What is IRR? And why should I know about it?

Technically put, this is the return on investment (ROI), a casual calculation of a ratio between net income and investment.

However, for potential investment, the calculation of the potential return on investment is more complex for start-ups than a traditional investment, but the underlying principle remains the same.

The metric most commonly used to determine the financial performance of a startup is the Internal Rate of Return (IRR).

What is the Internal Rate of Return?

IRR is a metric used in financial analysis to estimate the profitability of potential investments.

Simply put, IRR is the rate of growth that the investment is expected to experience. Technically speaking in a discounted cash flow analysis, IRR is the discount rate that equates the net present value (NPV) to zero.

The formula for IRR is complex, involving a number of mathematical formulae and processes. Luckily, there is a much simpler approach to calculating the internal rate of return, using spreadsheet formulae on Microsoft Excel or Google Sheets.

Why do investors look at your company’s IRR?

Investors will use IRR to determine their future returns from such an investment. Since returns coming from investing in start-ups are not certain, the future cash flows are likely to be highly variable. The IRR is a good way to “smooth” such variation and provide an understandable average rate of return to investors.

What value do I need my IRR to be?

There is no golden value for an IRR that will automatically ensure a potential investor does give you that investment. An ideal way to evaluate the IRR of a startup is to compare it against historical performance of investing returns, and consequently a good IRR for an investment in a startup would be one that returns equal or above the benchmark.

Whilst the IRR value will provide the investor with a ballpark figure of where your business could grow to, it is not the only part of the story. There are many other factors which play into an investor’s decision to invest in your venture or not.

Investors will look at further risk factors beyond the factors that go into calculating the IRR. They will also have in mind the need to diversify their portfolio across different asset classes and industries. Very few seasoned investors would place all of their capital into a startup venture, no matter how promising the forecasted IRR is.

In the end, IRR is one of many possible metrics and factors that investors can use to determine if an opportunity is worthwhile for them. If you are trying to sway an investor who is still undecided, you will need more than just an IRR forecast to convince them to invest in you. They will need to see that your idea is defensible, that you and the people around you are the best ones to turn the vision into reality and that you will be able to realise an exit for them in the not too distant future. Read here about how you can effectively communicate your exit strategy to investors.