Cracking the Code: What is Internal Rate of Return (IRR) for Investors

Let’s face it—accessibility to just random startup funding will not create investment success. It’s about understanding numbers. In particular, you need to see specifically how your money generates profits.

The Internal Rate of Return (IRR) serves as the solution for these types of calculations.

You have landed at the perfect destination if you have questions like “What is internal rate?” or “What is a good internal rate of return?” Your understanding of IRR will lead to better investment decisions regardless of your experience in the field. It doesn't matter if you are angel investor or venture capitalist or just someone wetting their feet in the investment world.

So let’s break it down. No jargon. No fluff. The explanation provides straightforward usable information about investment practices.

First Things First: What Is Internal Rate of Return?

The easiest definition of IRR looks like this.

IRR is the annualized rate of return at which an investment breaks even—when the net present value (NPV) of all future cash flows equals zero.

Still sounds complicated?

Let’s make it easier. You invest $100,000 in a startup. That startup returns $250,000 over 5 years. The IRR determines the annual percentage rate which your capital grew over that specific period.

When people inquire about IRR (despite its technical name)

So when someone asks “what is an IRR?”, they just want to know about your investment's yearly growth speed.

Why Should Investors Care About IRR?

The IRR tool functions as a bridge between different investment periods and helps you compare apples to oranges.

You want to evaluate two startup companies. Startup A believes that your investment will grow to double its amount within a 4-year period. The investment from Startup B proposes a triple return on your investment, but it requires waiting eight years for that growth. Which one’s better?

That’s where IRR steps in. The IRR method provides a single annual growth rate to make various future returns comparable. Moreover, IRR enables investors to evaluate different time-based investment options.

Furthermore, using IRR allows investors to identify excellent returns and avoid subpar investment options.

The Internal Rate of Return Meaning In Real Life

Let’s understand the Internal Rate of Return meaning in real life with an example. You invest $50,000 in a company. During a period of 3 years you will receive these cash flows.

Year 1: $10,000

Year 2: $20,000

Year 3: $40,000

You want to know what is internal rate of return for this situation. To find the rate of return that sets the net present value to zero, you need to place the data into financial calculators followed by Excel problem-solving tools. Spoiler alert: it’s around 28%. That 28% is your IRR. The money value increased at an average annual rate of 28% during that time period.

Not bad, right?

How Is IRR Calculated in VC?

Ah, now we’re getting to the good stuff. So, here we explain how is IRR calculated in vc?

Venture Capital (VC) functions as an independent financial system. The cash flows aren’t steady. You don’t get dividends. Companies deliver most of their returns at the final stage through initial public offerings or acquisition events.

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What is the procedure for computing IRR when applying a Venture Capital approach?

Here’s how you do it:

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1. The initial investment stands at $200,000 when you put it in during 2020.
2. The capital addition of another $50,000 would happen during 2022.
3. The company gets acquired by another entity in 2025 which results in your receipt of $1,000,000.

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The IRR calculation includes every cash flow from both investments and disinvestments using a formula or software. The calculated IRR using this method may produce a result similar to 35%.

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So during these five years, your capital invested grew on average by 35% each year. Such numbers represent a strong metric among investors who work in the VC industry. More on that soon.

What Is a Good Internal Rate of Return?

Great question. The reply depends on the circumstances.

Here’s a quick guide:

• Over 20%: Very good in VC. You’re beating most benchmarks.
• 10–20%: Solid. Especially if you’re well diversified.

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High-risk investments like startups should not utilize low returns below 10 percent. 

However, IRR should not become your sole focus point in investment decisions. It’s just one tool. Getting a high IRR from a minimal investment looks wonderful while a 5x cash payment with a slightly lower IRR will lead to a significant return.

The success of a venture capital investment strongly depends on when the investment happens. Your rate of return increases when you retrieve your funds more quickly. The return on investment through IRR appears stronger when a company achieves a 2x multiplication of its investment within two years even if its time-to-double process takes significantly less time than the corresponding achievement of a 10x multiplication over ten years. 

Choosing between the two options would be challenging. Your preference lies between rapid returns and investment volume or a mixed response. Select your preferred approach.

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IRR vs. Other Metrics

IRR isn’t the only game in town. Here’s how it stacks up against some other common metrics:

1. Multiple on Invested Capital (MOIC)

• MOIC = Total Return / Original Investment
  
  
• It tells you how many times your money came back.
  
  
• IRR adds the time element. MOIC doesn’t.
  
  

Example:

• MOIC of 3x sounds great.
  
  
• But if it took 15 years to get there, the IRR could be underwhelming.
  
  

2. Cash-on-Cash Return

• Very similar to MOIC.
  
  
• Again, it doesn't factor in time.
  
  

3. Net Present Value (NPV)

• NPV shows the dollar value added by an investment after accounting for time and cost of capital.
  
  
• IRR is the rate at which that NPV equals zero.
  
  

Think of NPV as a dollar figure, and IRR as the percentage rate.

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IRR Pitfalls to Watch Out For

No metric is perfect. Here are a few quirks of IRR:

1. Assumes Reinvestment at the Same Rate

IRR makes the assumption that reinvestment occurs at identical rates to those from the project. IRR functions under the condition that reinvested funds will maintain the exact rate of return from previous cash flows. That’s not always realistic. 

2. Multiple IRRs

Yes, this can happen. The existence of multiple IRR results from unpredictable variations in cash flow patterns throughout the year.

3. Timing Distorts Reality

The payout before the expected time period leads to raised IRR calculations. Sometimes increased IRR does not indicate a better investment outcome.

Let’s say you invest $100k and get $200k back in 1 year. IRR? A whopping 100%.
Now compare that to getting $1 million back in 10 years. IRR might be lower, but your return is way bigger.

IRR analysis must be used together with other evaluation metrics because of its limitations.

How to Improve Your IRR as an Investor

You can’t control everything. So, you should consider these tips:

1. Invest Early

Startup investment made early helps to achieve lower market entry points. The success of your startup will increase your investment return if calculated through IRR.

2. Be Selective

Business success is the only factor that makes IRR impressive. Do your due diligence. Teams, traction, and trends should be your selection criteria.

3. Diversify

All new startups will not achieve commercial success. Spread your bets. A successful outcome from one investment will increase the total IRR across your entire portfolio.

4. Follow On Wisely

A strategy to boost profit from winning investments involves additional funding. The hype should only be followed with careful data analysis. 

Tools to Calculate IRR

Unless you love algebra, you’ll want tools to do the math for you. Here are some options:

• Excel or Google Sheets: Use the =IRR() function
  
  
• AngelList: Automatically calculates IRR for your investments
  
  
• Portfolio management apps: Many offer built-in IRR tracking
  
  

Just plug in your cash flows—money out and money in—and let the software work its magic.

Final Thoughts: Why IRR Matters for Your Investing Journey

Knowledge about IRR gives investors a strategic advantage. The Internal Rate of Return provides insights into money growth rate. It helps you compare deals. By using IRR, you gain authority to select better decision options.

So the next time someone asks “What is internal rate?” or “What is a good internal rate of return?”—you will have both the information and the ability to use it. And, that’s what makes a savvy investor.

Learn More with Angel School

Want to go deeper? Learn startup analyzing methods while mastering term sheets and calculating IRR mastery with professional skills.

Join us at Angel School. Our Venture Fundamentals course serves investors who need educational resources. The program breaks down difficult VC principles into simple concepts. Apart from that, it helps you develop confidence levels which leads to portfolio growth.

No matter where you are investing, it always starts with knowledge. Keep learning, keep investing!

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