Last week I gave a Silicon Valley VC’s take on the company pitches on Shark Tank as the new season four started, and it was well received. Here are my thoughts on the companies that were featured in the second episode of season four:
Surfset Fitness has built an exercise machine to simulate surfing and wants to use these to set up exercise classes across the US. The entrepreneurs made $150k in revenue running classes for four months at a gym in New York, selling out the classes at $35/class. They plan to franchise the model (presumably including selling equipment plus a certification program). The company sought $150k for 10% of the company, implying a $1.5M post money valuation.
The company received three offers from the sharks. Mark Cuban offered $300k for 33% of the company, implying a $900k post money valuation. Robert offered $150k for 20% of the company, implying a $750k post money valuation, or as Cuban characterized it “less money at a lower valuation”. Daymond offered $150k for 25% of the company, plus “manufacturing support” (whatever that means!), implying a $600k post money valuation.
The company ended up negotiating with Cuban and settled on $300k for 30% of the company, or a $1M post money valuation.
I want to examine the question of valuation, as the focus on post money valuation is quite misleading. The right number to focus on is pre money valuation, as that is how an investor is valuing the company before the investment.
Post money valuation = Pre money valuation + Investment.
This makes intuitive sense. The money invested is worth what it is worth, so after the investment, the company should be worth it’s intrinsic worth (pre money valuation) plus the money. Ownership is always calculated on post money value. So the percent that a new investor owns is calculated by dividing the investment amount by the post money valuation.
Under this lens then, lets look at the pre money values of each of the “bids” and “asks”:
- The company sought $150k for 10% of the company, implying a $1.5M post money valuation and a $1.35M pre money valuation.
- Mark Cuban offered $300k for 33% of the company, implying a $900k post money valuation and a $600k pre money valuation.
- Robert offered $150k for 20% of the company, implying a $750k post money valuation, but also a $600k pre money valuation.
- Daymond offered $150k for 25% of the company, implying a $600k post money valuation and a $450k post money valuation.
- The deal settled at $300k for 30% of the company, implying a $1M post money valuation and a $700k pre money valuation.
One thing that immediately becomes apparent is that Robert’s deal is not “less money at a lower valuation” as Cuban claimed, but rather less money at the same valuation as Cuban’s offer. It also means less dilution, something that entrepreneurs should be very mindful of. They want to create wealth for themselves, as well as their investors and employees, and that requires them still having a meaningful ownership stake at exit. The entrepreneurs believed that they could build the business faster with more capital, so it’s not an unreasonable thing to give up more dilution for more money at the same valuation. But if they thought that they only needed the $150k that they asked for, they would have been better off taking Robert’s offer (or asking Cuban to match it).
Alpha M is a personal image consulting business trying to turn a consulting service into a product. The entrepreneur was doing $50k in quarterly revenue by individually helping men dress better and thereby become more confident. He wanted to productize his approach via a 6 DVD set, selling for $297, that gives men advice about what clothes they should buy and what to wear with what. His dismal sales (75 units last month) is a reflection of how hard it is to sell content. At heart, the product could be just as effectively delivered as free content on a website. There is plenty of similar content available free on the web.
All the sharks passed, and rightfully so. It is hard-to-impossible to build a scale business on selling “evergreen” content these days.
eCreamery is a gourmet icrecream shop in Omaha, trying to expand online by creating the category of “online icecream gifting”. The company hand-makes each batch of personally configured icecream, puts custom labels on each batch and mails them to the recipient. Average pricing is $55 for 4 pints, + $25 for shipping and handling, resulting in a total price of $80.
The sharks asked all the right questions to assess an ecommerce business, drilling down on customer acquisition cost versus lifetime value (focusing on repeat purchase rate, average price and gross margin), focus (should the company shut down it’s retail operations and focus on online), price point and competitive set (is this competing with local icecream or online florists).
The feedback from the sharks was generally pretty positive. Despite this, all the sharks passed. Kevin was willing to make half the investment if one of the others was willing to join him, but none of them were, so he also passed. The putative reasons for the pass were all pretty amorphous; “too much complexity”, “no competition yet”, “don’t like investing in companies with other investors” etc. I imagine the entrepreneurs were pretty confused about how to reconcile the positive feedback with the no-bids. The reasons were all either vague, or issues that seemed tangential but that the company could do nothing to address. This is not an uncommon situation, when an investor likes some of what they are seeing but not enough to be ready to make an investment right away. They don’t want to commit today, but want to keep the door open for the future.
Cate is a smartphone app that intercepts calls and texts from “blacklisted” numbers so that they don’t show up in text and call history. It is marketed as an app for cheaters to help them hide their cheating from their partners. The entrepreneur is a real hustler. He didn’t invent the app, he found it, bought it from the inventor, and now is trying to raise money at a significant uptick to grow the business. All in, he had invested $40k into the app, between buying it for $17.5k and spending additional money on development and marketing since then. He was seeking $50k for 5% of the company ($950k pre money), but signalled immediately that he was open to offers.
I think branding the app as a “cheaters app” is a real mistake. How would a customer explain to their partner why they have the app on their phone? If the only reason you’d have the app is to hide cheating, it defeats the purpose of hiding cheating. Some of the sharks suggested other use cases in the finance or law enforcement communities where privacy and security is important. This makes some sense (although now your’e talking about enterprise sales instead of consumer marketing) but perhaps most important is to think about a broader “privacy” branding to avoid the “guilt by existence of the cheater app” problem. For the same reason, Google’s Chrome browser positions its “incognito mode” as for privacy and security, whereas the most common reason that people might want their web browsing to remain secret is to hide their visits to porn sites. Incognito mode is the Google Chrome’s equivalent of the Cate app.
Some of the sharks passed because they did not want to be associated with a “cheaters app”. But Kevin had no problem with it and countered with $50k for 50% of the company ($50k pre money). Barbara offered $50k for 30% ($117k pre money) adding the proviso that the app boraden its focus to privacy and away from just cheating. To all this the entrepreneur countered with $50k for 15% ($283k pre), again indicating an openness to counter offers. Kevin (now joined by Daymond) countered with $50k for 35% ($93k pre money) and made it clear that this offer was final. Barbara offered $50k for 25% ($150k pre). The entrepreneur said to Kevinand Daymond that if they would do $75k for 35%($164k pre) they had a deal right now. The Sharks countered with $60k for 35% ($121k pre money) and the deal got done at $70k for 35% ($150k).
The entrepreneur played a dangerous game by anchoring so high on valuation ($950k), and sticking high when it was clear that the sharks wanted something far lower (starting at $50k). But when he saw that he had two bidders, he definitely played them off of each other well to maximize his valuation. He did a nice job of switching the basis of negotiation to amount raised ($50k to $75k) after having done all that he could on the first dimension (the 35% dilution), and on keeping the process fast to keep the “deal heat” high and the competitive juices running. In the end he improved his position by 3x from where he started by running a good auction process. His basis is around $40k, his first offer was $50k pre money and he got them up to $150k. The entrepreneur clearly has a knack for running a competitive fundraising or sale process, but many entrepreneurs do not find this natural. Getting this right can be the difference between a so-so valuation and a good one. Getting the right advice from lawyers, advisors and bankers can help a lot.
As with the first post, I’m trying to draw one or two lessons that apply more broadly to startups from each company pitch. I’d love your thoughts and comments. And see my review of week 3.