How do Sharks value businesses in Shark Tank?
Introduction
“Shark Tank” is a popular show on which investors (or Sharks) hear pitches from business owners who want funding from them. One of the most intriguing aspects of the show is how the “sharks” determine the value of these businesses.
When a business owner presents their pitch to the Sharks, they usually state the amount of money they are seeking and what percentage of their company they are willing to give up in exchange for the investment. The Sharks will then ask questions to gather more information about the business and its financials, and they may also conduct their own due diligence to verify the information provided.
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How Sharks value businesses in Shark Tank
First of all let’s understand the two most important terms:-
Pre-money valuation
It refers to the estimated value of a company or startup immediately before it receives external investment, such as a new funding round. Pre-money valuation refers to the estimated value of a company or startup immediately before it receives external investment, such as a new funding round.
Post – money Valuation
Post-money valuation, on the other hand, refers to the estimated value of a company or startup immediately after it receives external investment. It represents the total value of the company after new investment has been made.
For example, let’s say a startup has a pre-money valuation of $1 million and receives a new investment of $500,000. The post-money valuation of the startup would be $1.5 million, calculated as follows:
Post-money valuation = Pre-money valuation + New investment Post-money valuation = $1 million + $500,000 Post-money valuation = $1.5 million
So, how is the valuation of a start-up determined?
Sharks value a business in Shark Tank based on several factors, including:
Financial Performance:
Revenue Multiplier
It’s based on the company’s annual revenue. For example, let’s say the watch brand startup has annual revenue of $1 million and the Sharks are interested in investing. The entrepreneur could apply the revenue multiplier to get an estimated valuation. Let’s say the industry average revenue multiplier for comparable watch brand is 4.
At a revenue multiplier of 4x, this would value the company at $4 million (4 x $1 million). Based on this valuation, the entrepreneur can justify the deal for a 10% stake in the business for a $400,000 investment from the Sharks.
Earning multiplier
Multiply the company’s earnings by the earnings multiple to get the estimated valuation. Let’s say the watch brand has $1 million in annual sales and $100,000 in EBITDA (Earnings before interest, tax, depreciation and amortization). Based on comparable watch brands or a watch industry index (Information can be obtained from publicly traded markets), let’s assume an earnings multiple of 8x is appropriate.
At 8x earnings, this would value the business at $800,000 or (8 x $100,000). This is the pre-money valuation of the watch brand.
Based on this valuation, the entrepreneur can justify the deal for a 10% stake in the business for a $100,000 investment from the sharks, which would lead to a post-money valuation of $900,000 ($800,000 + $100,000).
Discounted Cash Flow (DCF) analysis
DCF analysis is a widely used method for valuing companies, particularly in the technology and startup industries. Discounted cash flow (DCF) analysis is a financial valuation method used to estimate the present value of a company’s future cash flows. This method takes into account a number of factors, such as growth rates, risks, and discount rates, to arrive at a present value for the company.
For example, let’s say a company has projected cash flows of $1 million per year for the next ten years. The discount rate is assumed to be 10%, which is the cost of capital for the company. To calculate the present value of these cash flows, we would use the following formula:
PV = CF1 / (1 + r)^1 + CF2 / (1 + r)^2 + … + CF10 / (1 + r)^10
Where PV is the present value, CF is the cash flow for each year, r is the discount rate, and the superscripts indicate the year.
Using this formula, the present value of the ten-year cash flows would be:
PV = $1,000,000 / (1 + 0.10)^1 + $1,000,000 / (1 + 0.10)^2 + … + $1,000,000 / (1 + 0.10)^10 PV = $6,144,329.90
This means that the present value of the company’s future cash flows is $6.14 million, which is the estimated value of the company based on the DCF analysis.
Future Market Valuation
The entrepreneur can estimate the company’s future net income based on projected earnings in the next few years. For instance, the entrepreneur expects to make $400,000 in net income by third year. If the tech industry has an average forward earnings multiple of 15x, the company’s estimated valuation in year three would be $6 million (15 x $400,000).
The Sharks want to make a profit and get their investment back, so they would consider investing if the company can generate $6 million in revenue by third year. However, if the business fails to generate the expected profit, the Sharks may ask for a higher ownership percentage or suggest a lower loan amount, or a combination of both.
The Intangibles of Valuation
The Intangibles of valuation on Shark Tank is one of the reasons it is so popular. Valuation on Shark Tank is not solely based on financial figures, but also intangible factors like the story and experience of the entrepreneur. The Sharks consider the whole package in their valuation, with numbers being the most significant part of the exercise. Other intangibles such as a compelling personal or product-related story can sway the Sharks’ valuation decision.
The Sharks ask a series of questions about the company, including costs, product margin, marketing, previous and future sales to ascertain demand for the product. Increasing demand and sales are positive signs, but if sales remain stagnant or decline, the Sharks will ask for reasons why. If the reason is not convincing, the Sharks may opt out of the deal. Overall, the valuation process on Shark Tank takes into account both quantitative and qualitative factors in making investment decisions.
Analytical accountant and curious blogger with over 5 years of experience as an Audit Associate and accountant. With expertise in auditing, accounting, and finance I help organizations drive top-notch financial management practices to achieve organizational success.
