When You Swim With Sharks, Take Your Calculator

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You ought to have your calculator handy when you watch ABC’s Shark Tank, the TV show where wealthy angel investors make on-the-spot investments into small businesses.

Last night a middle-aged company owner was offered 3 deals in rapid succession.  For me, this was a simple math problem: Which offer gave the owner the best valuation?

The Offers
Every offer implies what the investor thinks your company is worth: your company’s valuation.  Valuation is not just the total amount of money an investor offers, but the total value of the company implied by that offer. (I’ll do the math for you in a second.)

So which would you chose?  The offers were as follows (you’d get what is bold, the investor receives the rest):

  1. You get $500,000 – Investor takes 20% of the company and a 15% royalty until the investment is paid back
  2. You get $1 million – Investor takes 30% of the company and a 10% royalty until the investment is paid back
  3. You get $4 million  and a 10% royalty forever – Investor takes 100% of the company

The Math
To start, let’s keep the math simple.  If $500,000 is the offer for 20%, then the total valuation is $2,500,00.  That’s the cash paid divided by the percentage purchase, or $500,000 / 20% = $2,500.000.  Do this calculation with each offer, and you’ll see that the base valuations within these three offers are strikingly different:

  • The first values the total company at just $2.5 million.
  • The second, at $3.3 million.
  • The third … at well over the $4 million cash offer since continuing royalties could have netted him many millions more over his lifetime.  In fact, by my calculation, the third offer put the valuation at nearly $6 million.

The Choice
The entrepreneur could not decide. It was clear that he had a great deal of emotional attachment to his business.  He was tempted by the $4 million buy-out offer, but hesitated to part with the business he had built from scratch.

In the end the deals all shifted a bit (as they tend to do on Shark Tank), but the entrepreneur walked away with something closest to deal number 1.  He actually took the offer with the lowest valuation.

Why settle for less money from an investor who thinks your company is less valuable?  This is a bit like selling your house at foreclosure prices.

I believe he took the deal because it was backed by 3 of the show’s angels, including Mark Cuban.  Perhaps he also really wanted to continue building the business himself, rather than give up total control in an outright sale.

Or maybe he simply did not have a calculator handy.

For me, the best bet would have been the $4 million sale with a 10% continuing royalty.  Why?  Not only would the entrepreneur walk away with certain wealth, but a 10% royalty (which is typically taken out of top line sales) is equivalent to about a 30% ownership stake. (Read more about royalties.) So he could have taken the money and been assured of continuing payments … perhaps even very large payments for a very long time.

BONUS:  Here’s a FREE Shark Tank valuation spreadsheet I created to show you all three Shark Tank offers from the episode detailed above.  And when you are ready to calculate the valuation of your own company, please try my Capitalization Table.

Next time you go swimming with the sharks, I hope you’ll take a calculator (or my spreadsheet)!

Dedicated to your (highly valued) profits, David

PS: Need help figuring your own valuation?  Use my Capitalization Table to see what your investors think your company is worth (and who controls the voting stock!).  And if you have trouble filling out the cap table, I’ll do it for you.  Click here to get started on your own cap table valuation.

20 Comments
  1. I’m a startup company bringing some new products to market. I’m looking for an investor but have no sales yet. How could I value my company??

  2. Hi Manny! Startup valuations are harder, but not impossible. My best advice is to let the investors set the value. If you’ve seen Shark Tank, you know that valuations are not generally high for new companies — probably less than $500,000 in most cases. [If your products are “tech” or have complex patents, then that’s a different story…].

    In any case, startup valuations are set as much through negotiation as anything. You can “project” sales and profits, which could give people a benchmark for your value, but in the end the investor will dictate what he thinks it is worth.

    Best of luck,
    David

  3. Dave, your “Shark Tank” articles are the best I’ve come across. You never know when you might find yourself in front of “Mr. Wonderful” … Laurie Ludwig

  4. Hi, how do you work out the third offer to get 6 million? Also I can not seem to find your article on royalties. Thank you so much for writing this stuff

    • Thanks Savannah:

      In the third scenario, the business owner would sell his entire company to the investor for $4 million, but he would retain a “10% royalty on sales”. Shark tank is light on details, but to me that means that the business owner would continue to get 10 cents of every sales dollar… forever.

      Now here’s the tricky part.

      Most company make 20% to 30% NET profit (bottom line). Since the royalty is paid on SALES (top line), that royalty is worth one-half (10% / 20%) to one-third (10% / 30%) of the profits. That is the same thing as continuing to own half (or one-third) of the business!

      Not knowing what the sales are, we cannot nail down the value of the royalties, but we can estimate that if the business has sales of $10 million per year — he gets $1 million … EVERY YEAR for life!

      One other way to estimate this is to say that offer #2 put the value of 30% at $1 million. Since the royalty is (as we said above) worth about half to one-third of the company, that’s MORE than the 30%, and so must be worth at least $1 million.

      You can beat me up on this calculation — we really do not have all the numbers we’d need to do it right… but my gut says that deal #3 would have been a huge home run for the guy!

  5. Hi Dave,

    I watch Shark tank regularly. I don’t follow the concept of an offer these shark make is where they seek an equity in the company but require return of their capital/investment in 2 yrs or 3 yrs etc. My understanding is that when you invest in a company for an equity share you basically look you capital and don’t get it back unless the company is sold.

    I would appreciate if you can shade some light on this.

    Thanks

    • You are absolutely right, Maz.
      See my other article on Shark Tank about “royalties” — these guys have been so UNSUCCESSFUL in making their companies successful, that they have to “loan” the money instead of investing it. They want their cake and to eat it too!

  6. Hi Dave, What I don’t understand about the show is the concept of valuation in terms of the question that often gets asked: “how are you going to use the money for the business”, implying that the invested cash goes back into the business (as opposed to your example where you wrote “you get…”). For example, I would expect that in the first 2 options in your example (ignoring the royalties), the equity investment cash would have to go back into the business, effectively providing that same equity investor with his equity percentage worth of his own investment. But in the third option, I would expect the entrepreneur gets to keep the money for himself, he has sold his entire business. If this is true, how can we value all 3 options using the same calculation?

    • Great Point Johnny:

      In the 3rd example you would indeed sell your ownership shares to the shark. In the first two, you would sell company stock to the investor, but keep your own ownership shares also.

      So, in a sense, he does own a piece of his own investment!

      I made the mistake of mixing “you” and “your business” — which I guess is an error borne of being a small business owner myself. It often feels like “I am the company”! But in fact, angel investors do put their money into the company, and it would be unusual for “you” (the business owner) to take any of it out of the company.

      Later stage deals are sometimes structured that way — when your company is large enough, you can often sell part of your ownership and take money out of the deal itself. But early stage growth capital is all about putting money into the company.

      Thanks Johnny!

      • Overall the point I’m trying to illustrate is in comparing options 1/2 to 3, its not apples to apples in calculating the ‘company value’ derived from the offers. If we continue to ignore the royalties, the option 3 shark values the company at $4 million (=4,000,000 / 100%) and is willing to pay that amount without the cash going back into the business. Lets say a hypothetical 4th option shark agreed with the $4 million valuation, but only wanted 50% of the business and hence offered $2 million for it (=4,000,000 / 50%). The show would label this as the “same valuation” and all other things equal, an equivalent offer. But it’s actually far from equivalent because in option #4, half of that investment theoretically goes back to the shark as an equity owner once injected in the company. So if that shark really thinks the current company value is $4 million, he should really have to offer $4 million for 50% equity to make it equivalent to option #3.

        • Wellllll… …I agree with your conclusion, but not necessarily with your math.

          We agree that the offers are not equivalent: they are, as you said, apples to oranges.

          The problem with your math is this: No owner truly “owns” or “takes” cash that is in the business. Once an investor puts money into the company’s bank account, it belongs to the whole company and represents part of the value of the company. Saying that a 50% owner owns 50% of the investment he made is having your cake and eating it too.

          The math is simple: Investment $ / Share % Received = Total Company “Valuation”.

          Now here’s why we agree on the apples / oranges thing…

          In Offer #3, the current owner sells everything to the investor and walks away with the $4 million cash. That means that the company does not get ANY of that money. So really, in this case, the investor bought 100% but does not get any of the benefit of his investment. If he wants to grow the company, he’ll have to put in MORE money out of his pocket.

          That’s why these deals are not apples to apples… in 1 & 2, the business actually increases in value because it has cash in the bank. In #3, the asset base of the company (cash in bank) does not change at all!

          Talk about a crazy show. You are dead right that they do a very poor job of explaining the economics. And its a shame, too, because these are simple and important concepts that America needs to learn and apply. Ahhh…. but it is good prime time entertainment, isn’t it??!!

          Cheers,
          David

          • Completely agree. My example was basically an extreme one to illustrate the concept. Agree that is extremely entertaining! Thanks Dave

        • Johnny:

          One other thing — we should have been talking about “Pre-Money Valuation” vs. “Post Money Valuation”… but that seemed a bit too complex for this blog post.

          The concept is that Pre-Money Valuation + Investment = Post Money Valuation.

          And that starts to address your concept about owning part of what you put in.

          I have to admit, I’m intrigued by your example. I’m going to noodle this some more.

  7. Yes the concept of pre vs. post and which they are referencing in Shark Tank as ‘company valuation’ has always bothered me ever since the show started (the show “Dragon’s Den” in Canada preceded Shark Tank and I have always watched).

    Due to the fact that the sharks always ask “how are you going to use the money we invest for the business?”, it seems obvious that they must be referencing a post-money valuation (simply because they are expecting their money to be used for the business they’re investing in). But if that’s true, then they technically shouldn’t be saying things like “there is no way that you are worth $XX today” because that would appear to mean they are referencing a pre-money valuation. So it doesn’t add up!

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