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Think Big. Move Fast.

Last year I recapped a few episodes of season 4 of Sharktank from a VC’s point of view. A few people have asked me to do the same, at least for the Season 5 premier. So here goes! (You can watch it here for a couple of weeks if you didn’t see it last night).

POSTCARDS ON THE RUN

The first pitch most closely resembled a company that I may actually see as a VC. Josh Brooks, who ran marketing for MySpace for three years, is the founder of a company that lets users take photos form their phones, and then use those photos to send postcards in the real world to their friends and family. The smartphone app that enables this is free but it costs $2.49 to send each postcard.

Brooks has previously raised $1.6M to fund the company at a $6M post money valuation from a number of investors including Selena Gomez. Despite having over 500k downloads and making $450k in revenue over the last 21 months, he had only $185k left in the bank, which meant that he would be out of business in 90 days if he didn’t raise more money. He was seeking $300k for 5% of the company, implying a $5.7M pre money valuation and planned to use the money to market the app.

Most of the sharks dropped out quickly, concerned about the short runway for the company, lack of any barriers to entry, lack of issued patents, missing product features and valuation expectations. Only one, Robert Herjavic, showed interest. He thought that the Selena Gomez connection could help motivate users like his daughters to use the product since they didn’t email or text him.

Herjavic made an offer to invest $300k for 10% (implying a $2.7M pre money valuation). After some back and forth, Herjavic and Brooks came to agreement on a $3.7M pre money valuation.

I think that most of the sharks were right to pass on this investment, but think that many of their reasons for passing were spurious. Lack of barriers to entry, unissued patents, and even missing product features are all red herrings that won’t affect whether or not this company will be successful. What is important is prior execution. This is a company that has failed to find product market fit over the last 21 months and after spending almost $2M (capital raised plus revenue). A cursory check of the iPhone app store shows that another app with the same functionality, Postagram, has more reviews and better ratings than Postcards on the Run, and achieved that without the benefit of a celebrity endorsement from Selena Gomez. It is hard to understand why $300k and a few more months would lead to a better outcome. The issue seems to be more about the team’s execution, and the team hasn’t changed.

Brooks was lucky to get an offer from Herjavic and came close to overplaying his hand on the valuation discussion. With his back to the wall and about to run out of money, his first priority should have been runway extension, not dilution from new capital. And although the headline difference between a $5.7M pre money valuation and a $2.7M pre money valuation seems big, the actual implication is only between 5% and 10% dilution since the round size is small. When the company’s survival is on the line, such details should pale into insignificance. While Brooks was able to improve the deal somewhat, I regard the risk he took in losing the deal over a couple of points of dilution as being a very poor decision. If that is indicative of his general decision making, it is not that surprising that the company has failed to gain meaningful traction over the last two years.

LYNNAE’S GOURMET PICKLES

The next company was a gourmet pickle business that launched in September 2011 and sold $144k worth of pickles in the last 12 months. They were seeking $125k for 20% of the company and intended to use the money to fund inventory growth.

None of the sharks were terribly interested. Some passed because they didn’t like the product personally, others because they thought the price was too high. Mark Cuban thought that if they were indeed successful, that it would only attract competitive from the bigger food companies who would crush them.

Barbara Corcoran passed in the most confusing manner, saying, “Your sales growth is tremendous, you don’t really need my money since you are so successful, so I’m out”. That is the equivalent of the “It’s not you, it’s me, I’m not good enough for you” break up line.

Of all the discussion, I thought that Cuban’s was the most instructive. There are definitely some industries where due to economies of scale (which can be on production costs or distribution reach) incumbents have enormous advantages. In these industries, even if startups are smart and nimble and innovate quickly, they can have a tough time creating long term enterprise value. If barriers to entry are low, all the startups do is serve as outsourced R&D for the big incumbents who can come in and use their scale to eventually recapture share from the startups who proved out a new market.

One example of this was the Flip video camera. The product was introduced in 2006 and created a whole new category of easy to use video cameras. Sales skyrocketed and the company was bought by  Cisco for $590M in 2009. But by this time, competition was already starting to flood in from big consumer electronics companies like Sony, as well as video cameras becoming standard in smartphones. These huge companies put pricing and margin pressure on the category, and about a year from the acquisition, Cisco shut down the Flip business altogether. On the one hand, Flip ended up being a good outcome for its founders and investors, but on the other hand, if they hadn’t sold when they did, they would likely have suffered the same fate and gone to zero. The startup did everything right (including selling at the right time fortunately!), but the long term winners in the category were the incumbent consumer electronics firms.

When Zynga was at its peak, social gaming showed the same characteristics. New startups would quickly innovate and create a new category of game (farming, city builder, organized crime etc), and Zynga would quickly build a game in the same category and become the market leader (Farmville, Cityville, Mafia Wars). Their superior ability to cross-distribute games when at their height enabled them to let startups do the innovation for them, and to rapidly follow the most successful models and dominate through better marketing and distribution.

I suspect pickles show the same market characteristics.

ROLODOC

Rolodoc was a train wreck of a presentation from start to finish. Two doctor brothers have an alpha version of a mobile app to allow patients and doctors to communicate with each other securely, and for patients to find doctors through search. About 50 of their friends were using it. They were trying to raise $50k for 20% of the company.

The founders did a terrible job of explaining what the product did and how it was differentiated, constantly falling back on calling it “social media” as though that would explain everything. They also had a wildly unrealistic plan for signing up doctors to build profiles on the app, expecting that they could do this part time by sending a few emails, without having to give up their day jobs.

The sharks quickly, and with great prejudice, passed on the company.

SWEETBALLZ

The last company to pitch in the Season 5 premier makes Cakeballs, cakepops minus the stick, in four packs that sell for between $1.99-$2.49 and cost $0.86 to make. The company was trying to raise $250k for 10% of the company  (implying a $2.25M pre money valuation) in order to fund inventory growth. They had done $700k in sales in the last 90 days, 95% of which had come from 7-11 convenience stores. The company has made $95k in profit so far, after the two founders paid themselves $3k/mth each in distributions.

All the sharks showed interest with the $250k being initially offered for 40% of the company. But eventually two syndicates emerged. Mark Cuban and Barbara Corcoran offered $250k for 25%, implying a $750k pre money valuation. O’Leary, Greiner and Herjavic offered $250k for 30%, implying a $507k pre money valuation. Both syndicates competed on the distribution and marketing that they could bring to the table. The founders ended up accepting the Cuban-Corcoran offer which had a substantially higher pre money value.

If the numbers represented are right, this represents a great deal for the sharks. If the company really did $95k in profit on $700k in sales in the last 90 days and this is sustainable, then it should be able to realize $380k in profit over the course of a year. Even a $750k pre money valuation would represent a less than 2x multiple of profit, which is a screamingly good deal for the investors.

One interesting element to the deal that eventually disappeared was that O’Leary at one stage asked for a matching cash distribution for all cash distributions made to founders. While the specifics of this don’t seem entirely fair, the concept here is an important one for minority investors if the founders control the company. The founders could conceivably decide to pay themselves above market salaries that artificially reduce the companies profitability, which would benefit them at the expense of the other shareholders. (At $3k/month, they don’t appear to be doing that here.) One way to handle this is to have founder compensation set by the board (including a representative of the minority investors). Another way is to have all cash distributions made to shareholders be made pro rata according to ownership. This isn’t what O’Leary proposed (his suggestion was more aggressive than that) but it does address an important area where founder who are majority owners can come into conflict with minority investors.

WRAPUP

Hopefully these breakdowns of the four pitches in last nights how give you some insight into how VCs think about investments in startups! If you find this interesting, follow us on Twitter at @lightspeedvp

 

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