When does a ‘shark’ consider a business ‘investable’? Angel investing 101 according to TV show Shark Tank…
I’ve been sick, lying in bed and binge watching Shark Tank. It’s a hit reality show in the US where business founders pitch for investments from some of America’s most famous angel investors and venture capitalists.
Well… I guess out of every misfortune there is a silver lining (or at least one tries to find one). For me I shall translate this unproductive period into a useful one by condensing what I’ve learnt from the show into a Medium story about how business angels evaluate investments (according to Mark Cuban and his fellow ‘sharks’ anyway).
Because it is a TV show, some degree of dramatization and showmanship is to be expected from the staging and editing, as well as the way the sharks critic the pitches. But if you watch enough episodes, you will come to realize there is a consistent and logical methodology to the evaluation of every pitch.
That methodology can be summarized into the following three aspects:
The very first thing that the sharks would ask any founder is their sales. In Shark Tank there’s been a variety of crazy ideas — elf sweaters, construction machinery playgrounds, custom cat drawings, cricket energy bars and even a live horror entertainment company that got US$2 million from Mark Cuban!
While the sharks may laugh at the pitches and ideas initially, if the business has already proven itself with significant sales, the sharks sober up and start negotiating a deal. Any seasoned entrepreneur knows that consumer reactions are hard to predict. They only foolproof method is to try and sell the product!
That said, veteran TV infomercial queen Lori Greiner always quips that she loves ‘a better mousetrap’ — a better version of a product already proven to have huge demand.
A big boost to an attractive product is having some sort of patent on it. Mindful of the fact that most hot selling products can be knocked off quickly and easily, sharks like to know if it can at least be protected in more law abiding markets like the US.
In general, the sharks also prefer products rather than services i.e. an item sitting on a website or shelf waiting to be sold, as opposed to, a business that delivers a service provided by a human being. The reason for this is simple: services are harder to scale up and maintain quality. They require hiring, training and managing human beings, which is often far more tricky than just rolling another item out from a factory.
Size of the market is important, but sharks hate it when founders quote big market sizes to justify their valuation or business potential. They are seasoned investors and businessman, and know that no matter how big or attractive the market, the real key to taking a bite out of it is execution — which is entirely dependent on the founder and his team’s abilities (more on that later). That is proven via his background or how the business has performed so far.
Last but not least, the sharks tend to fight for the deal more if they see a great fit into their existing portfolio of businesses. For example, Kevin O’Leary aka ‘Mr Wonderful’ has a platform that targets weddings and young couples. If he sees a fit to push a new product or service, you can be sure he will use that to get a good deal from the founder. And it makes sense for both parties. Anyone who has tried to sell something new will know the importance of an existing base of customers.
There are many theories and ways to value a business. The mathematically inclined readers can google to find out more. But since the Shark Tank is a mass market TV show, they try to keep it simple. If a founder asks for $100,000 for 10% of their company, then they are saying their company is worth one million dollars.
The first thing the sharks will ask is, how much is the product and what’s the cost of making it, to determine the profit margin. For example, if each product is sold at $10 and the cost of making that product is $5, then you have a 50% margin. Now, if your revenue last year was $100,000, then you should have made a profit of $50,000. From a valuation perspective, you are asking for an investment that prices your company at 10 times of revenue, and 20 times of profit.
This is where investment valuation really becomes as much an art as a science, and the sharks start to look down and scribble with the pen and notebook they all carry to perform their own ‘back of the envelope’ calculations.
Using the simple numbers we have previously cited, a 10% share in a company that is making a profit of $50,000 implies the investor’s share in those profits is $5,000. If he gave you $100,000 today in exchange for that 10% equity, it would take him 20 years to make that investment back assuming revenue remained the same year after year.
Businesses grow (hopefully), and those 20 years might become just 5–7 years or even less if revenue keeps growing. Fulfilling future projections is really a matter of execution ability and maybe even some luck and connections. For the sharks they mix, into the equation, their own ability to help the business grow, as well as some sense of what the typical growth rate for that industry/product has been historically. In most cases they don’t like to invest in anything where it will take more than seven years to recover their investment. 3–4 years is excellent, beyond 10 is out of the question. (Venture Capital and Private Equity tend to look at similar investment duration too.)
Beyond revenue and profit valuation, sharks are also interested in the amount of debt the company has and the shareholding percentage the founder has in the company (if he has sold equity to raise funds previously). Companies with high debt are very unattractive to sharks for obvious reasons. And they also stay away immediately from companies where the founders have lost majority share in their business. It’s simple, the motivation and control over the fate of the business disappears if you no longer own a majority stake.
Finally, as I’ve argued in my article “The Truth Behind How Venture Capital Chooses Startups”, many professional investors believe the most critical factor to a startup’s success is the people in it, especially the founders.
The sharks may admire and praise the occasional pitches where the founders are young prodigies in their teens or even elementary school, but they have never made an investment (at least in the seasons I’ve watched) without an adult running it full-time.
There was even one pitch where the founder of the “Famous Amos” cookies came to pitch his latest cookie venture at the grand old age of 80! (He lost the that first cookie company from mismanagement and dilution of ownership). As much as the sharks were in awe and respect of the man and his life story, they held back from making an investment.
In addition to a full-time commitment to running the business, sharks also like entrepreneurs with experience and proven success in the space or industry they are pitching in.
Some founders gush about their deep passion for the business and how they have gone “all-in”. Others swear to work to the bone or tell their sob stories about how they overcame great odds or dire circumstances to create the business. Obviously, as a TV show these scenes are usually edited in to capture viewers’ interest, but success at getting an investment really depends on whether the sharks buy into the cause or story and if they take a personal liking to the founder.
They are sharks, not ‘angels’
The fact of the matter is, while the sharks sometimes invest in stories or causes they like, they got to where they are in wealth through shrewd business sense and wise decision making, not sentimental hopes and dreams.
While the entertaining and elaborate pitches does create a great PR and media exposure effect for the founders who successfully get onto the show, the basic lessons discussed above on how a professional investor evaluates your investment proposition are really the basis for securing a funding deal.
So if you have a startup and a chance to pitch in front of a business angel, make sure you are well positioned to make a compelling pitch given the criteria discussed above. Don’t go before you’re ready. In most cases you’ll only get to pitch once to any potential investor. Substance will meet with success sooner or later, whereas fluff is easy to spot and tear apart!