You’re giving them money, but how do you calculate their actual return?
Your investors give you money. You give your investors money. In the end, they want a good return on the money they’ve given you. How do you calculate the return you’re providing? The number you’re after is the “internal rate of return” (IRR) of the cash flowing between you and them. Most spreadsheets have an IRR function you can use for this calculation.
Step 1: Identify the cash flows
First, lay out the cash flows as a series of numbers. Use negative numbers for cash you receive from the investors. Use positive numbers for cash the investors receive. Each number should represent the same time period.
For example, if investors give you $1,000 at the start of January, and you give them $50 at the start of February, April, and June, and also return the $1,000 principal in June, the cash flows look like this:
|
A
|
B
|
C
|
D
|
E
|
F
|
|
|
1 |
Jan
|
Feb
|
Mar
|
Apr
|
May
|
Jun
|
|
2 |
-1000
|
50
|
0
|
50
|
0
|
1050
|
Step 2: Use the IRR function to calculate the rate of return.
If you’ve typed the above into a spreadsheet, the formula to calculate the rate of return is:
IRR(A2:F2) which equals 3%
Example #1: A bank loan
A bank loans you $10,000. They expect $500/month payments for 6 months. They want principal repaid at the same time as the last payment.
|
A
|
B
|
C
|
D
|
E
|
F
|
G
|
|
| 1 |
Jan
|
Feb
|
Mar
|
Apr
|
May
|
Jun |
Jul
|
| 2 |
-10,000 |
500
|
500
|
500
|
500
|
500 |
10,500
|
IRR (A2:G2) = 5%
Example #2: Equity investment
Investors put in $50,000 in preferred stock. They expect a $1,000 dividend each year for four years. On the fifth anniversary of their investment, they expect the company to be acquired, with their stake worth $100,000.
|
|
A |
B |
C |
D |
E |
F |
|
1 |
Now
|
Y1
|
Y2
|
Y3
|
Y4
|
Y5
|
|
2 |
-50,000
|
1,000
|
1,000
|
1,000
|
1,000
|
100,000
|
IRR (A2:F2) = 16%
What cash do I need to provide them to produce the return they demand?
Often you know how much you want investors to invest, and they are demanding a certain rate of return. What cash flows do you need to provide to give them that rate of return?
If they provide $100,000 and demand a 40% rate of return per year, that means you’ll have to pay them $40,000 each year. If you agree that they get their money in a lump sum when the company goes public, then the 40% compounds. The calculation is easy—the total due each year is the previous year’s total plus the interest (40%):
|
Year |
What you owe them |
|
Now
|
$100,000 |
|
1
|
$140,000 (100,000 + 40%*100,000) |
|
2
|
$196,000 (140,000 + 40%*140,000) |
|
3
|
$274,400 (196,000 + 40%*196,000) |
|
4
|
$384,160 (274,400 + 40%*274,400) |
|
5
|
$537,824 (384,160 + 40%*384,160) |
If you estimate the company will be worth $5,000,000 at the end of the fifth year, then the investors will need to own 10.8% of the company ($537,824 / $5,000,000) in order for them to get their 40% return.