The internal rate of return, or IRR is the industry standard metric for calculating the annualized effective rate of return that an LP investor has earned on their invested capital In a VC fund, the IRR takes into account the amount invested and the timing and the amounts of the funds cash flows, including the capital calls and any distributions.

The IRR is calculated by solving for the discount rates r that will result in the present value of all of the cash flows CF in this formula during the life of an investment both inflows and outflows being zero.

This method takes into account the time value of money, since both the total time horizon and the timings of any interim cash flows are taken into account.

However, a major weakness of the IRR is that it assumes that any cash flows received before the maturity of an investment are reinvested at the IRR itself for a VC fund.

This will include all investments exited before the maturity of the fund.

The IRR might be significantly different from the actual rates of return that an investor can achieve on these cash flows.

There are a number of different ways in which the IRR can be expressed.

It can be measured using a realized IRR where cash flows or profits have actually passed through to investors or an unrealized IRR, which counts the theoretical profits, which could have been distributed to investors if currently unexited investments were exited at their current market valuation.

This is highly dependent on the estimates of current market value.

In addition, the IRR can be expressed on a gross basis, where the calculations take into account the amount of capital and cash flows between the fund and its investment companies.

Or the net IRR basis, where the calculation looks at the cash flows between the VC fund and its LP investors, meaning that these cash flows are impacted by management fees and carried interest, cash flows paid to the gps.