Time is money. A saying known all over the world. One term that has been gaining notoriety is internal rate of return (IRR) because it factors in time, unlike multiples. Both IRRs and multiples serve a similar purpose: to help a venture capitalist (VC) evaluate and gain potential profits while investing in startups.
Understanding IRR: Measuring Growth Over Time
IRRs are an investment method that highlights the potential volatility of money over time. An IRR is the percentage rate at which your money grows annually. To calculate IRR, you can use the formula:
IRR = [ {(Payoff/Investment)〖^(1/n)〗 -1} x 100% ].
Where n represents the number of years between the investment and payoff. However, this equation is only valid if you invest once, all at the start, and there is a single payoff at the end. For example, if you invest $100,000 and earn $300,000 in one year, the IRR would be 200%. The equation would go as follows:
IRR = [ {($300k/$100k)〖^(1/1)〗 -1} x 100% ] = 200%.
IRRs vs. Multiples: What Gets Left Out
One advantage of IRRs is a quick and profitable exit under the right circumstances. Furthermore, as a VC, you can compare your annual rate of return between startups and decide where to continue investing. Another upside of IRRs is that they account for the time value of money— the principle that a dollar today is worth more than a dollar in the future due to inflation and opportunity cost.
By contrast, a multiple is focused on the total profit gained from the investment and does not account for the period of time in which you are investing. It is measured in multipliers. If you invest $100,000 today and later exit with $600,000, that would be a 6x multiple. Multiples, can be risky, not very time-efficient and might underperform due to trends, political climate, market fluctuations, etc. Consequently, you will look for tremendous multiples to make an overall profit on all of your total investments.
Why IRRs Offer a Clearer Picture
So why are IRRs better than multiples? Both measure investment performance, and both measure money in versus money out. However, IRRs may be more efficient for investing, especially ones of low risk and short term. IRRs account for something that multiples do not— which is time. For example, take an investment where $100 was invested and $200 was earned back within a year. This would result in a 2x multiple and 100% IRR. If the same return occurred over 5 years instead, the IRR would be 14.9% and the multiple would remain at 2x.
IRRs, as they factor in time, offer a more detailed and informative analysis on the performance of your investment. While multiples remain a useful shorthand for summarizing outcomes, IRRs give you a much sharper tool for understanding the efficiency of your capital.