IRR Analysis

How to Analyze an IRR Report:

Experienced entrepreneurs rarely provide a slide in their investor pitch showing expected IRRs. The reason in simple: it sets an expectation that could come back to bite them in the future. Instead, entrepreneurs should present pro forma financials, a capitalization table, and data about similar companies that have been acquired (showing their acquisition prices as multiples of revenues and profit). Then let potential investors make their own calculations about expected IRRs; that way they can use their own multiples and apply any discounts they want to, and you have made no implied promises. What Offtoa does for you is (1) it shows you five ways to value your company at liquidation time, (2) based on the cap table and liquidation preferences, shows how the proceeds of a liquidation event would be distributed among the shareholders, and (3) calculates the expected internal rates of return for each class. Finally, Offtoa performs an analysis of these IRRs looking for properties that investors would look for. The primary reason for surfacing these issues is so you can fix them now rather than suffer the embarrassment of potential investors finding them later.

Here is a partial list of the kinds of issues that Offtoa looks for:

• Investors Receive Higher Return Than Earlier Investors
• Investors Unlikely to Find Returns Acceptable
• Some Investors Receiving Zero (or Negative) IRR

Whenever Offtoa finds one of these issues, it highlights the symptom for you on the IRR table, and offers a list of suggested solutions, each of which describes exactly which assumptions you need to change to fix the problem. However, don't just “fix” the problem by blindly selecting one of the suggestions. That will result in you having a set of financial statements that look good but have no basis in reality. Instead, make changes to assumptions that you believe are feasible and then change your business strategy to reflect the new plan. If none of the suggestions are feasible in your mind, then perhaps you don't have a viable company :).

Questions:

What can I learn from the IRR report?

There are two primary goals of the financial feasibility analysis of IRR's: (a) does each class of shareholder receive a better return than subsequent classes of shareholders (this is due to the fact that each successive round of investor is taking less risk than earlier rounds of investors), and (b) do all classes of shareholders receive acceptable returns?

What should I do if my plan shows a group of investors receiving a better return than an earlier group of investors?

Although this situation might end up occurring as the result of unusual circumstances, you would never want to plan for it to occur up front. After all, that would mean you would be asking investors to invest their money while knowing that they can receive better terms if they wait until the next round; this is of dubious ethical character. To fix this situation in your plan, do one or more of the following:

1. Lower the price per share of the earlier round.
2. Raise the price per share of the later round.
3. Accelerate the earlier round.
4. Delay the later round.

Why do investors want such high IRRs?

All investors have a choice of investments; they can invest anywhere in the range from low-risk, low-return to high-risk, high-return. When they decide they want to invest in start-up companies, they are taking extremely high risk. In fact, the probability is high that they will lose their entire principal. No matter what you say or do, your company is a high risk venture. Therefore it had better have a corresponding high return for the investor. After all, if it offered a lower return, the investor could easily find lower-risk investments that returned such lower returns. To make matters even worse, as a founder/officer of the company, you have control of the transformation of the idea into a success. On the other hand, the investor has almost no control; they are for the most part, a silent partner. They are at your mercy. In short, they are taking total risk and have almost no control. The least they deserve is a high return on their investment.

Some first time entrepreneurs express the opinion, “I'm doing all the hard work; all the investors are doing is putting up the money. I deserve the big returns; they don't.” This is a bad attitude to have and will often result in getting no investors. An entrepreneur interested in attracting investments should understand and appreciate the typical investor's attitude: “I am putting up all the money. I am taking all the risk. Entrepreneurs only risk their time. I have almost no control. The entrepreneur has complete control over success or failure.”