If you’re a fan of Shark Tank, you may have wondered why the sharks are so interested in what percentage of the business they can acquire for their money – and why it’s different from the percentage the business owners are offering. It all comes down to how the shark will get their money back.
While business owners/entrepreneurs can borrow money from banks, friends, or relatives, these days they can also go on “Shark Tank” (or “Dragons’ Den,” as it’s known in, for example, Canada where I live) and get money there. If you’re a fan of the show — and I am — you may have wondered why the sharks (or dragons) are constantly negotiating with the business owners about what percentage of the business the shark/dragon will take in return for the money involved.
Surprisingly, it’s not simple greed that drives Kevin O’Leary’s negotiations with the entrepreneurs. However, understanding what is driving the negotiation does require some understanding of what investors like Kevin O’Leary are trying to accomplish. Not surprisingly, understanding investors (like the ones on “Shark Tank”) is a key topic in Learning Tree’s Learning Tree’s Finance for Non-financial Managers course.
When a bank lends money to an entrepreneur, that money must be paid back, even if the business fails (friends and family may, of course, be more forgiving). Investors like the sharks/dragons, on the other hand, are owners and, if a business fails, owners lose their investment. It’s that difference between a lender and an owner that explains why, on the show, the negotiation for the percentage of ownership is so important.
Unlike the entrepreneurs, though, investors like the dragons/sharks don’t want to be long-term owners (to quote one Shark, Barbara Corcoran, “I don’t want to be the entrepreneur here. I’m an investor”). The goal of the sharks/dragons is to invest their money…and then get it back so that they can, in turn, invest that money in some other enterprise.
Investors have two ways to get their money back. First, of course, they can take a share of the business’ profits every year. Alternatively, dragons/sharks can sell their ownership of the business to a new owner (or to other owners in the business). Selling their share to new owners also includes selling shares in the business because shareholders are, effectively, part owners of the business. However they do it, though, how much money the investors will get from selling the business (or from the business’ profits) is dependent on how much of the business the shark/dragon owns.
But the investors aren’t interested in just getting their money back – they also want to make a profit from their investment. If you assume (as the sharks/dragons do) that they can earn 15% by putting their money into any number of “safe” investments, the investors want to make at least 15% on their investment. In addition, investments in new business often don’t pay off – many businesses fail or don’t achieve their goals. To compensate for those losses, investors like the sharks/dragons are looking for returns in the range of 30% or better.
And that’s a 30% return a year. When dragons/sharks invests $100,000 in a business then they are expecting to get $130,000 out of the investment at the end of the first year: their $100,000 investment plus a 30%/$30,000 profit. If the dragons/sharks don’t get that $30,000 profit at the end of the first year, they consider that missing $30,000 a further investment in the business. So, in the second year, the dragon/shark expects to get a 30% return on that $30,000, also. At the end of the second year, therefore, investors like the sharks/dragons expect to get their $100,000 plus $30,000 from the first years plus $30,000 from the second year plus $10,000 from the $30,000 they didn’t get in the first year — $170,000, altogether. And, with every year that the dragons/shark leave their money in the business, that expected profit keeps increasing. Not surprisingly, therefore, the kind of investors represented by the sharks/dragons are expecting to get their money back in two to three years (at the most).
Now consider an entrepreneur who comes in and thinks their business is worth $400,000 and is asking a dragon/shark to invest $100,000, for a 25% share of the business. But if, after a year, the business is sold for $200,000 then that 25% share of the sale gives the dragon/shark only $50,000 – not even close to the $100,000 investment, let alone the $130,000 the shark/dragon wants.
But the shark/dragon doesn’t have to accept the entrepreneur’s valuation. If the shark/dragon recognizes the real “sale value” of the business is $200,000 then, in order to get their $130,000 back from that business, the dragon/shark would will want to take a 65% share of the business. Complicating the process, the dragons/sharks are actually attempting to calculate the value of the business when they sell their share of the business in two or three years. If the dragon/shark asks for 65% on a $100,000 investment then they think this business will be worth $200,000 within a year — if they thought the business wouldn’t be worth $200,000 until two years had passed, they’d ask for a larger percentage.
While getting their money out with a profit is a primary interest for the sharks/dragons, other factors do control what percentage of the business that the shark/dragon wants. Sometimes the shark/dragon will want a 50% share of the business because that larger share gives them more control over how the business is run and its strategic direction (Kevin O’Leary once commented that a 5% share of a business was so small that it turned him into “Uncle Kevin who never gets his calls returned”).
Dragons/sharks may also try to negotiate a deal where they take a royalty on products sold so that they can get their money back in some period of time. Effectively the shark/dragon is giving the business a loan with a relatively small interest rate (the royalties are often in the 3% to 5% range). While the payback period isn’t fixed, the shark/dragon is typically trying to set the royalty high enough that they will have their money back in a couple of years. That doesn’t make the loan a good deal, though: From the entrepreneur’s point of view, even after this “loan” is paid off, the shark/dragon still owns a share of the business and is entitled to part of the business ’ profits or the value of the business if it’s sold. The entrepreneurs have to factor that loss of profits into the cost of the “loan.” The good news here is that the dragon/shark will want a smaller share of the business because, having already got their investment back, all they want from the sale is their profit.
Normally, however, if a deal is made it’s a case of “cash for a percentage of the business.” Not surprisingly, then, one of the main sources of conflict in the show is around the valuation of the business (though that may not always be obvious when you’re watching the show). The entrepreneurs know how much money they want and will set a high valuation for their business in order to give up as little of their business to get that amount; the dragons/sharks will assume a lower valuation to ensure that they can get their money back and make a profit.
The next time you watch the show, when you see the sharks/dragons asking for a larger percentage of the business, you’ll know that what you’re seeing is that difference in valuation playing out.