Venture capital is a form of private equity investing that serves as a powerful catalyst for innovation and growth. By backing young, promising companies, VC firms seek to profit from new technologies and business models that will generate rapid growth.
It’s important for venture capitalists and their investors, such as pensions and endowments, to be able to gauge the performance of VC investments. However, measuring performance isn’t always easy—most VC investments are long-term, and there is no market where the equity can be easily bought and sold to help establish valuations. That’s where IRR comes in.
What is venture capital IRR?
An internal rate of return, or IRR, is one way of measuring the success of a venture capital fund. At its most basic, the IRR is the annualized return that a VC fund generates, or expects to generate over the duration of the investment, typically eight years or so. It’s a metric that can also be used to calculate an individual’s return on an investment.
IRR comes in two varieties:
- Realized IRR. This is only those cash flows or profits that have actually passed through to investors.
- Unrealized IRR. This counts those profits—if there are any—as well the theoretical profits that would be distributed to investors in a VC fund. These figures are calculated using private market valuation estimates.
A relatively simple formula can compute basic IRR. The calculations get more complicated when making a calculation over years, with both positive and negative cash flows.
IRR is classified in two other ways as well:
- Gross IRR refers to the annualized return generated or expected to be generated by a fund or portfolio investment.
- Net IRR refers to that return after the payment of fees. VC firms, much like hedge funds, typically charge a management fee equal to 2% of the assets in the fund, plus 20% of any profits. This is known as a performance or incentive fee, or sometimes as carried interest.
How do venture capital firms use IRR?
Venture capital firms use IRR for many reasons. First, they are likely to use IRR estimates to help determine whether it would be worthwhile to make an investment in a particular startup. All things being equal, the firm will opt to finance a company with a higher forecast IRR than those with lower expectations. Of course other factors, like the riskiness of a venture, will almost certainly come into play.
Projections of future IRRs are also used to entice institutions, such as pensions, endowments and foundations, to invest in new funds that VC firms launch. VC firms also will point to their past record of IRR generation to entice investors.
Conversely, institutional investors, along with their consultants, weigh VC firm forecasts of IRR when deciding whether to invest in a new fund. They also consider the past IRRs of older funds.
How is IRR calculated?
Calculating the IRR for an investment is relatively easy. Take the difference between the current value of the investment and the original beginning value, divide it by the original value and multiply the result by 100. If a VC fund makes multiple investments at different times, the calculation gets more challenging, but it still can be done with some basic math.
Forecasting, or estimating future IRR, however, is dizzyingly complex. To do so, it’s necessary to be familiar with, among other things, a closely related metric—net present value, or NPV.
NPV is the value of all future cash flows from an investment discounted to reflect what they are worth in today’s dollars. Accordingly, it accounts for the time value of money—a future dollar is worth less than one in hand today.
A simple formula for determining NPV is:
NPV = TVECF - TVIC
In this equation, TVECF is today’s value of expected cash flows in the future and TVIC is today’s value of invested cash. The TVECF must be discounted by an appropriate interest rate to reflect the time value of money.
Once you have the NPV, you can calculate the IRR estimate. This requires an estimation of what IRR will set the net present value to zero.
Here are the steps:
- First, select two estimated discount rates. These are high and low estimates to use to try and determine the point at which the NPV is zero. (Investments with IRRs above zero may be worth making, while those below zero are not.)
- Second, calculate the NPVs of the investment. Using the two values selected in step one, calculate the NPVs of each based on each estimation. These too will result in high and low estimates.
- Third, calculate the IRR. Now that you have your two discount rates and two NPVs, you can begin calculating the IRR.
And here is the formula to arrive at the venture capital IRR calculation:
IRR = R1 + ( (NPV1 * (R2 - R1)) / (NPV1 - NPV2) )
In this case, R1 is the lower discount rate, R2 is the higher discount rate, NPV1 is the higher net present value, NPV2 is the lower net present value.
If all this seems complicated, or just plain confusing, there are many online calculators designed to estimate IRR.
What is a good IRR for venture capital?
“Since VC funds have very high risk, very high return profiles, normally anything above 30% is the target,” says Titan senior investment strategist John Bottcher.
How often VC funds actually hit that figure isn’t clear, given the paucity of publicly available data. In general, many of the investments VC funds make are losers, some break even while a handful are big winners that more than offset the other.
What are some top-performing VC funds by IRR?
The IRRs of venture capital funds are something of a mystery, at least to the public. When IRR is unimpressive, the VC firms often don’t publicly report the figures. Nor do institutional investors publicize their investing blunders. After all, investment managers look silly paying lofty fees for VC returns that are mediocre or worse.
A recent Securities and Exchange Commission (SEC) filing shows how varied IRR can be, even from the same firm. TPG, a big leveraged buyout firm that went public in early 2022, also runs a group of later-stage VC funds. One of its filings with the SEC in late 2021 showed that the IRR in VC investments between 2007 to 2020 ranged from 6% to 36%, depending on the fund. The average was 15%.
What are the limitations of IRR?
IRR is just one way of measuring the returns of a venture capital investment and forecasting future profits. It’s important because IRR takes into account the time value of money, something that a simple total return figure does not.
Future IRR forecasts rely on a number of variables. These include future cash flow estimates, estimated NPV and the rate at which those figures are discounted into today’s dollars. But because it relies on estimates and guesswork, IRR forecasts seldom match actual returns.
The bottom line
Venture capital is a dynamic industry of vital importance to the economy. Its performance is judged largely by a singular metric, IRR. Understanding IRR is critical to evaluating the venture capital industry. Even though it is an important metric, it should be considered in tandem with a host of other gauges, from NPV to return on equity, to get a broader view of venture performance.
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