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What is "Internal Rate of Return, aka IRR"?

In this piece, you learn what "Internal Rate of Return” is, its key elements, and its significance. This article is part of a comprehensive series designed to help you navigate the VC world and its terms and concepts. Whether you're an entrepreneur seeking funding, a student learning about the industry or you’re thinking about becoming an investor, this series is your gateway to VC clarity.
Published:
January 29, 2024
reading time In Minutes:
2
What is "Internal Rate of Return, aka IRR"?

IRR stands for "Internal Rate of Return," and it is a financial metric commonly used in venture capital (VC) and private equity to measure the profitability and performance of an investment. IRR represents the annualized rate of return that an investment is expected to generate over its holding period, taking into account the time value of money.

The formula for calculating IRR involves solving for the discount rate that equates the present value of a fund's cash inflows (such as distributions and proceeds from exits) with the present value of its cash outflows (initial investment and ongoing capital calls). The IRR is expressed as a percentage.

In the context of VC:

IRRIRR is calculated as follows:

IRR=(Total DistributionsTotal Invested Capital)1Number of Years−1IRR=(Total Invested CapitalTotal Distributions​)Number of Years1​−1

  • Total Distributions: The total amount of money returned to investors, including proceeds from exits, dividends, and other distributions.
  • Total Invested Capital: The total amount of capital that investors initially contributed to the investment.
  • Number of Years: The holding period of the investment.

A higher IRR indicates a more favorable return on investment. However, it's important to note that IRR has some limitations, particularly in situations where there are multiple cash flows with changing signs (positive and negative) over time.

Investors and fund managers use IRR to assess the attractiveness of an investment, compare the performance of different investments, and make decisions about deploying capital. It is a valuable metric for evaluating the risk-adjusted returns of a venture capital or private equity fund.

AUTHOR:
Wellstreet
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