Growth5 Blog

Wednesday, February 17, 2010

Calculating Return on Investment

Fred Wilson provided this extremely helpful post on how to quickly and properly calculate a return on investment.

Disclaimer: this calculation is for small Angel investments – your brother-in-law is opening a restaurant, a neighbor has a hobby that can be monetized, etc... Fred and his wife use this calculation to assess investments they do together completely separate from his vc firm.

Some people think this is WAY over-simplifying return assessment even on a small Angel investment, I disagree. If the investment can't pass this simple smell test, there's no need to waste time putting language together for a small business plan or further revenue/expense Excel sheets. The investment will still end up in the same place - there will just be a lot more reading (obfuscation of the original smell test) and unnecessary estimated P&L spreadsheets that mask the fact that no money will be made.

It gets frustrating when entrepreneurs don't calculate estimated return properly in the materials they provide for you to make an investment decision on. "If they can't calculate what my return on this investment is supposed to be properly, how can I trust the rest of the numbers they are giving me?"

Fred provide screen shots and a Google Doc you can click on to see how he sets it all up. It's very straightforward. Check out his post first, then come back here; some of the items below might help if you get stuck.

1. Think of this calculation as a cash flow analysis for the investor alone (not the business). How much money are they putting into your business, and how much do you estimate they will get back each year over the life of the investment. It's that simple.

2. The reason you put the investors original amount as negative is because it is negative to the investor (it's additive to the business you are asking them to invest in, but we're focusing on the investor in this exercise).

3. The IRR function in Excel or Google Docs, looks like this (as defined by Google Docs):
Internal Rate of Return

"=IRR(values, guess)"

Calculates the internal rate of return for an investment. The values represent cash flow values at regular intervals, at least one value must be negative (payments), and at least one value must be positive (income). Values is an array containing the values. Guess (optional) is the estimated value. If you can provide only a few values, you should provide an initial guess to enable the iteration.
values: this is your row of annual cash flows. The first number is typically negative (the amount the investor put into your business) and the following numbers are typically positive, but varied, as the return each year will hardly ever be exactly the same.

This function automatically assesses how many years (or periods) the IRR is for as that is how many numbers there are in the array (B6:J6, for example).

guess: if you've ever used "Goal Seek" in Excel, you know why this at one point was necessary. Excel / Google Docs uses an iterative process to hone in on the IRR - back in the day it helped to get Excel started by providing an IRR guess of say, ".1" or 10 percent. I would bet this is no longer necessary at all, but I always put in .1 just out of habit. If you enter nothing as a guess, Excel/Google Docs automatically enters .1 in the formula.

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