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Internal Rate Of Return: A Simple, Non-Mathematical Explanation
How do venture investors compare investments in portfolio companies when the amounts invested, the timing of those investments, the returns, and the timing of those returns are all different? The tool venture investors use to compare the rates of return on each investment on an “apples-to-apples” basis is the internal rate of return (also known as the compound annual growth rate or CAGR).
A typical venture investment involves several investments into a portfolio company at various stages of the company's development. From an investment perspective, those investments are considered negative cash flow; that is, cash going out from the venture fund. Of course, the cash goes out from the venture fund at different times. Investing $100 today is more expensive to the venture fund than investing $100 in a Series C Preferred Stock round three years from today because the venture fund would only have to put aside, say, $80 today to grow into the $100 needed in three years for the Series C Preferred Stock investment. This $80 is known as the discounted value or the value in “today's dollars” of the $100 investment that would be made in 3 years. Accordingly, any “apple-to-apples” comparison of investments would have to compare investments based on today's dollars.
Similarly, when the portfolio company is successful, cash is returned to the venture fund. This is positive cash flow for the venture fund. Obviously, it would be better for the venture fund to receive the positive cash flow earlier rather than later for the same reason the venture fund would prefer to have the negative cash flow later rather than earlier. Receiving dollars today is more valuable than receiving the same number of dollars in the future, because if the fund receives the dollars today, it can invest those funds and earn a return on them. Accordingly, an “apples-to-apples” comparison of investments would have to compare investments not just on when the dollars are invested and how much those dollars are, but also on when the returning cash is received and how much it is. Thus, if a venture fund is to compare an investment into one portfolio company versus another, it will want to compare those investments based on outflows of cash in today's dollars and inflows of cash in today's dollars.
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