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The Brode Report  |  March 2013

David Brode profile  

Hi everyone,

I had one of those great Boulder moments yesterday. One day we had a snowy, icy morning drive with lots of new snow and more falling. But by noon two days later it was nearly 70 degrees, and as I got out of the car I thought, "I'd really like to sit out in the sun for a few minutes." And then my next thought was "But I better not slip on all this ice here in the shade!" And that's springtime in Boulder. Hope you're enjoying the transition from winter.

Best regards,



I love working through complex corporate finance analyses; I'd be happy to leverage the
style of analysis that I applied here to your problem or project then

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IRR and Multiples

sharesRecently I saw curious deal terms from a private equity firm. The money people had Series A stock and received all the cash flow until certain conditions were met, at which point Series B holders would start to see money. There were two conditions and both had to be true for Series B to be in the money, i.e. the conditions are a threshold or hurdle to be overcome. The chart below shows how it worked:

Level IRR Mult Series B
Units %
of CF
1 < 10% < 1.0 0%
2 10% 1.0 15%
3 15% 1.5 20%
4 20% 2.0 25%
5 25% 2.5 25%
6 30% 3.0 30%

So until the Series A investors reach a 10% IRR AND a 1.0x, the Series B would get no cash. But once both conditions were met, Series B would get 15% of the cash flow. For Series B to get 20% of the next dollar, (Level 3), Series A would have to be at 15% IRR and 1.5x multiple. So much for the mechanics.

This was curious to me because I’ve rarely seen two-factor tests. I’ve seen IRR tests frequently, but I couldn’t recall seeing one that measured based on both IRR and Multiple. And what’s even more interesting to me is that IRR and Multiple are related. Think of it like this: if all investments lasted exactly one year IRR and Multiple look like this:

IRR Mult
- 1.00
10% 1.10
15% 1.15
20% 1.20
25% 1.25
30% 1.30

Let’s look at an example where the entire investment is drawn on Day 1 and the full return is realized after one to seven years. In these cases, we can show the equivalent multiple for an IRR or vice versa. Consider this, based on the first table:

    Series B     Year of Projection: Mult translated to IRR
IRR Mult Units % Level   1  2  3  4  5  6  7 
-100% - 0% 1                
10% 1.0 15% 2   0% 0% 0% 0% 0% 0% 0%
15% 1.5 20% 3   50% 22% 14% 11% 8% 7% 6%
20% 2.0 25% 4   100% 41% 26% 19% 15% 12% 10%
25% 2.5 25% 5   150% 58% 36% 26% 20% 16% 14%
30% 3.0 30% 6   200% 73% 44% 32% 25% 20% 17%

The yellow cells in the table show all those cases where the multiple test implies a lower IRR than the IRR test does. In these cases the multiple rules. Of course, Year 1 is pretty obvious. What’s interesting is that by the time you get to Year 4, the Multiple test is irrelevant. For example, on Level 2 you need a 10% IRR and a 1.0x Multiple. This one actually makes me chuckle, because a 1.0x Multiple = 0% IRR by definition. So if you have a 10% IRR, you have always exceeded your 1.0x Multiple. And so it goes…the 1.5x Multiple with 15% IRR doesn’t matter after Year 3, and the other steps are pretty much irrelevant by Year 4.

time value of moneyI will note that there is one good reason to put in a multiple test: if someone uses your money just to get the deal done, and then tries to replace you with cheaper financing, you could be hurt because a 20% IRR on 3 months of investment just isn’t that much, but you invested lots of time in getting the deal done, opportunity cost of missing other deals, etc. That’s when a 2.0x Multiple could really help.

But in general, this extra clause really doesn’t do much for the investor who asked for it. I do find that people get obsessed about multiples. I once had an argument with a fellow finance guy who insisted that investors only cared about multiple and never about IRR. I offered him a choice between two deals, both totally guaranteed payouts. Deal #1 let you invest for one year with a 1.5x multiple giving an IRR of 50%. Deal #2 gave a 3x multiple, but didn’t pay out for 30 years. Which is better? The 3x multiple is the equivalent of a 4.7% IRR, but that shouldn’t matter, right, since investors only care about multiple, right? This particular guy still couldn’t see past his axiom that “you can’t eat IRR,” but I bet most of us would still take Deal #1.

time value of moneyIn any case, the key thing that multiples miss is the time value of money whereas IRR does capture something important about time value. I’m still a purist and believe that discounted cash flow gives the true correct answer. IRR, while imperfect, is closer to DCF than are multiples, which are oblivious to the passage of time.

In the final analysis, I prefer a simpler single test to this more complicated structure. If investors can name their terms, they can make it as complicated as they want. But they can achieve 95% of their results with a simpler test that will be easier for everyone to accept.

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Groupon Update

GrouponWell, it finally happened. The NYT reports the latest step in the downfall of Groupon:

Andrew MasonAndrew Mason, the irreverent chief executive of Groupon, was ousted on Thursday, after the company's dismal fourth-quarter results capped a string of disappointing quarters. True to his humorous style, Mr. Mason wrote in a letter to employees: "After four and a half intense and wonderful years as C.E.O. of Groupon, I've decided that I'd like to spend more time with my family. Just kidding - I was fired today. If you're wondering why... you haven't been paying attention."
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