The underlying theme of the Shark Tank TV series is for either the Sharks (the investors) or the entrepreneurs (pitching their business) to convince the other side to accept the valuation of their business and negotiate a deal based on it. The entrepreneurs tend to come in with high valuations, and the Sharks counter with lower valuations.
How entrepreneurs and the Sharks value businesses presented on the show varies, but a good valuation of a company takes into account certain factors such as revenue, earnings, and the value of companies within the same sector.
- The Sharks on Shark Tank typically require a stake in the business—or a percentage of ownership—as well as a share of the profits.
- A revenue valuation, which considers the prior year's sales and revenue and any sales in the pipeline, is often determined.
- The Sharks use a company's profit compared to the company's valuation from revenue to come up with an earnings multiple.
Understanding How a Business Is Valued on 'Shark Tank'
Shark Tank is a popular show on which investors (or Sharks) hear pitches from business owners who want funding from them. In exchange for their money, the Sharks typically require a stake in the business, which is a percentage of ownership and a share of the profits. In return for giving up a stake in the company, the entrepreneur gets funding, but often, more importantly, they get access to the Sharks, their network of contacts, their suppliers, and their experience.
Determining the amount to invest in the company and the percentage of ownership that each is willing to consider comes down to forecasting revenue, earnings, and applying a valuation to the company.
Typically, an entrepreneur will ask for an amount in exchange for a percentage of ownership. For example, an entrepreneur might ask for $100,000 from the Sharks in exchange for 10% ownership in the company. From there, the Sharks begin to determine whether it's properly valued.
The Sharks will usually confirm that the entrepreneur is valuing the company at $1 million in sales. The Sharks would arrive at that total because if 10% ownership equals $100,000, it means that one-tenth of the company equals $100,000, and therefore, ten-tenths (or 100%) of the company equals $1 million.
If the company is valued at $1 million in sales, the Sharks would ask what the annual sales were for the prior year. If the response is $250,000, it will take four years for the company to reach $1 million in sales. If the response was $75,000 in sales, the Sharks would likely question the owner's valuation of $1 million. However, if last year's sales were $250,000, but the entrepreneur recently entered into a sales agreement with Walmart to sell $600,000 worth of product, the valuation would be more attractive to the Sharks based on the sales forecast. In other words, the valuation doesn't only consider the prior year's sales and revenue but also what the company has in its sales pipeline.
The companies on Shark Tank are not publicly traded, meaning they don't have equity shares or published earnings multiples for investors to consider. However, the Sharks can still use the company's profit as compared to the company's valuation from sales revenue to come up with an earnings multiple.
For example, if the company is valued at $1 million and the owner earns $100,000 in profit, the company would have an earnings multiple of 10 or ($1 million / $100,000). However, we have no idea whether an earnings multiple of 10 is good for the company or not.
This is where comparative analysis comes into play. Let's say in our earlier example that the company is a clothing retailer. The Sharks can compare the multiple to those of other companies within the same industry.
For example, let's say the entrepreneur is pitching a clothing brand with $1 million in annual sales with $100,000 in profits. The entrepreneur could apply the metrics of the specialty retail apparel sector by using the sector's earnings multiples. Let's say the sector has an average earnings multiple of 12.
At 12x earnings, this would value the business at $1.2 million or (12 x $100,000). Based on this valuation, the entrepreneur can justify the deal for a 10% stake in the business for a $100,000 investment from the sharks.
Future Market Valuation
A future valuation could also be calculated in the same way the revenue and earnings multiples are. The only drawback is that the numbers are forecasts and can be inaccurate. The Sharks would likely ask what the entrepreneur is forecasting for sales and profits in the next three years. They would then compare those numbers to those of other companies in the retail clothing industry.
The entrepreneur might forecast that earnings in the next three years would lead to $400,000 in net income in year three. If the retail industry typically has a 14.75x forward earnings multiple, the future valuation would be $5.9 million in sales or (14.75 x $400,000).
The Sharks ultimately want to get their investment back and earn a profit. If the Sharks agree that the company could possibly generate $5.9 million in business by year three, a 10% stake for $100,000 might be attractive. However, it's possible that the business might not generate $400,000 in profit by year three. As a result, the sharks would likely demand a higher ownership percentage, counteroffer with a lower loan amount, or propose some combination of both.
The Intangibles of Valuation
If the Sharks valued a company solely based on figures, then the show would be without drama or excitement. But the intangibles of valuation on Shark Tank is one of the reasons it is so popular. Much like other seasoned investors, the Sharks consider the whole package—numbers, story, and experience—in their valuation of companies, though the numbers are often the most significant part of this exercise.
But other intangibles are also important. For example, the story—both, personal and product related—can help sway their valuation decision. If an entrepreneur has a compelling story of hard work and determination, then the Sharks might agree to his or her valuation. without much debate.
The Sharks also ask a series of questions about the company. For example, they might ask what it costs to manufacture the company's product and its selling price. This will help them calculate product margin. They will inquire about other costs, such as marketing, and also ask for the previous year's sales and future sales pipelines to ascertain demand for the product. Increasing demand and sales is always a good sign. But if sales declined, remained stagnant, or increased by only a slight amount, then the Sharks will ask for the reason they did. If the reason is unconvincing, then the Sharks will opt out.
Special Considerations—Risks to Valuation
The Sharks might say they can't apply the same valuation to the entrepreneur's company based on valuation metrics from publicly traded companies. There are several distinctions between a small business and a public corporation.
A large, established retailer might have thousands of stores worldwide, but a small business may only have a few locations. Though the growth rate is justifiably higher for the small business, the risk is much larger due to the risk of failure and liquidity risk in terms of an exit strategy. Liquidity is a measure of how easily an investment can be bought or sold. If there are many buyers and sellers vying for an investment, there is ample liquidity. If there are few buyers and sellers, there's illiquidity.
The lack of liquidity creates more risk for the Sharks to bear, which entails applying risk-adjusted discounting to make the reward worth the risk. As a result, the Sharks have much more wiggle room to base their offers on a risk-adjusted discounted valuation.
The Sharks could counteroffer with a higher stake in the company, say 30% ownership for a $100,000 loan. Even if the valuation metrics (based on revenue and earnings) indicate that the Sharks should have a lower stake, the risk of loss from investing in an unknown company usually adds to the Shark's ownership stake.
The Sharks could also increase their ownership stake based on the intangibles they bring to the table. Those intangibles might include their experience, access to retail outlets for selling products, or supply chains.