Internal rate of return (IRR)

What is internal rate of return?

Internal rate of return (IRR) is a financial metric used to measure how profitable an investment might be. IRR is essentially the break-even rate of return or the interest rate at which the current net present value (NPV) of all future cash flows (both inflows and outflows) from the investment are equal to zero.

IRR is expressed as a percentage (for example, 8%) and helps assess how efficient or worthwhile an investment might be. It’s a widely used measurement in investment analysis, capital budgeting, and project appraisal to compare multiple investment options.

An investment is considered viable if the IRR exceeds the required rate of return (also known as the hurdle rate or cost of capital). A higher IRR typically reflects a more attractive investment, though it can also represent a riskier investment where you need a higher hurdle rate to compensate for the additional risk.

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Internal rate of return formula

The IRR formula looks like this:

You can calculate IRR by setting NPV to zero and solving for the discount rate. The easiest way to determine IRR is with a spreadsheet-based internal rate of return calculator.

Gross IRR vs. net IRR

There are two ways to measure IRR in the context of a fund:

• Deal IRR (also known as gross IRR): Measures the return from a fund’s portfolio. This is a common way to determine how successful the general partners’ (GPs’) investments are to date.

• Net IRR: Measures the return to limited partners (LPs) minus any management fees or carried interest. This is used to measure the value of the investment in the fund made by the LPs.

Why is IRR important?

Benchmarking is the process of comparing your IRR to comparable investment opportunities to see your relative performance against your peers. This helps VC and PE funds measure the effectiveness of their deals and their performance against other funds.

Unlike other forms of performance measurement, like return on investment (ROI) and net present value (NPV), IRR allows you to make apples-to-apples comparisons across asset classes and public market indexes—no matter the time frame.

IRR is also an important metric that LPs look at when you’re raising money for your fund—if you consistently show excellent returns on your investments, it may be easier to attract investors.

What is a good IRR?

What’s considered a “good” IRR can vary based on the type of investment you’re making. In general, many early-stage VC investors target a 30% net IRR, while many later-stage VC and growth equity PE investors target a net IRR of around 20% (both, over an average period of eight years). However, some investors aim for a higher IRR.

How to calculate IRR

Using a spreadsheet-based IRR calculator or dedicated fund administrator like Carta is the best way to quickly calculate IRR.

Download the IRR calculator

Get help calculating your IRR

While an IRR calculator is more efficient than calculating your IRR manually, it still leaves room for errors. Some of the most common mistakes people make include entering the dates and amounts wrong.

Go beyond our IRR calculator and automate the process with Carta’s fund administration service. We sync our general ledger daily and calculate everything for you so you can access your real-time IRR.

Learn more about Carta for Venture Capital, or talk to an expert about Carta fund admin today.