Internal Rate of Return
How to Read the Offtoa Internal Rate of Return (IRR) Report:
If you are planning to have external parties invest in your company, this is one of the most important reports for you. Internal rate of return (or IRR for short) is the most common way for angel investors and venture capitalists to determine if the investment is bringing them a good financial return. Of course, they will only invest if the business makes sense from all perspectives, but assuming that it passes all those tests, then it comes down to what kind of return they will get. Since start-ups by their very nature are extremely high risk, they must have a correspondingly high financial return, or else they will invest in something less risky. IRR is the compounded annualized rate of return for their investment. Thus, for example, if an investor invests $1,000,000 in a company, and 1 year later the company is acquired and that investor's share of the proceeds is $1,500,000, the investor's IRR is 50%. That is, s/he received a 50% return on the investment. Another example: If the same investor invests $1,000,000 in a company, and 2 years later the company is acquired and that investor's share of the proceeds is $2,000,000, the investor's IRR is only 41.4%. That is, s/he received a 41.4% 2-year compounded return on the investment ($1,000,000 x 1.4142 = ~$2,000,000).
Offtoa's IRR report shows the three phases of determining internal rates of return for classes of shareholders.
In the upper table, we determine the company's value at the time of the liquidity event. Offtoa uses five valuation techniques (multiples of trailing revenues, gross profits, EBITDA, EBIT, and EAT, where the “multiple” used is a function of the specific industry) and averages their results. In the case of an acquisition, this is a prediction of how much a third party might pay to acquire the company, and thus is the amount available for distribution to shareholders. In the case of an IPO, this is a prediction of the market value of shares owned by shareholders.
The trailing revenues, gross profits, EBITDA, EBIT, and EAT in the second column of the upper table were extracted the income statement for the year immediately preceding the liquidity event. The valuation multiples in the third column of the upper table show recent valuation multiples the companies in the subject industry. The fourth column is just the product of the previous two columns. At the bottom of the fourth column, we show the average of the four above valuations. For the following tables, we will assume that if the company succeeds in accomplishing all its goals and all the given assumptions come to pass, and a liquidity event occurs, then shareholders will collectively hold equity worth this amount.
In the center table of the report, we determine how the company value calculated in the previous step would be distributed among shareholders. Out of the proceeds, preferred shareholders with liquidation rights receive their payments first. Specifically, those with 1x liquidation rights receive 1 times their initial investment; those with 2x liquidation rights receive 2 times their initial investment; and so on. The remaining proceeds would then be distributed on a pro rata basis among all shareholders (common and preferred alike, assuming that preferred shares are fully participating) based on how many shares they own.
In the lower table of the report, we show for each shareholder class how much they invested originally, how many years they waited for the liquidity event (from the time of their initial investment), the total amount of their proceeds (sum of liquidation rights, if any, plus their pro rata share of the general distribution), and the calculated IRRs.
What can I learn from the IRR report?
What should I do if my plan shows a group of investors receiving a better return than an earlier group of investors?
Why do investors want such high IRRs?
How do I change the IRR my investors expect?
How do I change the valuation of my company?