IRR vs. NPV vs. Cash-on-Cash
Net present value (NPV) and Internal Rate of Return (IRR) are popular for evaluating opportunities and great for choosing investments in corporate projects. Yet most venture capitalists use “Cash-on-Cash” mathematics when it comes to making investment decisions and discussing returns. I studied this in depth when I was writing my book. There are several reasons for this:
- Convention. That’s just the way people do business here in Silicon Valley.
- Mathematical simplicity. Put $10 million in and got $100 million out, that’s 10X. Pretty easy to figure out on the fly.
- Single investment, single payout. NPV is great for dealing with a stream of payments over time, most investors put money in at one point and get it out at another with no interstitial inflows or outflows.
- Discrete opportunities. IRR comes with some baggage of implications about the nature of the investment opportunity, namely that it is ongoing and liquid. Venture investments are one-shot deals with characteristics that differ greatly from public market investments or bond annuities.
- Cash-on-cash ignores the time aspect of investment. Both IRR and NPV make use of the concept of the “time value of money.” There are two reasons why venture capitalists might prefer to ignore the time value of money. A 10X cash-on-cash return sounds more impressive than the same return normalized for a 10-year holding period. Sometimes a fast return doesn’t make sense as an IRR/NPV number. Consider Instagram’s sale to Facebook. Venture capitalists invested at a $500 million valuation and sold the company two days later for $1 billion. It’s a 2X return or about a gazillian percent IRR. The time is less relevant because it’s a discrete opportunity, not repeatable.