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.