Shark Tank: The Tank Can Only Do So Much

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Shark Tank is a very entertaining and popular show.  Each week, more than four million viewers tune in to see great ideas, strong pitches and newly minted potential millionaires.  Just as entertaining as the deals that go well are the ones that go poorly.  Here we explore the nature of deals on Shark Tank, the ups and downs of valuation, and the challenges in exposing venture capital type investment decisions to a broad audience.  After all, in the show’s need to reach a popular audience, it can’t show the more technical side of venture capital (VC) decision making.

 

First, let me share that I really enjoy Shark Tank.  I enjoy each of the venture capitalists on it.  Exposing a broad audience to the thought processes involved via a show about entrepreneurs, startups, and venture capitalists / investors is wonderful.  Yet, there are some challenges with exposing the process to a broad audience and that’s our focus here.

 

One of the givens, here, is that drama of the tank needed to be amped up to make it exciting for America.  Thus the dramatic music and monikers the VC team attach themselves including, for example, “Mr Wonderful”. I do not lament this at all.  It makes for excellent TV, drama, and adds to the appeal of the show.  Kevin O’Leary’s “Mr. Wonderful” handle is particularly funny and shows clear wit:  my bet is that, if Kevin is interviewed years from now about the show, he would be the first to explain this was sort of a tongue-and-cheek name with which he dubbed himself to add a little spice to the show.  It makes things a little over the top in a positive way.  Indeed, the juxtaposition of the title “Mr. Wonderful” against some deals which are really not so wonderful is always entertaining.  Of course, there are those moments where the deals Mr. O’Leary makes with business owners truly do make him their Mr. Wonderful–and, after all, the business owners wouldn’t be there if they didn’t need a Mr. Wonderful for something.

 

Besides the entertaining names and amp-ed up drama, there are some challenges in the show that we should explore as they relate to business model innovation, valuation and liquidation preferences.  Liquidation preferences you say? These are never even mentioned on the show.  This is one of the challenges in bringing Shark Tank to a broader audience. Each time Mr. O’Leary (ok, yes, I enjoy his disciplined investor role) asks:  “But how will I get my money back?”, he is boiling down a key part of portion of VC deals to a focus on how money is returned to investors.  In VC deals, this issue is much more complex than what can be covered in the brief, digestible portions required by the Shark Tank format.

 

Real-life VC deals typically include a term sheet, where the entrepreneur team is presented with the terms of the deal with which the venture capitalists will invest.  (Of course, many real life VC deals involve much more, such as a series of meetings rather than a less than five minute interaction on which the sharks base their investment decisions.) One of the most poorly understood elements of the term sheet is liquidation preferences.  It would be very difficult to put liquidation preferences on TV and make these sexy yet they are key in most deals.  Unfortunately, liquidation preferences are some of the most important terms on the venture capital sheet and can often lead to misalignment of the investor / entrepreneur team on down the line.  Let me explain.

 

A typical liquidation preference sheet will include terms such as a 3X, 1X, participation / no participation and no cap / cap feature.  Let’s take each one of these and explain what they can cause later in terms of investor-entrepreneur alignment.  First, when we invest in a new company we join the ‘stack.’  The stack is the order in which teams are paid back for their investment.  The most recent investors are at the top of the stack of cards and are paid back first.  Then, at the bottom of the stack, are the early stage  / series A / seed funding venture capitalists.  An exit event, most commonly selling the company to a buyer, is the time at which the buyout will occur and the investors have the ability to be repaid with their winnings.  The term sheet specifies on what terms and in what manner the investor will make back their money (and then some we hope–otherwise why assume the risk of the investment).  First, let’s focus on the ‘3X’ or ‘1X’ situations.  The investor will obtain either three times, thus the “3X” or one time (“1X”), or somewhere inbetween, amount for their initial investment.  So, if I give $5000 to a startup and there are no other investors later, and I have a 3X term I will expect to be returned three times my initial amount or $15000 during an exit event.  However, there may also be a cap.  A cap means I can receive no more than a certain amount. So, although this wouldn’t make sense for almost any deal, if I have a $10000 cap, and I have a 3X initial investment on $5000 I could only be repaid $10000 total at the end of the day.  Such deals are not done routinely.  We only use this to highlight the nature of a cap.  The cap says:  “Investors you can only obtain this much money in return total for your initial investment.”

 

More interesting is the concept of participation. That means that an investor will receive their 3X or 1X, sometimes called multiple, of investment return and then will go on to participate in the buyout of the shares (of which they own some) at the price stipulated by the buyer company.  So, in the example given above, the investor would receive $15000 plus the value of their stock as they participate in the stock buyout up to whatever cap exists if a cap is in the terms sheet.  No participation means they would receive nothing for that stock.  Keep in mind the investors are paid before the startup team in all scenarios. So, the startup team and the investor can easily become misaligned.

 

If you do the calculations for various sale prices for companies with various liquidation preferences in the term sheet, sometimes the amount the investor makes on the deal will not vary over a certain number of sale prices.  What I mean is that if a company sells between $1 to $5 million the venture capitalist may have the exact same return on the investment depending on their liquidation preferences per the term sheet.  Ut-oh.  Misalignment!  Where the startup team may want to hold out for a 5 million dollar exit (remember the startup team is paid last so they likely wish to hold out for more), the VC group may be content to sell at a much lower price.  After all, the VC makes the same amount at a 2-5 million dollar sale price depending on the liquidation preferences.

 

Do some math with the 3X, 1X, participation and cap versus no cap situation and you will see this to be true.  Again, this may cause misalignment when it comes time to sell a company.  We can’t highlight this enough:  the investors may wish to sell at a much lower price than the startup team because they will obtain the same amount in return regardless of the sale price. The investor team may want to hold out for more reimbursement for their company and yet the investors may wish to sell.  Clearly, pardon our repetition here, liquidation preferences are a source of misalignment.

 

So, on Shark Tank, liquidation preferences are never mentioned.  We can’t blame them!  How could that sort of explanation come across on TV, when many startup business owners are not acquainted with the liquidation preference issues?  In the tank, companies are often valued by saying 100% of the company’s ownership shares are equivalent to their gross sales receipts.  The shark will take that amount of ownership equity for an investment equal to the share price as determined by that calculation, and sometimes the shark also wants a certain amount of royalty for each object sold in perpetuity.  This is very challenging.   The shark becomes a part owner of the company and sometimes even takes majority interest in the company.  Again, usually the liquidation terms will be clear on the initial term sheet.  However, on Shark Tank, liquidation preferences are never mentioned.  Do the Sharks, some of whom are very experienced venture capitalists, expect to simply be reimbursed as if they were a routine owner when an exit strategy is executed? Or do they expect the company to continue ad infinitum and they can take profit as any owner would? It is very difficult to tell and again liquidation preferences would not play well on TV.  Again, in fact, liquidation preferences are often poorly understood by the entrepreneurs who accept investment deals. This is one of the more challenging aspects of venture capital and entrepreneur interaction.  It’s no surprise that some Shark Tank deals despite a handshake on TV, break down in the due diligence process or later once the show is over and the lights are off.  There is a lot more to a deal than how things look on the tank on TV, and that’s ok.

 

Let’s return to valuation:  one of the other challenging aspects of Shark Tank is the valuation.  Valuations are done very strictly and are often based on gross revenue.  Sharks often incredulously ask owners of the company how they can value a company so highly when it has done so little in sales.  For now please recognize that this is a very conservative, pro-Shark method of valuation.  It does not make the Sharks wrong or “evil”.  In fact, they are simply trying to ensure that they are being conservative investors in this respect.  They only have a brief window on which to evaluate a company for significant investments.  If it were you, wouldn’t you adopt a valuation method that is conservative in your favor?

 

However, I would like you to recognize and perhaps search online for methods of valuation for different companies. I think you will find that very enlightening and different than the seemingly straightforward method of valuation that the Sharks use on TV.  Again, I really enjoy Shark Tank and I think it is excellent because it exposes America to certain ideas about investing, building a business, and innovation.  It shows personal stories of Sharks and future millionaires who have worked hard and brought a company very far.  It really highlights the American dream.  Certain limitations are imposed by the fact that it must make for good, watchable, TV.  And I respect that.  It’s more valuable to have an entertaining show that demonstrates the basics of investing and business building rather than have a perfect show that focuses on liquidation preferences, term sheets and valuation models.

 

A lot of what the Sharks talk about is interesting to me for other reasons.  Remember, it is very challenging for a Shark to hear a cold pitch and determine whether to invest or not.  In this respect I don’t blame them, and as a matter of fact compliment them, on using conservative valuation methodology.  This is because they have not built personal relationships with these entrepreneurs.  Recall they have to decide in a relatively short amount of time, if the TV show runs as advertised, whether they will or will not invest in a given situation.  This makes valuation very difficult and makes the deal fraught with much more risk than you would typically have up front in a deal.  As was recently explained in Venture Capital 101 on Coursera by the Ulu Ventures team:  the bulk of cold calls deals, or deals that are not introduced to venture capitalists by friends or others in the VC community, typically go bad and are low-quality investments.  This is why the venture capital community typically gives a “no” 99% of the time to deals which do not come to them from friends or contacts.  Although we don’t know all the background on Shark Tank and we don’t know how entrepreneurs are vetted before they are on TV, if Sharks truly have such a brief time to vet the deal and decide whether to invest we can understand and appreciate why they are so conservative in the valuations.  My bet is that entrepreneurs and teams are often selected based on their story, the quality of the potential deal, their looks, and other things that may make them more TV friendly with only the investment opportunity as one parameter.

 

In the end, Shark Tank is an excellent TV show that exposes America to the investment community, some of the ways in which investment deals are done, and highlights many of the tenants of the American dream.  This useful, excellent show has certain constraints owing to the fact that it functions popular TV show.  Again, the dramatic music, the over the top pitches, and sometimes even the Sharks’ responses (I don’t recall as many surprised whooooaaa’s from the Sharks in the first season), are meant to heighten drama and interest in this excellent show.  Rather than feeling this detracts from the show, I feel it entices a broad audience to understand and be exposed to the rudiments of investing.  The limitations of Shark Tank include the valuation methodology and the absence of discussion of liquidation preferences to name a few, yet we can all enjoy this excellent TV show and that brings real value to us as an audience.

 

Dynamic Ownership Equity & Other Alignment Techniques

 

 

 

Racing Toward Change - Speedometer

 

We discussed, in an early post, some of the importance of alignment to the startup team.  As the business progresses, peoples’ interests can become misaligned owing to various factors. For example, liquidation preferences may make investors be very content to sell a company at a much lower price than the initial startup team would. This can be because, as mentioned before, the liquidation preferences at the time of their initial investment set the stage for this situation.  This is one of the many emergent properties of the business as it grows.  Individuals from the initial startup team may become misaligned.  Changes in their personal lives, and other business issues, may make misalignment into an increasingly important factor.  In this post I will discuss some of the techniques our team uses to try to help the team continue to grow in the same direction.

Dynamic Ownership Equity

 

One of these techniques is dynamic ownership equity.  As discussed previously, the concept of dynamic ownership equity is very clearly discussed in Noam Wasserman’s The Founder’s Dilemmas.  This concept has been very useful for us in our angel investment practice. Dynamic ownership equity means that equity ownership changes as the business reaches different milestones.  For example, when the investors have their initial investment returned to them plus a certain margin, the portion of the business they own may change.

Take, for example, a business that has three entities owning it.  We will call them entity A, B and C.  We will say that entity A had the initial idea for the business and has a 35% ownership equity owing to the “idea premium”.  The idea premium is the concept that the person who has the idea may have more ownership equity especially at the beginning of the company.  Let’s say entity B has 15% ownership equity and entity C has 50% ownership equity at time 0 or when the business starts. Let’s say entity C is the investor who brings capital to the business, entity A brings the idea and certain technical expertise, and that entity B brings both a managerial style and personal connection network to the business.

The team can and should negotiate out ahead of time different milestones at which ownership equity changes.  Over time the idea premium may erode and entity A’s ownership equity, for example, could decrease.  The entity C could decrease their ownership equity with time once they have been returned their initial investment.  Over time, perhaps, entity B’s managerial skills may be come more important.  Multiple milestones can occur, and the milestones we often use are revenue-based.  That is, at the final stage of equity balance maturation the final ownership equities for each entity usually come about when the business reaches some certain gross revenue milestone.  This is because, we would rather, as investors, have a passive source of income which is 10% of $2 million rather than 80% of a $20 thousand dollar company.  We feel dynamic ownership equity gets us there and keeps the team alive as we get there.  This concept of a smaller % and yet higher return is easily understood once we run the numbers. There are many different techniques and ideas on how to balance ownership equity.  However, the idea that it changes over time as different stages of the business are achieved and that different talents are more important at each stage is clearly useful.

Regular Meetings

 

In addition to dynamic ownership equity there are other techniques we utilize to help keep the team growing in the same direction.  One of these is regular meetings.  Regular meetings with a focused agenda on key metrics to which the team has agreed ahead of time helps keep us growing in the same direction.  If we can understand our business in numbers, as mentioned in an earlier blog post, we can really get a feel for our business in different lenses which are objective.  People are less likely to get their feelings hurt in this manner.  A focus on metrics in which we believe is key.

 

Making A Business Canvas (And Updating It!)

 

One of the other things we perform in meetings is recreating our business model canvas and updating it.  This gives us a snapshot of our business over time. We then place the metrics on what we feel the key portions of our business are and follow these.  Having these updated business model canvas allows us to have a snapshot of our business over time and get a sense for what our revenue streams etc. should look like.  As we mentioned in an earlier blog post a formal business plan often does not persist beyond first contact with the real world.  That’s why, in many cases, being able to create business model canvas is much more useful.

Direct Conversations…& Avoid Founding With Family(!)

 

An additional technique we utilize to keep everyone moving in the same direction is having direct conversations.  What I mean by this is we really try to focus from the beginning of the company on the idea that there are some things we must discuss for the good of the company even when the issues, or we, are uncomfortable.  This is one of the barriers to founding a business with family.  Often founding businesses with a family member can put certain constraints on what can and cant be talked about in the business.  It is harder to discuss the elephant in the room when family is in the room also.  This makes us feel that, in line with Noam Wasserman’s description in The Founder’s Dilemmas, founding a business with family is akin to playing with fire. (For more on that, click here.) If the business does not go well, and keep in mind more than 60% of new business ‘fail’, this may leave family members with a bad taste in their mouths, blame, and much finger pointing at each other.

In conclusion, the team alignment in the new business model is an important key to success.  We need to take care to use special techniques to promote team alignment through every stage of the business.  Some of these techniques include dynamic ownership equity, updating the business model canvas, focusing on metrics with which everyone has agreed, and the avoidance of founding a company with family.  We hope that you may find these techniques useful in your practice and again I recommend, as always, that you read more about the concepts of dynamic ownership equity and some the importance of metrics via online search.

The Importance Of The Team

Some famous venture capitalists have estimated that 65% of new startup businesses fail because of team dynamics and team-related issues.  This really highlights how important it is that the team be functional and that the team members be able to perform on an individual basis as well. In our experience this is one of the most challenging portions of the startups:  how do we decide if the team is right and if the team is adequate to make the business go?

 

We use several techniques to try to determine if the team is ok before investing, or before starting up the new venture as an initial member of the startup team.  First, simply, there needs to be a team.  Sometimes we have excellent, star performers come to us with fantastic business ideas which seem a sure-fire win.  However, there needs to be a team presented as part of the business idea.  As we have said before a great business idea is only a portion of the battle when it comes to making a great business model. We often ask, at the first meeting, about who the team members are and their backgrounds.  Let me share with you that there is evidence that a team size of approximately 3-4 is statistically significantly associated with improved outcomes for the business model.  And this is per an online Stanford business course that was given on coursera.org. (That same course, Technology Entrepreneurship by Chuck Eesley, is also on novoed.com.) This course is available to everyone and is given on an intermittent basis.

 

Whether you agree that the ideal team size is 3-4, there are some important considerations beyond simply team size.  The team members need to have some background in the idea they are describing.  Industry experience and an extensive set of network contacts adds to and enhances the legitimacy of the business idea.

 

 

Venture capitalists have estimated that it takes approximately 6-7 million dollars in capital expenditure to train a VC capitalist. That has been an interesting statistic to me, whether you feel it is overly broad or not.  It is interesting to me that one way to measure venture capitalist learning and growth is in the total amount of the deals they have performed as evidenced by the amount of capital they’ve run through in getting there.

 

In our experience as Angel investors, we have learned a great deal from trial and error despite trying to do all the book learning, background work, and other issues.  I can’t say strongly enough that we have learned a lot, as expected, by actually doing the work.  One of the lessons learned has been just how easy it is to miscalibrate the team.  We have had several incidences now of startups in which we have participated where we were very confident that the team performance, background, and structure was adequate and we found out later that we were quite incorrect.  We take these experiences as paying-for-education-type experiences.  We take the lessons learned from these and try to not make the same mistakes in the future. However, that said, there are other important topics such as alignment.

 

We will discuss alignment in a separate blog entry.  Here, let me tell you that alignment issues occur when the startup teams interests are no longer completely aligned.  These may emerge as the business grows and different people expect different things from the business.  These may arise from a non-recognition of one startup team member by another startup team member.  Alignment issues are very common and there are multiple techniques to keep the team in alignment as it moves forward together. In our experience, despite adequate ideas and margins, the most common reason for failure of a business model is in fact team dynamics.

 

Please, recognize that I don’t mean that a business is doing poorly or failing and then team alignment becomes an issue. Rather team alignment issues and team performance issues come first and then the businesses do poorly afterwards.  The team dynamic issues I am describing here are usually seen before issues with the business and are seen in that first 4-5 months necessary to get a sense for whether the business model works.  I cant say strongly enough that our experience substantiates that at least 65% of business ideas and innovative business model canvass do not work because of team dynamics.  In our experience it is probably more like 75% that the causal reason is probably the team rather than the idea, regulatory issues, or other significant issues.  Check in on later blog entries where we will discuss different issues such as team alignment and ways to keep the startup team aligned in healthcare and beyond.