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'Shark Tank': What Fans Should Know About Betting On Startups

Dec 24 2013, 11:26am CST | by

'Shark Tank': What Fans Should Know About Betting On Startups
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Seven million viewers watch ABC’s “Shark Tank,” a reality show that pits four savvy venture capital investors—the “sharks”—against wide-eyed entrepreneurs who need funding to expand their companies. The entrepreneurs’ challenge: to raise as much money as they can while not giving up too much equity to the sharks. It’s fun to cheer against the toothy critters. But seeing as it’s the holidays, let’s show them some compassion by putting this game in better perspective.

Say you start a company that makes financial-education software for high schools, colleges and corporations. You’ve designed the curriculum, built a prototype program and even booked $100,000 in revenue over the last 12 months. The company has serious growth potential (or so you think), but you need $250,000 in additional funding to ramp up your sales and marketing efforts, among other needs.

In exchange for the $250,000, you offer to give up a 10% ownership stake in your company. Smelling blood, a shark says he’ll give you the $250,000—for 50%. Half?!, you gurgle. How greedy can these guys get?

That’s how viewers are supposed to react. But before you feel too bad for the prey, ponder the predator’s plight.

Risk And Reward

Generally speaking, real-life sharks aim to make 10 times their money within 3-to-7 years—preferably by selling their stake to another company, or in an initial public offering. If that sounds greedy, remember that a lot of those bets completely tank—as in, go to zero–so the sharks need a few big winners to keep swimming.

Understand, too, that investing in young companies is riskier than scuba diving with great whites. The probability that a new business survives its first five years is about 50%, estimates the Small Business Administration—and many of those survivors won’t have the kind of sizzling growth prospects that attract schools of suitors. So you can’t blame the sharks for wanting to be adequately compensated for accepting such enormous risk.

But how does the shark determine how much risk he’s ultimately willing to take? After all, maybe that 50% stake is still too low.

That calculation takes a lot more effort than a TV show can capture, but we can shed a bit more light on it—and the math is easy.

The central concept at work here is that money a shark invests in one company is money he can’t invest elsewhere. In other words, there’s an opportunity cost to his capital.

That opportunity cost—called the “discount rate”—is the minimum annual rate of return the shark expects to earn in order to justify taking a certain amount of risk. The more risk the shark perceives, the higher discount rate he will assume.

For comparison, the discount rate on the S&P 500 is around 10%—meaning that investors expect to earn at least 10% a year for accepting the risk that comes with betting on stocks. Startups, however, are much riskier investments, so venture capitalists expect to earn far higher returns for betting on them. In these treacherous waters, the discount rate might be more like 40% or higher.

So, to understand if a shark is being particularly aggressive or just, well, a shark, try to get a feel for the discount rate he’s assuming. It’s one number, but it says a lot.

Who’s The Shark?

Now back to your theoretical financial-education software company. We need to make a few fairly reasonable assumptions to drive home this example, so bear with me.

Assumption #1: Say the shark aims to make 10 times his original investment within seven years. That equates to a discount rate of 40%. (To calculate it, use the “internal rate of return” function on a financial calculator; online video tutorials abound.)

Assumption #2: Say your startup, based on its current prospects and with no additional funding, is worth $500,000 today. (That’s equal to five times annual revenue, which might be on the high side, but again, it’s the holidays.)

Assumption #3: Say your company will need no additional outside funding over the next seven years. (This is a huge assumption—and doesn’t work in the shark’s favor, because each additional financing arrangement dilutes his stake—but it will keep the math simple.)

Before he makes an offer, the shark has to estimate how much he thinks your company will be worth seven years from now. That estimate (combined with the discount rate) will determine how much equity he’s willing to take.

If the shark accepts your offer ($250,000 for a 10% stake), that implies he thinks your company—which is worth just $500,000 today—will be worth $25 million seven years from now. (The math: 10% of $25 million is $2.5 million, and one-tenth of that—because the shark wants to make 10 times his money—is $250,000.)

By asking for a 50% stake, the shark figures your $500,000 company will be worth more like $5 million in seven years. Big difference!

Will your company be worth $5 million or $25 million in seven years? That’s the art of investing, and it’s where the real work (which “Shark Tank” spares us all) comes in.

Say the shark is more impatient. Instead of making 10 times his money within seven years, he wants to do it in three years. What’s the discount rate on that investment? Try 115%. Now that’s some serious risk. In this scenario, if the shark took your original offer, some might say you’d be the shark—that is, unless your little software company happens to really take off and be worth $25 million three years from now. Again, making that educated guess takes lots of work, and a more than a little luck.

Yes, some sharks make big bucks. (The sharpest can afford personal submarines, let alone private jets.) But many others end up hanging by their clients’ hooks.

That’s why when sharks bite, they open wide—and chomp hard.

Have any good advice on raising capital, negotiating with investors or generally navigating treacherous entrepreneurial waters? Please share your comments.

Source: Forbes

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