It was a busy weekend, so I didn’t get to watch Shark Tank until this evening. So here is the breakdown of Season 4 week 3:
LIZ LOVELY COOKIES
The first company makes gluten-free, diary-free gourmet cookies. There was some dispute among the sharks about if they tasted good or not. The company did $1M in sales last year, 90% from wholesale, and had a 10% profit margin. They wanted to get to $10M in sales and then get bought by a big food company. They were seeking $200k for 10% of the company (a $1.8M pre money valuation).
All the sharks but Cuban quickly passed. Cuban has interest in a gluten free diet, and claimed that he liked the company, but his only concern was valuation. Price is always a consideration in investing, but particularly so if the entrepreneurs have shown an interest in an early exit. Since an early exit caps the upside potential, getting in at the right, low valuation is necessary to be able to make a high multiple on your investment. Many VCs won’t even consider an investment in a company where the founders are expressly looking to exit early. They want to see an opportunity for 10x or even 100x returns. Individual investors often don’t have the same return targets, so may be more willing to settle for a smaller exit if the deal is priced right.
Cuban asked the company to make him an offer and he would take it or leave it. This was smart of him, and predatory. He knew that he was the company’s only option, and he made them negotiate against themselves to see what was the worst deal that they were willing to take. The posturing that he would take the deal or leave it was his way of ensuring that there was real pressure to put their best terms on the table.
The company came back and offered him 20% of the company for the $200k (an $800k pre money valuation). He passed. Later he said that he wanted 33% for the $200k (ie a $400k pre money valuation). This would never happen in real life. In a normal setting, given that the two parties were in a range where a deal might have been found, they would have gone back and forth a couple of times before settling on a deal. But Cuban knew that if he didn’t show that his threat to take the deal or walk was real, he would never get real price discovery if he made a similar offer in the future. He passed on a deal he could have gotten done in favor of establishing more pricing power in the future
Rockbands sells hand carved rocks with “healing properties” attached to a leather wrist band. The Rock Bands retail for $99-150, wholesale for $50 and have a $12 CoGS. The company has sold $300k worth of rock bands over the last five and a half years, including some to celebrities and famous politicians. The sales history is anemic, but perhaps the biggest asset that the company has is a trademark for Rockbands in the apparel field. The entrepreneur was seeking $100k for 20% of the company
Kevin and Barbara offered to buy the company outright for $100k, and to pay a 7% royalty into perpetuity on all sales. They planned to license the brand heavily, and to sue Activision for the use of the mark in apparel related to the Rock Band game, as well as others who had infringed. Barbara noted that the entrepreneur had been unlucky, and that luck doesn’t change, which is why he should sell the company to them.
Daymond and Mark countered with $100k for 40%. They said that the company’s challenge is fulfilment and back office – and they’ve helped other investments with the same issues in the past. They promised that the company would also pursue licensing. The entrepreneur took this offer.
Although the economics of the offer that the entrepreneur took are undoubtedly better than Kevin and Barbara’s offer in a success case, I suspect that he may have been better off taking the other offer. Barbara is right that luck doesn’t often change. That is because you make your own luck, and if over 5.5 years the entrepreneur hadn’t been able to make something positive happen, even with the celebrity support, then it is probably a problem with execution and judgement. Even with another $100k, I’m not optimistic that with the same guy in charge, things will go dramatically differently.
On the other hand, a 7% royalty means that Kevin and Barbara got to keep 93% of future revenues. That has them incented to pursue licensing and litigation seriously, and these are two areas where they are likely to execute better than the entrepreneur. He might have been better off letting them work for him, instead of him working for Mark and Daymond.
Fuzzi Bunz makes reusable diapers. A baby generates 1 ton of disposable diapers before being potty trained, and these take 400 yrs to decompose and together constitute the 3rd largest source of landfill. Fuzzi Bunz addresses this environmental problem, as well as having benefits for reduced diaper rash.
The company was founded 12 years ago and had done $24M in sales to date. Last year it did $3.9M in sales but made only $20k in profit, despite not having any advertising costs. The entrepreneur claimed that her patent was weak and as a result competitors had copied her product and were collectively doing $30-40M in sales. She was suing some of those infringing her patent but had not had success to date. She was seeking $500k for 15% of the company.
All the sharks passed. Cuban passed because he noted that despite the entrepreneur being the innovator and first to market, she had been unable to outcompete the followers.
Barbara questioned her judgement. The entrepreneur replied, “Barbara – if you invest in me I’ll do whatever you tell me to do.” That set alarm bells ringing in my head. The entrepreneur lacked vision and commitment and was looking to be told what to do. No wonder she had been out competed.
Robert said- “You seem to be looking for a lifeline. When a stone starts rolling down a hill its very difficult to stop”. He is right. There is a lot of momentum in startups. When they work, they work fast. When the momentum is lost, or worse, turns negative, it is very difficult to turn around. It is always possible, but as an investor, there are usually better opportunities to put your money to work, where momentum is on your side.
The entrepreneur has real tenacity. As she said, she is not a quitter. But sometimes, not being a quitter is not enough.
The last company makes a device that attaches your biceps to each other with an elastic strap behind the back to pull the shoulders back and improve posture. The company has sold $330k of product over the last two years, all online, mostly to ballroom dancers, where the product has developed a niche following. The company has been run as a hobby by the two founders, yet has made around $130k in profit, due in large part to very high gross margins. The product retails for $39.95, wholesales for $19.95, and costs just $5 to make. The founders were seeking $100k for 15% of the company, implying a $567k valuation.
Kevin offered $100k for 50% and asked for an additional 10% royalty. The entrepreneur said no right away, said that it was too much equity, and replied, “I’m not begging for anything, I’m offering something”. This was characterized by the show’s producers as arrogance, and Daymond agreed. That’s crap. An entrepreneur has every right to turn down an offer, especially one that was as egregious as Kevin’s. He valued a company making around $70k per year in profit at less than $100k, and that really is ridiculous. And the broader point is true. An investment is a partnership, and a mutually agreeable deal between an investor and an entrepreneur. Trying to characterize it as a gift from the investor is really ridiculous, and a set up for an unhealthy relationship between the two parties.
Barbara passed on market size. She thinks that the appeal for the product is limited, and I think that she is right.
Robert offered $100k for 40%. The entrepreneurs asked if there were any other offers. Robert took offense and pulled his offer. He said that he didn’t like getting worked. While the entrepreneurs could have handled the situation a bit more gracefully, rather than calling for last bids like an auctioneer, they were well within their rights to understand all their options.
Cuban was the last shark in the deal, as he often is. He asked for 30% equity plus a $5 royalty until he got his capital back, and for the founder to quit his job to work on Posture Now full time. The entrepreneurs took the deal. Cuban positioned the royalty as a way of protecting himself in case the product was a fad that didn’t have ongoing entreprise value, which is a reasonable perspective. But his structuring was also advantageous because he got to get his capital back first, while still sharing 30% of the upside. These are typically called “participating preferred” structures, and are quite uncommon in West Coast VC deals these days, although they were once more common a couple of decades ago, and are still seen in some East Coast deals.
In most investments, the investor gets straight preferred stock. That means that in a sale they can either chose to get their money back, or to get a proportion of the sales proceeds equivalent to their ownerships stake. If the company is sold for more than the post money value of their investment, they would prefer to convert to common stock and get the proportion of the sales proceeds equivalent to their ownership stake as this is worth more than their investment. But if the company is sold for less than their post money valuation, they would prefer to get their money back. This structure protects the investor in that they always get their money back first, since theirs is the money that is gone into the company.
Participating preferred is sometimes called a “double dip” structure because the investor gets back both their investment AND the proportion of the sales proceeds equivalent to their ownership stake. This is obviously pretty investor friendly. It can get used to protect an investor from a small quick exit as it juices returns the most in small exits, and has little impact on large exits. If a company is having trouble raising money because investors are worried about a small quick exit, but entrepreneurs want a higher valuation, this can help bridge the gap.
As always, 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 week four’s breakdown now up.