Every week, my DVR records the latest episode of Shark Tank. And every week, when I’m done watching it, I wonder why I continue to do so. The show is not without its merits — it’s compelling television. However, aspiring entrepreneurs whose views on business are formed largely through “Shark Tank University” are going to be ill-prepared to succeed. Tempted as I am to clickbait you with “The Five Things Shark Tank Gets Wrong,” I’m going to focus on one thing at a time. In this article, we’re going to take a look at what is likely the most contentious subject on every episode: valuation.
The Valuation Calculation is Wrong
Valuation, or the financial value ascribed to a business, is frequently a point in which the investors on Shark Tank push back against the entrepreneurs or even disagree among themselves. In that respect, the show mirrors the real world, i.e. different people will disagree as to how much a particular business is worth. We can talk about market dynamics and how rounds are actually priced in another article. The key point here relates to the specifics of the valuation calculation based on the data that is presented to the audience. On every episode, we are introduced to new entrepreneurs and each comes with a specific dollar figure to raise and the percentage ownership an investor will receive in return.
Those two numbers are sufficient to derive the valuation of the business, but the formula that is used on the show is wrong. While I believe that the “Sharks” know this, I suspect that the producers ask them to fudge the numbers to make it easier for the audience to follow along from home. It’s a shame because the show could easily add some graphics that walk through the calculation. But alas, the show is more entertainment than education.
Let’s take a look at how they calculate valuation on the show and then compare that with what entrepreneurs and investors do when they’re not on television.
Bob’s Road Trip Diapers launched 8 months ago and Bob has moved $50,000 worth of product in that time. Bob is bearish on gas station bathrooms and thinks that this business can own a (particularly off-putting) segment of the long-distance driver market so he’s asking for $100,000 for 33.3% of the company.
Mr. Wonderful cocks his head to the side and says, “So the imputed valuation for your poopy product is $300,000. You’re out of your mind! There’s no way this business is worth more than $200,000 right now.”
If you’ve never raised capital or been an investor before, Mr. Wonderful’s math makes sense:
$100,000/33.3% = $300,000
It might make sense, but it’s wrong. It’s wrong because it doesn’t actually reflect the value of the cash that was injected into the business. If you have a business that is worth $0 and someone invests $100,000 — forget the percentage ownership for a moment — what is the new value of the business? Well, you started with $0 and added $100,000, which looks like this: $0 + $100,000 = $100,000. This is an extreme example because all of the value of the business comes from the new investment. However, it should be clear that it’s folly to dismiss the impact of new money in the calculation.
So let’s revisit the fake Shark Tank scenario from before. Mr. Wonderful is contemplating an investment of $100,000 so he can come away owning 33.3% of the business. What’s the actual valuation of the business as it’s being pitched?
At this point, some percentage of you who are reading this have one question: “Huh?” Don’t worry, the math is still pretty straightforward. But before we get to the math, it’s a good time to get clear on terminology because the valuation issue on Shark Tank results in part from ambiguity around the words they use.
When discussing valuation, there are actually two numbers — and terms — that are used: pre-money valuation and post-money valuation. (To get you more comfortable with startup slang, I’ll drop the word “valuation” below.)
- Pre-money: this is the agreed-upon value of the business prior to taking a new round of investment. (Check out https://en.wikipedia.org/wiki/Pre-money_valuation for more details.)
- Post-money: this is the valuation of the business after the latest round of investment. The value is calculated like this: pre-money valuation + investment = post-money valuation. (Check out https://en.wikipedia.org/wiki/Post-money_valuation for more details.)
Fixing the Formula
On Shark Tank, the word “valuation” is regularly used in place of “post-money valuation.” In the real world, when investors and entrepreneurs discuss valuation, “pre-money” is what’s being discussed the vast majority of the time. Got it? Now we can get back to the math. When Bob walked into the tank, what value did he assign his business? He indicated that he wanted to raise $100,000 and give up 33.3% of the ownership in return.
Here’s our formula:
investor percentage ownership = investment / (pre-money valuation + investment)
Now let’s plug in the numbers:
33.3% = $100,000/(pre-money valuation + $100,000)
If we solve for pre-money valuation, we arrive at a number that is different than Mr. Wonderful’s: $200,000. Now let’s look back at fake Kevin O’Leary’s objection, which while fictional is actually consistent with his actual approach: “So the imputed valuation for your poopy product is $300,000. You’re out of your mind! There’s no way this business is worth more than $200,000 right now.”
What none of the Bobs who are on the show do is say, “I am in total agreement with you on the question of valuation. $300,000 would represent a 50% premium on top of the valuation I’ve assigned the business. So this will be an easy negotiation. I’ll take the $100,000 at a $200,000 pre-money valuation and give you 33.3% in return.”
There have been a few episodes of Shark Tank where entrepreneurs have referenced “pre-money valuation,” but to the extent that there was additional commentary, it seems to have ended up on the cutting room floor. I can only imagine what would happen to an entrepreneur who wanted to negotiate liquidation preferences! While I remain a regular viewer of the show, I’m disappointed that the Shark Tank platform isn’t used to demystify entrepreneurship more proactively. Oddly enough, HBO’s Silicon Valley, a work of fiction, rings true in many ways that “reality TV” doesn’t.