Around 7 years ago my wife and I invested in a local startup company. There was a buzz around the company, (which I will anonymously call “XYZ”), and a number of successful local individuals were investing including a number of my wife’s doctor and dentist friends, so we dove in. A couple of years later, XYZ went bankrupt and we all lost our entire investment. Prior to the bankruptcy, there were numerous stressful and heated meetings that I could have lived without attending. This was the first time we had ever invested money in a startup company.
A year or so later I started consistently watching Shark Tank. After watching about 10 episodes, I had an epiphany: If I had been a Shark Tank fan prior to XYZ’s pitch, I would have saved my money. I honestly think I have learned a lot about entrepreneurship and business just by watching how the Sharks operate. These lessons have been instrumental to me in my business, my investments, and how I counsel clients.
Below are the top 10 things I’ve learned about business from watching Shark Tank and how these lessons might have saved me from this stupid investment.
1. The Sharks Demand Sales.
The one question every contestant is asked is “what are your sales?” No matter how cool the product or presentation is, or even how great the intellectual property portfolio is, the Sharks are only really interested when the contestant shows decent enough sales to prove the concept in the marketplace. The market is cruel, and it is much more difficult to predict than most of us realize. Actual substantial revenue is the only real proof that a new product or service is viable. The risk of investing in a venture that has yet to establish sales is huge. XYZ, Inc. had a cool product, but had yet to establish revenue. This should have been a big red flag for me. The Sharks would have either been “out” based on this alone, or else they would have demanded a huge chunk of the company to compensate for this huge risk.
2. The Sharks Invest in People More than Products or Ideas.
The Sharks will often invest in an impressive entrepreneur with an average idea. The Sharks are usually “out” on a contestant that doesn’t have his/her act together even if they say they love the idea. I did like XYZ’s ideas and product, but later found a number of red flags in the background of XYZ’s founders. It turns out the founders had prior bankruptcies and lawsuits. Plus, they lacked track record of success.
3. The Sharks want Scale.
The Sharks sometimes take a pass on a company that, while it may be profitable to the owners, just does not have big revenue or liquidation potential. Startups are inherently risky, so investors should insist on a huge potential return; or else the investor is better off with safer investments like stocks, bonds, real estate, etc. XYZ presented itself as a scalable model, but I later uncover a big scalability challenge. Certain processes that made the technology work were manual, and therefore a challenge to scale. When I made the investment I had assumed this process was automated. This should have been a red flag that a real Shark would have noticed.
4. The Sharks are Disciplined on Valuation.
Company founders are notorious for absurdly overvaluing their business. This is understandable to an extent given the blood sweat and tears they put into the venture, but someone needs to splash on the cold water. The Sharks (especially “Mr. Wonderful” Kevin O’Leary) always pound contestants on their valuations. I naively invested in XYZ without even really calculating the outrageous valuation they were offering. The Sharks sometimes get 30-50% of a struggling but promising startup for the amount of money I shelled out for less than 1% of XYZ.
5. The Sharks want Entrepreneurs that are “ALL IN.”
The Sharks almost always deny contestants that have full-time jobs and are presenting on their “side business” unless the contestant is willing to quit his/her job right away and commit to the business. Startup success requires a maniacal effort and focus on the part of the founder that just isn’t possible as a side venture.
6. The Sharks Chew Up Contestants wanting to Live Off Investors.
The Sharks are hesitant when early entrepreneurs want a substantial salary, especially if the money is coming from investors. The Sharks want true entrepreneurs, not people creating their own job funded by investors. The Sharks respect founders getting paid when there is enough revenue to justify it, but they still want to see most of the free cash reinvested in the company. The XYZ founders were drawing salaries from the investment funds to cover their living expenses. The salaries were not huge, but they felt like a lot to investors when XYZ had no revenue. This was a sour point when XYZ went under.
7. The Sharks Swim Away from High Debt/Expenses.
I have noticed that the Sharks often pull out fast when the contestant admits to having high debt, even where the Sharks were otherwise interested. XYZ was carrying a lot of debt and they were fast and loose with expenditures. These should have been huge red flags for me.
8. The Sharks Do Not Want Too Many Investors Too Early.
The Sharks also often go cold on a contestant when he/she discusses having numerous investors /partners. Too many investors and partners make running a business more complicated. It increases liability since each investor could get upset and sue the company. XYZ had a ton of small investors. Keeping all of the investors informed and happy sucked up a lot of management’s time.
9. The Sharks Evaluate Return on Time not just Return on Investment.
The Sharks, especially Mark Cuban, often turn away contestants even with promising companies because the time the Shark will have to invest to help the company get going. This is an often-overlooked cost of private equity investing. In addition to being a total loss financially, my investment in XYZ took quite a bit of time – evaluating the product and company; reviewing the contracts; following up with management; shareholder meetings, etc.
10. The Sharks Love Intellectual Property.
The Sharks always want to make sure the contestant has a clear advantage over any potential competitors. They get hungry when they see a company with solid patents, trademarks, copyrights, or trade secrets. At the very least, the contestant should be patent pending if the business is based on an invention. If legal intellectual property isn’t possible, the contestant should at least be able to show a clear first-mover-advantage, network effect, unique skill set, or other competitive advantages. The Sharks love to challenge a contestant with “What is stopping anyone from doing what you do?”