Investors’ quest for IRR sets startup founders racing on a growth treadmill

Welcome to the venture treadmill. You may not realize it, but the day you sign your first SAFE, you’ve stepped onto a treadmill that you can’t get off until the company reaches an exit.

You probably think the reason investors are pushing you to go faster, faster, faster is to stay ahead of the competition and dominate the field.

But that’s not the real reason investors demand you make haste to grow faster. It’s not about the competition; it’s about the investment.

For investors, you’re not competing against other startups. You’re competing against the S&P 500 for investment dollars. You’re competing against real estate. You’re competing against treasury bills. And that’s a lot tougher than it sounds.

What is IRR and Why Is It the Only Thing that Matters?

I put $1M into your startup and get $2M out. A 2x return. Wonderful. But that doesn’t account for time. How long did it take to get that 2x return?

If I got that 2x return in a year, fantastic. If it took 10 years, well… If it took 20 years, hmm, I would’ve been better off investing in something else.

The Internal Rate of Return — the IRR — calculates return as a function of time.

A doubling of money in 1 year is a 100% gain per year. Investors won’t find many opportunities like that.

But if it takes 10 years, we can estimate it as 10% per year. Since interest compounds, though, the IRR actually comes out to 7.2% per year. And that’s very so-so.

A 7.2% return is better than safe treasuries, but much lower than typical returns from public stocks and real estate. And with the cash locked up for 10 years in a high-risk startup compared to those safe, liquid alternatives, it’s not a successful investment.

But you’re not planning on a measly 2x exit — yours will be at least 10x. Doesn’t that solve everything? Even if it takes 10 years, that’s still 25.9% per year. Try getting that from your Apple stock! (Actually, Apple’s return over the past 10 years has been 22.6%, about the same, without having the investment locked up for a decade.) Pretty good.

Get to that 10x exit in 5 years instead of 10, and it’s even better — a 58.5% IRR. Woohoo. That’s a serious win.

For investors, only 2 things matter: the size of the exit, and how long it takes to get there.

Juicing the IRR

We can increase our IRR by increasing the size of the exit or getting to an acquisition quicker.

So what does an investor want? Grow faster. Move quicker. Every day.

If you want investment, you’ll have to show a plan for fast growth to hundreds of millions in revenues in just a few short years. To get the next round of funding, you’ll need to show that you’re meeting those goals.

That means that from the first day you take cash from any investor, investors want you focused on 1 thing: how to grow faster. Because without exponential growth, we’re better off putting our money elsewhere.

Portfolio IRR is Key

If your startup returned 10x in 5 years for 58.5% IRR, that’s great. But…the rule of thumb for a seed stage startup is 90% will fail to generate a positive return. (Pre-seed is more like 95% failure rate.)

As an investor, I can’t just look at my successes. That would be like going to a casino and saying I won $100,000 on one bet while ignoring the $900K I lost on my other 9 bets.

I need to look at my whole portfolio of startup investments and compare that to alternatives like public stocks and real estate. So a 58.5% IRR might be wonderful by itself, if my other 9 investments turned up duds, my portfolio return is only 5.8% IRR. Not so great.

We need our few successes to return 100x instead of 10x, and hit 500% IRR for individual investments. A goal of 10x in 5 years turns into 100x in 5 years. That treadmill just got 10x faster. At least you’ll get plenty of exercise keeping up.

Venture Firms Compete With Each Other

For individual investors like me, I can compare the returns from my startup investing to other ways of growing my retirement savings: usually S&P 500 and real estate.

But VCs are a bit different. First, returns to their LP investors need to subtract VC fees of 2% per year plus 20% of gains. That 10x return in 5 years from the one exit is reduced to 7.4x return to the investor.

More importantly, VCs are in a race against each other. Whoever has the highest returns can raise their next, bigger fund. Every VC needs to have an IRR in the top 25% of funds at least, and ideally in the top 10%, if they want to keep their jobs.

So what do they demand of their portfolio companies? Grow faster, faster, faster. Faster than other startups and bring home that huge exit.

Driving Over the Speed Limit

The structure of venture capital makes the startup game a race. You don’t have to beat competitors so much as beating the returns from public markets. And the market is going up, relentlessly every day. It’s hard to keep up.

To be a good investment, the startup has to grow fast. Crazy fast. Faster than it should. It has to grow from a team of 2 to 10 to 100 to 1000 employees in just a few years. Be prepared for chaos.

Venture isn’t about building a solid, profitable business. It’s a 5 year sprint towards a huge exit. As soon as you accept that first check, take a deep breath and get ready to start running.