DETERMINING INTERNAL RATE OF RETURN

If we assume a venture capital fund is targeting a 40% annualized IRR on every investment it makes,
what does that mean?
If the VC fund targets a 40% return on a $10 million investment and the entire $10 million
is contributed at the outset, then 40% per year is $4 million per year, and after five years, the
total value of the investment would have to be $30 million.
o
$10M

$10 million invested at the beginning of year 1

End of year
1
2
3
4
5

Value
$14,000,000 ($10M + 4M);
$18,000,000 ($14M + 4M);
$22,000,000 ($18M + 4M); and so on
$26,000,000
$30,000,000

o This is a simple interest calculation. Although the $10 million investment tripled in
five years, it is far short of the kind of return a venture capital fund targets.
If the VC fund targets a 40% annualized IRR on a $10 million investment and the entire
$10 million is contributed at the outset, then $10 million with a 40% annually compounded
return over 5 years will have to grow to $53,782,400.
o $10 million invested at the beginning of year 1
o
$10 M

End of year
1
2
3
4
5

Value
$14,000,000 ($10M 1.4);
$19,600,000 ($14M 1.4);
$27,440,000 ($19.6M 1.4); and so on
$38,416,000
$53,782,400

o This is an example of a compounded interest calculation, with annual compounding.

The 40% annualized IRR targeted by a VC fund contemplates annual compounding
like this. Obviously, these kinds of investment results are jaw-dropping.

But would a company like SoftCo really need a $10 million investment all in one piece?
Even if it eventually needs a total capital inflow of $10 million, it certainly would not need it
all at once most of it would sit in a bank account not doing anything. And the venture
capital fund is very happy to invest the money SoftCo needs in pieces over time because that
immensely improves the IRR outcome on their investment.

 To illustrate this point, what if the fund invested $10 million in a company over 5 years,
but only invested $1 million in year 1, $2 million in year 2, $2 million in year 3, and $5
million in year 4?
o Assuming a $10 million investment and still targeting a 40% annualized IRR over 5
years, but with the $10 million contributed as described, the investment would only
have to yield $28,349,440, which is calculated as follows:
Year Inv. at Start of Year End of Year Value
1
$1M
$1,400,000 = ($1M plus 40%); or $1M 1.4;
2

$2M

$4,760,000 = ($2M plus 40%; plus 40% on the

prior $1.4M) or ($2M + $1.4M) 1.4;

$2M

$9,464,000 = ($2M plus 40%; plus 40% on the

prior $4.76M) or ($2M + $4.76M) 1.4;

$5M

$20,249,600 = ($5M plus 40%; plus 40% on the

prior $9.464M) or ($5M +$9.464M) 1.4;

No New Investment $28,349,440 = ($20,249,600 1.4).

o This calculation illustrates that the IRR is based only on the amount that is actually
invested. Therefore, assuming a 40% IRR, the $1 million invested in year one would
have to grow at a 40% compounded for all five years, while the last $5 million would
have to earn 40% per year for only two years.
We see that by spreading out the $10 million into tranches, the ultimate value the
investment needs to achieve in order for the VC to hit its targeted 40% IRR is cut in half.

VALUATION:
1.
Determining the value of a company, and therefore the portion of the company the VCs will
want in exchange for their investment, is the most difficult issue to be resolved between the company
(and its founders) and the venture capitalist.
A. What is pre-money valuation? The imputed value of a company based on the VCs
investment amount and the percentage of the company they want in exchange for that investment.
Pre-money valuation is the value of a business before an investment.
o The company has a pre-money valuation set before each round of financing, even if
the company has raised money in the past.
o A pre-money valuation is determined by an investor based on a number of assumptions
it makes about a companys prospects; different investors may make different
assumptions and therefore arrive at different valuations.
How does the investor determine the pre-money valuation? It (i) looks at how much
money the company needs, and therefore the amount of the proposed investment, then (ii)
analyzes what the company will be worth at a future sale or public offering, then (iii) looks at
what portion of the companys stock it needs to get for its investment in order to own enough
of the company at the time of the sale or public offering to achieve its target rate of return on
its investment.
B. What is post money valuation? The value of a business after an investment. It equals the
pre-money valuation plus the amount of money invested.
The percentage of the company that the venture capitalist is purchasing can be calculated
by using a fraction: the numerator is the amount of money invested and the denominator is
the post-money valuation (pre-money valuation plus the amount invested).
o For example, if SoftCo raises $10,000,000 at a $15,000,000 pre-money valuation, the
post-money valuation will be $25,000,000 and the VC investors will own the
following percentage of the company after their investment:
$10,000,000
= 10,000,000 25,000,000 = 2 5 or 40%
$15,000,000 + $10,000,000
o Always remember to count the new investment money when figuring out this
percentage. Some people think if you have a pre-money valuation of $5,000,000 and
you raise $1,000,000, the investors own 20% of the company. This is not correct; they
own $1,000,000 out of $6,000,000 (original $5,000,000 pre-money plus the
$1,000,000 investment) and thus, the investor owns 16.67% (not 20%).

2.

How do VCs calculate (or determine) valuation of a start-up business?

Sale of Company after 5 Years
Sale Proceeds

0_______1________2________3________4________5________ Time in Years

Investment - - - - - Rate of Return - - - - - - - - - - - - Future Value

Amt.
over Time
of Inv. Amt on Exit
They figure the likely value at exit and the likely number of years until exit and then,
using their targeted annualized rate of return and the amount of investment the company
needs, the VCs back into how much of the business they need to own now in order to make
sure they get the required rate of return upon exit.
A. Lets assume the company needs no further investments, so there is no dilution to a VCs
percentage ownership, and assume that the VC is looking for a 40% annual compounded rate of
return on its investments. Since we already have done the math, lets assume that the investment
amount is $10 million, which means that at a 40% compounded annual internal rate of return, the
projected value of that investment after five years would have to be $53,782,400 (the Future Value).
How much of the company will the investor need to own to hit the target Future Value on its
investment if the VC projects the companys Sale Proceeds will be $160 million?
Sale of Company after 5 Years
$160M Sale Proceeds
0_______1________2________3________4________5________ Time in Years
$10M
$53.78M

VCs Reqd Ownership

Investment - - - Rate of Return - - -- - - - - - - - - - - Future Value
$53.78M$160M = 33.6%
Amt.
over Time = 40%
of Inv. Amt on Exit
The Future Value of the $10 million investment must be approximately $53.78 million, so
if the predicted sale price of the entire company is $160 million, then the VC needs to own at
least one-third of the company at the time of the sale to hit its target. It needs to get at least
1/3 of the proceeds of the sale. $53.78M $160M = 33.6%.
In order to hedge its analysis, lets say the VC decides it needs to own 40% of the
company after making its $10 million investment (remember, valuation projections are more
art than science) so what does that mean the pre-money valuation of the company is?
Investment = $10M = 40% of post-money val.

Pre-money val. = $15M $25M post-money val.

o If a company needs $10M in investment, and the venture capitalist decide it needs to
own 40% of the company as a result of its investment (that is, 40% of the post-money
valuation) then the companys post-money valuation is $25M.
$10M 0.4 = $25M post-money valuation
o The pre-money valuation plus the investment amount equals the post-money valuation,
and the pre-money valuation plus $10M equals $25M, so the pre-money valuation is
$15 million. Check: if the $10M investment is 40% of the post-money valuation, then
the pre-money valuation represents 60% of the post-money valuation, and 60% of
$25M is $15M.
B. Using the same assumptions, what if the projected proceeds on the Sale of Company are
$75M instead of $160M? How much of the company would the $10M need to represent then?
Sale of Company after 5 Years
$75M Sale Proceeds
0_______1________2________3________4________5________ Time in Years
$10M
$53.78M

VCs Reqd Ownership

Investment - - - Rate of Return - - -- - - - - - - - - - - Future Value
$53.78M$75M = 71.7%
Amt.
over Time = 40%
of Inv. Amt on Exit
$53.78 million is almost 72% of $75 million, so the VCs investment would have to give it
almost 72% of the ownership of the company. Most VCs wouldnt take that much because
they prefer management to have a bigger stake in the company. Why? [In order to maintain a
suitable incentive for management to build the company.]
C. Using the other investment example we looked at, where the VC invested its $10M in
four tranches, what percentage ownership level would the VC require, assuming a sale at the
end of year five at $75M?
Sale of Company after 5 Years
$75M Sale Proceeds
0_______1________2________3________4________5________ Time in Years
$1M
$2M
$2M
$5M
$0
$28.35M

VCs Reqd Ownership

Investment - - - Rate of Return - - -- - - - - - - - - - - Future Value
$28.35M$75M = 37.8%
Amt.
over Time = 40%
of Inv. Amt on Exit
This example illustrates the impact of investing in tranches an investment that would be
out of the question if all the money were invested at once is suddenly very feasible through
the use of tranches. The VC would want to end up with about 38% ($28.35M $75M) of the
company under this scenario.
The same mathematics apply to both the VCs rate of return on money invested in a
company and on the rate of return the VC fund is delivering to its limited partners. In

both cases, the rate of return is improved by only delivering money when it can be put to work
promptly and effectively. This is why the VC fund only calls on its limited partners to deliver
money when the fund is ready to invest it into a company.