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What do you say when a potential investor asks what return you’re paying?

Let’s use this example of a projected payback (this could be equity or debt):

 Original Investment Amount (year 0) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Total Return (1,000) 50 75 100 125 150 175 200 250 300 400 1,825

The simplest way to calculate return is called “cash on cash return.”  This tells you the amount of cash the investor can expect to receive from her investment.

This is what venture capitalists mean when they talk about 10X return.

In the example above, you could say you are paying a 1.825X return (you are paying back the investor her original investment multiplied by 1.825).  You could also say that you are paying an 82.5% return (you are paying back 82.5% on top of the original investment.

To calculate this you use the following formula:

(Total cash received by investor – Original investment)/Original investment

Using the example above: (\$1,825 – \$1,000)/\$1,000 = 0.825 or 82.5%

One thing to note about this measure of return is that is says nothing about how long it takes for the investor to receive the return.  Because of that, it is not the best measure of return.  A measure of return ideally should take into account both the amount of money received AND how long it takes to get it.  Why?  Because of a concept called the “time value of money.”  This means that a dollar today is worth a lot more than a dollar ten years from now.

If you want to calculate the return on investment in a way that takes both money AND time into account, you use something called Internal Rate of Return (IRR).  The good news is that this can be calculated a spreadsheet program.

Here is the formula: =IRR(A1:K1)

(A1:K1) means you highlight all the cells that contain the original investment plus the annual projected return.

Here is an example:

 A B C D E F G H I J K L M 1 IRR Original Investment Amount (year 0) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Total Return 2 9% (1,000) 50 75 100 125 150 175 200 250 300 400 1,825

The formula in cell A2 is “=IRR(B2:L2)”