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IRR (Internal Rate of Return)

Quick Definition

The annualized return rate that makes the net present value of all cash flows equal to zero.

What is IRR?

IRR measures the annualized return considering the timing of cash flows. Unlike simple multiples, IRR accounts for when money was invested and returned. A 3x in 3 years beats a 3x in 10 years.

IRR vs. Multiple

A 20% IRR over 10 years produces 6.2x. But 20% IRR over 3 years only produces 1.7x. IRR rewards faster returns. Funds optimize for both: high multiples achieved quickly.

IRR Manipulation

IRR can be gamed with early distributions. Returning capital quickly boosts IRR even if total returns are mediocre. Always look at IRR alongside multiples.

Formula

IRR solves for r in:

0 = Σ (CFt / (1+r)^t)

Where CF includes all contributions (negative) and distributions (positive).

Typically calculated using software/Excel IRR function.

Example

Investment timeline:

  • Year 0: Invest $1M
  • Year 2: Distribute $500K
  • Year 4: Distribute $2M

Total return: 2.5x ($2.5M on $1M)

IRR: ~35% (accounting for timing)

Same 2.5x over 8 years would be ~12% IRR.

Related

Related Terms

Most Favored Nation (MFN)

A provision guaranteeing an investor will receive terms at least as favorable as any subsequent investor receives.

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Qualified Financing

The minimum raise amount that triggers automatic conversion of convertible notes or SAFEs.

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Maturity Date

The deadline by which a convertible note must be repaid or converted to equity.

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