Well, with the crazy amount of coverage since Instagram announced it was being acquired by Facebook for $1 billion, even people with the very barest amount of interest in the startup / venture world have asked what the big hubbub is about. If the $1 billion price tag were not enough, the media also revealed that just last week a group of investors led by Sequoia also invested in Instagram at a valuation of $500 million, only to exit a week later with a 2x cash-on-cash return! I won’t try and dissect and analyze the deal itself, since that’s already been done ad nauseam, but I’ll take a stab of breaking down IRR, which is one of the primary ways that VCs like Sequoia calculate returns on their investments. Hopefully this will provide some color to those friends asking IRR questions.

The IRR, or “internal rate of return,” is the rate of return / discount rate that makes the NPV of a stream of cash flows equal to zero. You can read in more detail here. In the case of Instagram’s Series B financing from last week, the cash flows would be a $50,000,000 cash outflow (invested amount) and a $100,000,000 inflow (sale proceeds) from the Series B investors’ perspective. Now, a 50% IRR is pretty good. A 100% IRR is fantastic. How does ~500 quadrillion % sound? (That would be 500 plus another 15 zeros). Well, that’s the IRR that the Series B investors received on their investment, assuming April 5th as the day they wired their money to Instagram and April 12th as the day they get their cash back.

But does a 497,237,713,464,852,000% IRR (to be exact) make any sense at ALL? Yesterday, I was chatting with Edlyn Yuen, an associate at StarVest Partners, and she got the same absurd-sounding number in Excel, too. Hmm. Let’s dig in a little deeper then… As you can tell below, the IRR decreases exponentially as time passes (the graph below in blue looks almost meaningless given the extreme drop). What was a 500 quadrillion % IRR (over a one week span) decreases to a measly 450,000% IRR once you get to a 1 month investment horizon.

By the time your length of investment increases to 3 months, you’re down to a “tiny” 1,500% IRR.

If we then zoom in a little closer and graph the expected IRR assuming a length of investment ranging from 3 months to 1 year, the graph below is what you get. As you can see, the IRR approaches 100% and hits 100% exactly on the 1-year anniversary. That much makes sense to me at the very least — on an annual basis, a 100% return equals a doubling of value (e.g., $50mm to $100mm).

So as you can see, while the 500 quadrillion % IRR seems completely absurd, once you examine how an IRR is calculated, it begins to makes sense, at least mathematically. Practically speaking, though, a quadrillion % still doesn’t make much sense in my head, much less 500. In any case, congrats to the Instagram team, as well as Sequoia, Thrive, Greylock, and Benchmark on a great exit!