Venture Capital Economics

Internal rate of return is a common metric used in venture to compare a fund’s performance across vintage years.

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- Venture investors use internal rate of return (IRR) to track how funds perform relative to each other and to other asset classes.
- Unlike many other performance metrics, IRR factors in the ‘time value’ of money.
- The higher the IRR, the better an investment is performing (or expected to perform).

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Calculating expected returns on a venture investment is more complicated than predicting how much your 401(k) will grow next year. Unlike other asset classes, venture investments:

- Remain illiquid for an extended period of time,
- Experience wild swings in valuation because of the volatile nature of startups, and,
- Have valuations that can’t be tracked in real-time, unlike, say, the price of a publicly traded stock.

Because of this, many fund managers (also known as general partners or “GPs”) use internal rate of return (IRR) to gauge the performance (or expected performance) of venture investments before they fully mature and to compare potential investments.

IRR shows the annualized percent return an investor’s portfolio company or fund has earned (or expects to earn) over the life of an investment. The higher the IRR, the better the investment is performing (or expected to perform).

IRR takes into account the following factors:

- The amount invested,
- The cash flow(s) an investor expects the investment to generate, and,
- The timing of those cash inflow and outflows.

Unlike other metrics, IRR allows investors to make standard comparisons across asset classes and funds of different vintage years—no matter the time frame. That’s because it takes into account the time value of money. This is an important concept for venture investors because of the long-term, illiquid nature of this asset class.

The concept holds that an investment that returns $1 today is more valuable than one that returns $1 in 7 years (the average time it takes for a SaaS company to go from seed to IPO) because you could invest that $1 today and turn it into something greater than $1 in 7 years.

For example, a venture fund that generates a 10x return for an investor over 7 years will produce a higher IRR than a fund that generates a 10x return over 14 years. The IRR takes into account the amount of time it took to generate the return, allowing for easier comparisons between funds.

And because it’s an annualized percentage, IRR also allows investors to compare venture investments to other asset classes.

According to research by Industry Ventures on historical venture returns, GPs should target an IRR of at least 30% when investing at the seed stage. Industry Ventures suggests targeting an IRR of 20% for later stages, given that those investments are generally less risky.

To calculate IRR, investors must first understand net present value (NPV). In the simplest terms, NPV estimates how much your investment will be worth in the future and translates that into today’s dollars. More precisely, it’s the difference between the present value of cash inflows (or predicted cash flows) and the present value of cash outflows (or predicted cash outflows) over a period of time.

IRR is the annual rate of return an investment must generate in order to make NPV equal to 0. In other words, it’s the rate that will make the present value of the future cash flows equal to the initial dollar investment (sometimes called the “break-even discount rate”).

To calculate IRR, the GP must estimate a fund’s cash flows (capital calls and distributions) over the period they’re measuring.

Here’s the formula for calculating IRR:

Fund managers most commonly use unrealized IRR, which indicates that profits have not yet come in (and they may not for some years). To calculate unrealized IRR, investors use the current value of a fund’s assets, as though they were sold at the time of calculation. This allows GPs to compare performance of investments that might exit on very different time horizons.

Once the fund fully matures and investors receive their distributions, the GP can calculate the realized IRR using the actual return numbers instead of estimates.

Total Value Paid In (TVPI) is another common metric GPs use to gauge fund performance. TVPI attempts to calculate the total value (both realized and unrealized profits and losses) that a fund has produced for investors relative to the amount of money contributed. Unlike IRR, TVPI does not factor in the time value of money.

The formula to calculate TVPI is:

TVPI = Total Value / Paid-In Capital

If the TVPI is above 1.00x, it means the investment grew in value. For example, if a fund had a TVPI of 1.25x, it would mean that for every $1 investors contributed, they saw a return of $1.25 (a 25% return).

The critical difference between IRR and TVPI is that TVPI doesn’t consider the timing of cash flows. A TVPI of 1.25x at the 1-year mark versus the same TVPI at the 5-year mark carry very different implications for investors. In the first instance, investors saw a 25% return after just one year. In the second, it took five years for investors to see a 25% return—roughly a 4.6% annual rate of return.

For funds of the same vintage year, TVPI can provide a helpful comparison (provided they’re similarly sized and invested at roughly the same cadence). For funds with different timelines, IRR is often more helpful.

TVPI is easier to calculate because GPs only need to know how much capital went into the fund, the distributions paid out by the fund, and the estimated value of the investments remaining in the fund. IRR requires knowing the timing of cash inflows, as well as that of actual and projected distributions.

IRR and TVPI can also have an inverse relationship. According to an AngelList analysis, funds that invest faster tend to have lower IRRs but higher TVPIs than their slower-investing peers—creating further ambiguity for investors.

The timing of fundraising and capital deployment, as well as the timing of returns, can greatly impact IRR calculations.

Further, valuations (and corresponding expected cash flows) in venture capital tend to be more of an art than a science—early stage startups are notoriously hard to value.

IRR is a valuable—albeit tricky—metric to analyze the return prospects of an investment. But it shouldn't be a GP’s only valuation method. Many GPs report both IRR and TVPI to give a more holistic understanding of their investment performance.

At AngelList, we developed a calculator that factors in both IRR and TVPI so investors can assess fund performance. Our calculator offers an apples-to-apples way of comparing venture funds across vintage years. Just input your fund's and IRR and TVPI to see how you stack up against your peers.

Read more about our performance calculator or try it for yourself.

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