Last night while I was watching Shark Tank, Kevin O’Leary insulted an entrepreneur for the umpteenth time about the presumptuousness of her valuation. In case you haven’t seen Shark Tank, entrepreneurs pitch their startups to a panel of investors. The problem is that these entrepreneurs almost never articulate valuations– they simply name the amount of money that they want to raise and what percentage of their business they are willing to exchange for that cash.

I’m sure that Kevin O’Leary knows how to calculate the valuation of a business, but for some reason, he consistently does it wrong on the show. For example, if an entrepreneur asks for $100,000 for a 25% stake in their business, O’Leary or one of the other judges will berate them and say that their business isn’t worth $400,000 (25% of $400,000). But as any finance person would tell you, if an entrepreneur is asking for $100,000 in return for 25% of their business, then they’re valuing the business at $300,000, not $400,000. This is the difference between a pre-money valuation and a post-money valuation. The pre-money valuation is what the business is worth prior to the $100,000 investment. The post-money valuation is the pre-money valuation cash plus the money that was just invested.

So why do Shark Tank’s producers allow the judges to consistently misrepresent the calculation of the startup’s valuation? I imagine they’re dumbing down the math for their audience. It would be confusing to say that a $100,000 investment represents 25% of a company currently valued at $300,000, although you could also say that $100,000 will represent 25% of the company after the investment.

What’s even more interesting is that the “deals” reached on Shark Tank are apparently “offers” for the judge to perform due diligence and structure an investment over a much longer period of time. One contestant said it can take 6 to 9 months post-show to structure an investment. Other terms part of these offers make a still bigger joke of the entire investment process on Shark Tank. I’ve heard several judges make offers where they acknowledge that the capital they’re providing is insufficient to build the business, but they’ll provide additional “non-dilutive capital” in the future. Does this mean that they’re offering free cash or debt in the future? And if it’s debt, what are the terms under which it’s repaid? What constitutes a default? Under which circumstances can debt be worse than dilution?

Shark Tank makes for great entertainment in so much as you’re watching judges analyze a bunch of startups. But their simplification of startup financing is so abbreviated as to make the process a bit of a joke. I’m not sure what would make for better television, but entrepreneurs certainly shouldn’t look to shows like this one for any sort of financing education.

The Takeaway:

  • No one should conflate pre-money and post-money valuations– they are two entirely different financial concepts.

– Andrew