Internal Rate of Return (IRR) is the discount rate at which the net present value of all cash flows from an investment equals zero. In simpler terms, IRR represents the annualized effective compound return rate an investor can expect to earn over the life of an investment, making it one of the most widely used metrics for evaluating and comparing investment opportunities.
The calculation considers both the timing and magnitude of all cash flows—initial capital invested, follow-on investments, distributions received, and final exit proceeds. A higher IRR indicates a more profitable investment, though the metric assumes that interim cash flows can be reinvested at the same rate, which may not reflect reality.
Why It Matters
IRR provides angel investors with a standardized way to compare returns across different investments with varying time horizons and cash flow patterns. A startup investment that returns 5x capital in three years generates a dramatically different IRR (71%) than the same multiple returned over seven years (28%). Most angel investors target IRRs of 25-40% or higher to compensate for the high risk and illiquidity of early-stage investments, recognizing that many portfolio companies will fail completely while a few exceptional performers drive overall returns.
Example
An angel investor commits $50,000 to a seed-stage SaaS company. Two years later, she invests another $25,000 in a follow-on round. After four years, the company is acquired, and she receives $300,000 from her equity stake. The IRR calculation accounts for the $50,000 outflow at year zero, the $25,000 outflow at year two, and the $300,000 inflow at year four, resulting in an IRR of approximately 48%. This single number allows her to compare this deal against a real estate investment that might return 18% IRR or a venture fund reporting 32% IRR, helping her allocate capital across opportunities.
Related Terms
Multiple on Invested Capital (MOIC), Net Present Value (NPV), Cash-on-Cash Return