IRR (internal rate of return) is starting to be used as an investment metric for early-stage startups. This actually should be interrupted as a joke since some valuations can be in the millions which is obviously not sustainable. IRR should only be use to evaluate mature and stable investments. Anything else should be reviewed with caution and reminiscing the days of Lehman Brothers, collateralized debt obligations (CDOs) and when companies were using non-GAAP reports to window dress their books.
The law of small numbers will definitely have an effect on how some of these companies are positioned as an attractive investment using IRR. For instance, to grow from 5 customers to 50 is relatively a lot easier than to grow from 5,000 to 50,000 if you are in B2B (business-to-business) markets. Also, with a smaller asset value, factors other than sales growth can have a significantly more material effect on total investment value (and especially with its cash flows) than with a company that already has built out its fixed infrastructure. For the former, there are multitude of examples where a company’s investment value can grow at 500% per month during one quarter and only 20% per month in another quarter. This would be a lot harder to do for the latter.
So, why is IRR a joke for early-stage startups? If a startup company would like to showcase its most attractive side for investment, it will then cherry pick its highest growth percentage month and use that as a baseline. IRR is usually prorated out to a 1-year time horizon and an early-stage startup, by its definition as being very young, only have a few months in existence. It can come up with a few good reasons why it chose its most attractive month as the baseline for the proration. On the flipside, a mature company has more stable growth and been in existence for years so the calculation is based on actual numbers.
As an investor, it is prudent to do your DD (due diligence). Don’t just look at metrics and pick the best ones without understanding the purpose of each metric. And now I chime in… 😊 I have an Accounting degree and was a Financial Analyst where I extensively worked in Microsoft Excel and created macros using VBA in my daily workflows. I specialized in Business Intelligence software as a Software Engineer. I am also an experience investor with over 15 years investing primarily in high beta investments but with a focus on managing out as much risk as possible. If you like to have an exciting discussion on investment opportunities, Let’s Talk!
