The critical moment of many Shark Tank deals is when one of the Sharks asks, “How did you get to that valuation?’ I can’t believe how often the contestants eliminate themselves with a poor answer to that question that stops their deal process almost before it begins. Answers such as : We have invested $2 million in the product, so our valuation should be at least $2 million, or Our investors have put in $3 million so far. It should be valued at $5 million, or, I heard that xyz Company got $30 million for their company. So based on that our company should be worth $10 million.” Well, ask any Shark. This is not how they look at the value. The Sharks and the market in general don’t care how much it cost you to develop the product or how much your investors have in or how much you need to retire or how much you think it is worth.
The Sharks look at what the ROI is for their investment in a company. So when the Sharks asked the seventeen year old how he arrived at his valuation he promptly responded with, our sales during this period were X$ and if your project that for a full year, they would total Y$. Our profit margins are at Z%, so if you project that forward, our annual cash flows would be XYZ$. At a cash flow multiple of 5 X, that gets you to our valuation. After a moment of stunned silence, one of the Sharks said, you have to be one of the smartest seventeen year-olds out there. I agree. This kid knew his stuff and he was prepared and he blew away the Sharks who have seen hundreds of contestants absolutely fumble this most basic of investor questions. Nice job, young man.
It is hard to criticize this very bright young man, but I am going to Bill Belichick him. The Patriots just won 27 – 3 and Belichick lists his three things the team could have done better. I only have one, and it is a minor nit, but could be important to him in the future. Most of the Sharks agreed that his was a fair valuation based on his multiple of cash flow analysis. One of the deficiencies of this approach, especially for very rapidly growing firms and earlier stage firms, is that the company growth rate is not accounted for in the cash flow multiple valuation approach. Why do some companies like Facebook and Google sell for much higher Price Earnings multiples than the average S&P stock? The answer is that these companies have a far higher earnings growth rate and that has been translated into a higher PE multiple. In fact, many investor professionals are now basing investing decisions on the PE growth multiple which does, in fact, incorporate the company’s growth rate into the valuation equation.
So even though the Sharks agreed that his was a fair valuation, remember the car buyer never pays list price, so they will be trying to bid that price down by selling the value of having the Shark involved (which is quite valuable, by the way). Our seventeen year old wunderkind could have planted a preemptive thought when presenting his valuation with something like, “So our valuation is 5 X annual earnings, but that value does not even account for the fact that our sales have been growing by 8% month over month.”
My assistant coach just passed me a note. What about the phenomenon for start-ups and emerging companies that their expenses are temporarily much higher due to the front loading of development and marketing expenses? If you look at the multiple of cash flow model, the entrepreneur is actually punished from a valuation perspective because of their growth expenditures if they are selling their company or seeking investors during this hyper growth phase.
So remember, buyers will try to come up with reasons why they should not pay you asking price for your company and you need to be able to counter with equally compelling reasons why they should. Maybe the Sharks should pay the seventeen year old entrepreneur a premium based on how much they might learn from this budding superstar entrepreneur.