Internal Rate of Return (IRR)
Many people know the old rule of thumb that at a 10% annual return, money doubles every seven years. (Actually it takes 7.27 years, but I guess this wouldn’t be a great rule of thumb.)
People who work in private equity, venture capital, or any other area where investment time horizons are measured in years rather than days, weeks or months – are generally pretty interested in the IRR of their investments. You’ll often hear a VC say something like “… we need a 35% IRR to justify so and so investment.” There’s plenty of discussion and debate elsewhere about the relevance of IRR as an investment measure, and the benefits of using IRR versus NPV (net present value) – so I’ll avoid getting into this debate here.
The problem with the above rule of thumb is that it doesn’t help you work out the result you’re interested in for other combinations of inputs. This is because the relationship between the variables is exponential rather than linear. You either need a calculator, a ready reckoner, or a large brain. In any case, it is useful to first explore the relationship between IRR (r), years the investment is held (t), and the sale multiple achieved (m). Read More…
