How Is a Business Valued on "Shark Tank?"

The underlying theme of the "Shark Tank" TV series is for either the Sharks (the investors) or the entrepreneurs (pitching their business) to convince the other side to accept their valuation of the business and negotiate a deal based on it. The entrepreneurs tend to come in with high valuations, while the Sharks counter with lower valuations.

How the entrepreneurs and the Sharks value the businesses presented on the show will likely vary, but a good valuation of a company takes into account certain factors such as present value, future value, the value of companies similar to it and risk.

Using the present value method to determine a company's current market valuation is based on comparing the entrepreneur's business to similar publicly traded companies and sectors or industry average financial ratios. Every sector and industry has financial metrics that are easy to find. A market capitalization value is derived based on the shares outstanding and the stock price. Common financial metrics such as price-earnings (P/E), price-sales (P/S), earnings per share (EPS), sales and income growth rate can be useful in determining a reasonable valuation.

For example, if an entrepreneur is pitching a clothing brand with $1 million in annual sales with $100,000 in profits, the entrepreneur may apply the metrics of the specialty retail apparel sector by using data to determine that the sector has an average P/E of 20.17 as of October 2018.

At 20.17x earnings, this would value the business at $2.017 million. Based on this valuation, the entrepreneur can justify the deal for a 10% stake in the business for a $200,000 investment from the Sharks. This would be based on current valuation.

The entrepreneur may forecast 100% annual earnings growth for the next three years, which is not hard to do with small numbers. This is based on estimates that include $400,000 in net income in year three at 14.75x forward earnings, putting the future valuation at $5.9 million.

Based on the future valuation, the entrepreneur could offer the deal at a 3.3% stake for $200,000 initially. After being laughed at by the Sharks, the entrepreneur could apply a generous discount – cash now is worth more than cash later – and could increase the proposed stake to 6.6% for the $200,000.

The Sharks could counter that offer using a P/S ratio with a real-life example like The Gap (GPS), assuming a P/S ratio at the time of 0.65. Applying the same ratio to the $1 million in annual sales would place a current valuation on the small business at $650,000. The Sharks can then apply a three- to five-year sector annual EPS growth rate of 11.94% to derive year-three income of $135,820.

From there, the Shark may then apply the forward P/E for The Gap of 9.36 as of October 2018 to derive a $1.271 million future valuation. Based on this valuation, a $200,000 investment would roughly equate to a 15% stake in the business.

The Sharks may remind the entrepreneur that they can't apply the same valuation metrics based on how publicly traded companies are valued. There are massive distinctions between a small business and a public corporation. The Gap is an established retailer with thousands of stores worldwide, while the small business may only have a few locations. While the growth rate is justifiably higher for the small business, the risk is much larger due to the risk of failure and liquidity risk in terms of an exit strategy. Shares in publicly traded companies can be liquidated in the stock market in seconds, which is impossible with stakes in a private small business.

The lack of liquidity creates more risk for the Sharks to bear, which entails applying risk-adjusted discounting to make the reward worth the risk. Based on this factor, the Sharks have much more wiggle room to base their offers on a risk-adjusted discounted valuation.

For example, applying a 50% risk-adjusted discount would bring the stake up to 30% for the $200,000 investment. Sharks can also apply the intangibles that they bring to the table to allow for an even larger discount, perhaps bringing up the stake to 50% for the $200,000 investment.

To counter blowback from the entrepreneurs about giving up too large of a stake in their business, the Sharks make the argument that their leadership, contacts, reputation and guidance contribute towards building a bigger pie to carve up between them. It would be better to own 50% of a $10 million company compared to 80% of a $1 million company.