Time for a breakdown of week 5 of season 4 of Shark Tank! I’ve been getting good feedback from people who enjoy getting an insight into how a VC thinks about an investment opportunity, and being able to actually see the pitch that generated the response.
The first company makes girls clothes, primarily pillow case dresses and hair bows, but also jackets, jeggings, tutus and other items, and sells them online. Pillow case dresses use ribbons around the neckline and as shoulder straps so that the dress can be expanded as kids grow. It costs Cozy Bug about $6 to make a dress (which will presumably go down with scale). Although the entrepreneur doesn’t mention price on the show, the Cozy Bug website shows the dresses selling for around $20. The entrepreneur is seeking not just money, but primarily contacts with buyers at big retailers to get wider distribution. She sold $300k of product in the last 30 days, primarily through Zulily.
Three sharks make an offer.
Kevin offered $50k. Instead of taking equity, he asked for a $2 per dress royalty until he recovered his capital, then $1 per dress thereafter. But the caveat is that the company can’t make anything but pillowcase dresses and hairbows.
Lori and Daymond both offer $50k for 30%. They argue over who can help Cozy Bug with distribution more. I think Daymond has the advantage given that he is in the apparel business and sold more than $3bn worth of merchandise last year, including $1bn of kids clothes. But Lori offers QVC.
Lori looks desperate, and pulls out her check book. She says that she is ready to write a check right now – with no additional diligence. When the entrepreneur wavers, Lori says, “If you’re not sure, I”ll pull my offer.”
The entrepreneur takes Daymonds deal and explains that she didn’t like Lori’s hardball approach.
This was a pretty dynamic situation. How should the entrepreneur think about Kevin’s royalty offer against Lori and Daymond’s equity offer? They seem quite different. Kevin’s offer seems to be pretty attractive given that there is no equity dilution. But it’s worth digging a bit deeper. Growth for Cozy Bug will come through wholesale distribtion. A typical retail markup is 50-70% over wholesale. So if the dresses retail at $20, they will wholesale at $6-10. Assume that at scale the company can cut manufacturing costs in half, from $6 to $3. That leaves a profit margin of between $3-7 (= $6-10 in wholesale price less $3 of costs) before any overhead. If she gets her overhead to $1/dress at scale, that leaves perhaps $2-6 in profit at scale. So a $1 per dress payment to kevin would represent somewhere between 16-50% of the profits. This is within the range of the 30% equity stake, worse when the company is smaller, but better if the company grows and gets more scale economies. The other tradeoff is that Kevin’s deal comes with a contraint on what products the company can sell, only pillow case dresses and hair bows. But this constraint is at odds with the founders vision. Given this context, plus Kevin being less likely to help on the distribution front, the equity offers are superior.
The entrepreneur made the right decision. I think Daymond is the best investor for the company. His experience and contacts are directly relevant to solving the core problem that Cozy Bug faces, getting retail distribution. I think that Lori knew that too, and that was why she acted so desperately to win the deal, first by offering to do the deal on the spot, without further diligence, then by threatening to pull her deal if it wasn’t accepted immediately.
All that being said, I think the Sharks all made a mistake to back Cozy Bug. Pillowcase dresses are not unique to Cozy Bug, they are all over Etsy for example. The $300k in sales on Zulily probably speaks more to the power of Zulily than the intrinsic attraction of Cozy Bugs pillow case dresses. Rumor has it that Zulily is raising capital at a valuation in the $1bn range right now. If they can move $300k of a commodity product from an unknown brand in one “on sale”, I can see why.
The next entrepreneur built a proprietary energy blend that had the equivalent effect of 3 cups of coffee, and baked it into a waffle. The product is designed to be eaten warm, but was sold in convenience stores, so was typically eaten cold. As a result, it tasted pretty dry. He had sold about $1k worth of product in the first 30 days of sales. He was seeking $75k for 25% of the company.
All the sharks passed, and rightfully so. Wired Waffles wasn’t a company (since it had no go-to-market), or even a product (since it tasted bad), but really just an idea. The entrepreneur was very wishy-washy, and didn’t defend himself well when holes were poked in his business plan. This is uninvestable in its current form.
The third company sells a tiny spatula that fit inside the small openings of bottles and tubes to scrape products out of ill designed makeup, facecream, shampoo, conditioner and other similar product containers. Consumer Reports says that 17% of such products are thrown away because consumers can’t get them out of the bottle.
The entrepreneur was engaging, ambitious and hard working, but completely unexperienced. She had made some prototypes and sold 15 of them on Ebay for prices between $2.99-$3.99. She was seeking $50k for 40% of the company. She planned to sell them on QVC, as wel as via direct sales companies like Mary Kay and Avon. As an aside, I think we are seeing a resurgence in direct sales companies that is very interesting.
All the sharks passed. Like with Wired Waffles, this was too early. It was an idea, not a product or a company. Lori pointed out the difficulty of selling something at that low a price point – the cost of shipping would dominate the cost of the product. She thought that it might make an interesting promotional item but didn’t see it being a standalone product. All said that they love the entrepreneur, but they don’t. Being a nice sweet person isn’t enough to justify an investment, and the entrepreneurs immaturity as a business person was too much of a hurdle for any of the sharks to get over.
The last company makes oral vitamin and supplement sprays. They claim that 100m people in the US have difficulty swallowing pills, so they propose an alternative delivery mechanism, oral sprays. They have a range of products for boosting energy, delivering vitamins, and helping with sleep. The company sought to raise $200k for 10% of the equity.
The company had done $125k in sales in nine months, not enough to justify the valuation that they were seeking. But they did have some other promising factors. Nature Made, one of the top vitamin makers in the US, had seen the product and wanted to license the manufacturing process that Marz Sprays had developed. And at a recent trade show the company had gathered 5 pending POs, each for more than $1M+. These were all international orders and so were pending review and approval in the relevant countries, which the company anticipated would take 60-90 days.
Three of the sharks dropped out quickly. Daymond believed that the international approval would be a lengthy and uncertain process, casting doubt on the POs. Robert didn’t believe in the efficacy of supplements in general. Cuban didn’t believe that the spray delivery approach was protectable.
Two were left. Lori liked the industy, and the spray. She offered $200k for 30%, contingent on getting the Nature Made deal. Kevin liked the size of the industry too, and wanted to participate with Lori. He proposed splitting an investment of $250k for 40%. Lori said that she’d rather do the deal on her own. Kevin responded by offering $200 for 25%. Lori matched his offer.
At this point, things got interesting. One of the cofounders, the sweatier one, said that he was interested in equity upside. He had originally wanted to sell only 10%, but now was looking at 25% dilution. He proposed being able to redeem half of Lori’s stake at a 3x markup. This means that he would be able to buy back 12.5% of his company from Lori in the future for $300k. Lori countered with a 4x markup.
The company asked Kevin if he would do this too. He said no. The company returned to Lori and after some bartering, settled on her deal.
After the deal was done, the sharks all agreed that Lori got hustled. She had no meaningful reply because she did get hustled. For taking all of the equity risk, she gave up half of the upside if things went very well. And the serious upside cases are where you make all of your money as an investor. If the company didn’t make a 4x return, she would get her return. But if it did incredibly well, say a 100x return, she would only get that 100x return on half of her money. On the other half, her return was capped at 4x. So on average, she would be getting a 52x return. That sounds pretty good, but she basically cut her return profile in half on all the big upside cases. But she eats all the downside if the company goes south. And most startups go south. That’s not a good deal as an investor.
In practice, you usually see redemptions go the other way. Instead of the company having the right to buy shares back from an investor, you see investors having the right to make the company buy back their shares. This can give the investor downside protection if things are going poorly, or it can give an investor liquidity if they don’t control the company and the entrepreneur does not want to sell the company in a timeframe that the investor wants.
In a hot deal, you often see the winner’s curse phenomenon. I think we saw this in both Cozy Bug and Marz Sprays this week. Having price discipline and a rigorous investment and diligence process is one of the hardest things to maintain in a competitive situation. This is one of the reasons that 3% of VC firms generate 95% of the industries returns (according to Cambridge and Associates).