You Can Take Your IRR and Shove It

In pitches and presentations everywhere, bright young entrepreneur tells cynical skeptical investors, usually with great pride and flourish, about their fabulous IRR for their great new startup. I get a gag reflex.

IRR stands for internal rate of return. You can check wikipedia or investopedia for what that’s supposed to mean and how it’s calculated. It’s supposed to compare cash spent on an investment, over several years, to cash that comes back, which spits out as a percentage. The higher the IRR, the better. They teach it in business schools. It’s kind of an MBA parlor game. It has some very limited usage in comparing past performance of investments, if you can hold all the definitions stable; think of it in a large company context, corporate investments, and corporate budgets.

IRR in a business pitch insults my intelligence. It depends on projected sales, costs, expenses, financing, investment, and some hypothetical valuation at some hypothetical time some years in the future. That, by definition, is a crock. Show me the projects, yes. Show me Sales, costs and expenses. Show me cash flow. Go ahead, guess at a future valuation, what the heck. I’ll look at how the assumptions come together and realism, or lack of it, on how the pieces mesh. But the IRR, which summarizing multiple layers of uncertainty as one single percentage number, is totally irrelevant at best, and downright annoying when entrepreneurs act like a projected IRR actually means anything.

And it gets worse, too: there’s the widespread misunderstanding that angel investors and venture capitalists have IRR targets. There’s the unspoken but felt thought: “jeez, what do these investors want? They turned down an IRR of 105%!” And you’ll see people, all over the web, asking what kind of yields they have to give to interest investors. What are the targets?

Talking of IRR if a projected shows me only that you’re too close to the academics. Investors will look at your plan, your team, your product/market fit, and your projections; and they’ll decide what they guess about your future. Stop sooner, before you get to IRR. Let it go.

7 thoughts on “You Can Take Your IRR and Shove It

  1. Tm:
    Enjoyed readng your Blog about IRR. I often questoned t’s msuse.
    The followng s another reason to queston the IRR as explaned n wkpeda as follows:
    “IRR assumes renvestment of nterm cash flows n projects wth equal rates of return (the renvestment can be the same project or a dfferent project). Therefore, IRR overstates the annual equvalent rate of return for a project whose nterm cash flows are renvested at a rate lower than the calculated IRR. Ths presents a problem, especally for hgh IRR projects, snce there s frequently not another project avalable n the nterm that can earn the same rate of return as the frst project.”

  2. I thnk the use of IRR n a busness plan would just state the obvous for those who actually know what t means n the fst place (what the projectons show). I’ve rarely seen t ncluded n a ptch. I haven’t come across nvestors who are offended by t beng presented but at the same tme none who would make a decson based on t. Investors wll base ther decson on ther n-depth due-dlgence and not on a projecton anyway. Best to leave IRR calculatons for nternal use when puttng the busness case together for an asset purchase – there t mght have some meanng.

    1. Tm, re what would I recommend plottng, thanks for askng: I want to see projected sales wth key assumptons that drve sales; also projected gross margn, payroll, sales and marketng expenses, and profts.

      I don’t take any of these numbers as f they were necessarly gong to happen; I take them as the founders’ statement of what they thnk they can do.

    1. Smth: You look past the IRR nto the assumptons on whch t rests, entrely and compare nstead the credblty of the assumptons. Choose the one you thnk s more lkely to execute and gve you money back from the money you nvest. Choose the one wth the best product-market mx, defensblty, scalablty, and management team. Don’t dstract your thnkng and judgment by thnkng that IRR s a sgnfcant number.

      BTW, IRR grew up n a world of sophstcated stock analyss and very large corporatons, always wth the underlyng assumpton that the underlyng factors were relatvely equal. That’s so not the case wth startups and entrepreneurshp, t’s knd of funny that IRR stll shows up n busness plans for nvestors. Only because busness profs grew up n the age of programmable calculators. I thnk.

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