Since investors normally expect returns within five to seven years after the initial investment, they're going to need a fairly accurate estimate of the potential returns on their invested capital before putting any money down. There are two common methods of breaking down returns: the Internal Rate of Return (IRR) and Multiple on Invested Capital (MOIC).
MOIC, also known as the Total Value to Paid-in-Capital (TVPI), is a calculation used to measure a fund's performance without taking time into account. This calculation is used to create a multiple of returns, not calculate the returns themselves.
For example, if your investor initially invested $10,000 and the fund is worth $50,000, then the multiple would be 5.0x. As you might expect, higher MOIC translates into higher gross returns.
For investors, the MOIC or TVPI metric is a great benchmark to compare with the more complex IRR, which takes time into account. MOIC can also be used to evaluate unrealized returns and realized investments.
How to calculate MOIC
MOIC can be used for both deal and portfolio analysis. Since it is a higher level calculation, carried interest and fees are not involved in gross MOIC. To calculate MOIC:
MOIC = (Realized Value + Unrealized Value) / Amount Invested
To evaluate your net MOIC, you would take the value from the above formula and subtract the cost of carried interest, taxes, and other fees.
What is the Internal Rate of Return?
The IRR calculation is far more complicated. For this equation, you'll need to know your net present value, cash flow, and time. Generally, this calculation can (and should) be completed with a spreadsheet or financial software, so you're not going to need to memorize it as long as the key inputs are available.
Let’s look at an example of IRR. If one contributes $10,000 to a fund and within five years the worth of that investment is $50,000, the IRR is 62.96%. However, if the same amount is earned within two years, the IRR is significantly higher, at 226.56%.
Gross IRR calculations do not factor in carried interest or fees, either. Adding these expenses into your calculations will provide your net IRR.
How is MOIC different than IRR?
The main difference between IRR and MOIC is that the latter does not take time into account. Unlike the MOIC rate, the gross IRR calculation is used to understand the yearly rate of return. In this case, the time horizon is critical, since the IRR covers the value of money over time.
While MOIC can be easier to calculate and understand at a glance, investors tend to use both calculations to weigh the value of a potential investment. Usually, investors are attracted to higher IRR, but higher MOIC means a lower churn rate of investments, which can also be valuable.
Let's look at two scenarios to see how this plays out in practice.
- Investment A: The investor has contributed $1,000. After five years, the fund has grown to $11,000, with a 199.17% IRR and an 11.0x MOIC. Both metrics are high, indicating a profitable investment.
- Investment B: The investor also contributed $1,000, which grows to $2,000 in two years. The IRR is 61.80% with a 2.0x MOIC. While the IRR suggests good future results, the MOIC is rather low. This investment analysis would likely chase off potential investors who want to significantly multiply the returns on their investments.
So it's usually, but not always the case that high IRR is accompanied by high MOIC. If you end up with a low MOIC, despite a high estimated IRR, you may need to make the case for why your organization is a worthy investment opportunity.
Other calculations to use in addition to MOIC
Outside of MOIC and IRR, there are other useful calculations, and you’re likely to come across both:
- Distributions to Paid-in-Capital (DPI) - This calculation measures the amount of the investment that has been returned to the investor versus how much of that capital is still in the fund.
- Residual Value to Paid-in-Capital (RVPI) - This ratio highlights the value of all of the investor's remaining investments within a fund in relation to the contributions of the other limited partners.
While these two tools can also be useful to measure realized returns and the fund's performance, they are less critical for business owners looking to present the value of their investment to potential equity funds.
Instead, it can be useful for CEOs and CFOs to rather highlight past performance, IRR, MOIC, assets, and cash flow.
Using the calculations
Since investors use MOIC as well as IRR to determine whether or not a company is worth investing in, you should have a solid understanding of how to arrive at your own valuations. Most investors still gravitate towards IRR, but if you can demonstrate that your startup or company can generate 2x, 3x, or more in returns, you will have more leverage when requesting funding.
With software investments, what else should you know?
Whether you're lending or taking advantage of investments in your own software, at some point, you'll also need to justify your spending on software development.
Foreworth helps you make informed investment decisions by giving you the opportunity to see an instant snapshot of any software, providing you with a set of key, actionable insights unique to your business case. Book a demo today to learn more.