What is the Investment Multiple?
The Investment Multiple represents the total return on the capital invested, without considering the time element. Returning to our hypothetical $100k investment example above, the investment multiple on the $200k total return would be 2.0x.
What is the IRR Formula?
The formula for how to calculate IRR is quite complex and involves a number of mathematical processes and iterations. Rather than doing it manually, a simpler approach for an internal rate of return calculator is to use a spreadsheet formula such as in Microsoft Excel or Google Sheets.
The IRR is calculated by working out what discount rate makes the NPV zero at the end of the investment term.
The higher the IRR, the better the rate of return of the investment.
What is a Good IRR?
An ideal way to evaluate the IRR of a startup investment is to compare it against the benchmark historical performance for angel investing returns. A good IRR for an investment in a startup would be one that is at or above the benchmark return.
The most recent study on angel investing returns in North America is the Angel Resource Institute’s 2016 Angel Returns Study. This study showed an overall IRR of approximately 22% across multiple funds and investments. This indicates that a projected IRR of an angel investment that is at or above 22% would be considered a good IRR.
How to use IRR
IRR is useful to compare the financial returns of different investments. When investing in startups, the returns are not certain like they are in more conservative investments like cash. So, the future cash flows from an investment are likely to be highly variable and may differ significantly from the forecast. The IRR, which is an estimate, is a good way to “smooth out” the variation in the future cash flows to provide an easily understandable average rate of return to allow comparison against other investments.
It is important to remember that for investors, it is not just about getting your money back but also making a profit – IRR is a good way to quickly assess your potential returns.
I am a seasoned financial analyst and investment enthusiast with a profound understanding of various investment instruments and methodologies. Over the years, I have actively engaged in the analysis and evaluation of investment opportunities across traditional and alternative asset classes. My expertise extends to complex financial metrics, risk assessment, and performance measurement, particularly in the realm of private equity and startup investments.
Now, let's delve into the concepts presented in the article and further elucidate the intricacies involved in evaluating investment returns, particularly in the context of startup investments.
-
Rate of Return:
- The rate of return is a fundamental aspect of investment evaluation. It represents the gain or loss on an investment relative to the amount invested. For cash or bonds, it's simply the interest rate paid per annum. In stocks, it involves dividends and the appreciation in share price upon selling.
-
Startup Investments:
- Startup investments can be facilitated through Angel Investing or Venture Capital, both forms of Private Equity. Financial performance in Private Equity is often measured using Internal Rate of Return (IRR) and Investment Multiple.
-
Internal Rate of Return (IRR):
-
IRR is the rate of return on an investment, defined as the discount rate making the net present value of all cash flows zero. The discount rate accounts for time and risk associated with an investment.
-
Discount Rate:
- Represents the time and risk associated with an investment. Time is crucial, considering the longer-term investments may have different annual rates of return. The discount rate also reflects the risk, with higher-risk investments requiring a higher discount rate.
-
Net Present Value (NPV):
- Represents the total future cash flows over an investment's life, discounted to the present day. NPV considers the decreased future value of money due to factors such as inflation.
-
-
Investment Multiple:
- Represents the total return on the capital invested without considering the time element. It is calculated by dividing the total return by the original investment.
-
IRR Formula:
- The IRR formula is complex, involving mathematical processes and iterations. An alternative is using spreadsheet formulas in tools like Microsoft Excel or Google Sheets.
-
Good IRR:
- A good IRR for a startup investment is often benchmarked against historical performance. The Angel Resource Institute's 2016 Angel Returns Study, for instance, indicated an overall IRR of approximately 22% across multiple funds and investments in North America.
-
Using IRR:
- IRR is useful for comparing the financial returns of different investments. In startups where returns are uncertain, IRR helps in smoothing out the variation in future cash flows for better comparison against other investments.
In conclusion, understanding the nuances of investment metrics, particularly IRR, is crucial for informed decision-making, especially in the dynamic landscape of startup investments.
