Unless you do what I do for a living, “valuation” probably isn’t a word you hear every day… but it is a word you hear a lot on the TV show Shark Tank .

And it’s usually a point of controversy.

But why do the entrepreneurs and the Sharks differ on valuation?

The Pitch

The entrepreneurs are passionate about their business and believe their vision of the future will turn out exactly as presented. The Sharks, on the other hand, know from experience that a lot can go wrong and that most small businesses fail. Therefore, if the Sharks are going to write a big check to an entrepreneur, they will need to get a substantial rate of return on that investment to compensate them for taking the risk.

Let’s start with an example.

You already know that when the entrepreneurs ask for their desired investment, they’ve placed a value on their company. For example, asking $100,000 for a 10% stake in the company implies a $1 million valuation ($100k/10% = $1M).

But if the Sharks feel that the business is really worth only half of that, they would counter with an offer of $100,000 for a 20% stake. ($100k investment /20% ownership = $500,000 valuation)

If the valuation isn't right for the Sharks, they will pass on the deal, but have you ever wondered how the Sharks determine their valuations?

Sharks are experienced investors and they arrive at their valuations very quickly. But don’t let their speed fool you into thinking that they are simply guessing or just being greedy. Although not apparent to the viewer, the Sharks are utilizing several methodologies in arriving at their valuations.

I'm going to explain what’s behind their questions and how the Sharks arrive at their valuations.

Income-Based Valuation Method

It all starts with the Sharks asking questions about recent sales and profits, but their real focus is on what the business is expected to achieve in the years to come.

This is because, at its essence, the value of a business is equal to the current value of what it is expected to earn in the future.

In other words, valuation is less about “what have you done for me lately” and more about “what will you do for me tomorrow?"

So the Sharks will estimate the earning potential of the business for the next few years, and with a Shark-like required rate of return to compensate them for risk, those estimated future earnings can be converted into a current value through a mathematical technique known as discounting.

This is the premise of an Income-based valuation methodology known as a discounted cash flow analysis .

I won't get into the details, but the important considerations behind the math of a discounted cash flow analysis are:

1) the greater the risk of the investment, the higher the required rate of return to compensate the investor for taking that risk; and

2) the higher the required rate of return that is applied to expected future earnings, the lower the present value of those future earnings.

Without even doing the math, you can understand why the Sharks will not pay a high price for an extremely risky investment.

But the Sharks will do the math, so they know what the risk-adjusted value of the next few years of estimated earnings are worth. However, those next few years of earnings only tell a part of the story and represent but a portion of the total value of the business.

To get the rest of the story, the Sharks also need to determine the value of the earnings in the years that follow these near-term estimates.

Trying to estimate future earnings for another 10 or 20 years is an exercise that can tax even the best crystal ball, but the Sharks can shortcut the process by considering how long they intend to remain invested in the business, and at what price they might be able to sell their investment at that time.

To estimate the total value of the business, the present value of the exit price is added to the present value of the estimated near-term earnings or cash flow.

All of this happens in mere minutes on television… but this is just one method for determining value.

Market-Based Valuation Method

The Sharks will also use a Market-based valuation method, which is based on metrics by which similar businesses have transacted. If you've ever bought a house, you already understand the principles of comparison and substitution that are inherent in a Market-based valuation method.

For example, when comparing the relative value of different houses, you can calculate the price per square foot to help make an informed decision about what you’re getting for the money. This is a type of valuation multiple.

Similarly, when companies are sold (or traded on a stock exchange) their valuation is expressed as a multiple of sales, earnings, or the most ubiquitous: the EBITDA multiple.

When you hear the Sharks talk about “the multiple” when discussing the entrepreneur’s valuation, they are referring to the implied multiple of sales or earnings expressed in relation to the overall valuation.

For example, if the entrepreneur’s desired valuation is $1 million and the business generated $10,000 of sales last year, the price/sales multiple is equal to $1 million /$10 thousand, or 100 times last year’s sales. The Sharks will assess these valuation multiples on a forward-looking basis as well (i.e., as a multiple of next year’s estimated sales).

When you hear the Sharks complain that “the multiple is ridiculous,” you’ll know that the lower the financial performance metric (the denominator), the higher the implied multiple; and the Sharks are not keen on paying high multiples for performance that may never materialize.

Other factors that the Sharks might consider in their valuation include intangible assets , like the value of the brand, patents and people .

Sharks will also assess how a particular business might fit in with other businesses they already own (synergies) as well as the fact their affiliation alone will likely enhance the value of the business, although investors are generally not inclined to pay for what they bring to the table.

Having considered Income-based and Market-based valuation methods, the Sharks have a good idea of what the business is worth, but they aren't done yet.

Important Considerations For Private Companies

Unlike an investment in publicly trade stocks, an investment in the privately- held companies that appear in the Shark Tank can’t be exited in a matter of seconds with a sell order.

All other things equal, the lack of a ready, liquid market to sell the investment reduces the value of the investment.

The Sharks must also consider a discount for the lack of marketability associated with their investment.

Lastly is the matter of who calls the shots. The Sharks want control and the entrepreneurs do not want to give it to them.

The controlling interest holder in the business gets the final say on all decisions, and there is real value associated with having that ability.

The Sharks will also need to consider a discount for lack of control when taking a minority stake in a company.

Feeding Frenzy Or... "You're Dead To Me"

The Sharks now have their valuations – and let the negotiations begin!

The next time you’re watching Shark Tank, you can impress your friends with your knowledge of valuation.

That's all I have to say on this subject, so for that reason... I’m out!

_______________________________

* * * The Shark Tank spin off Beyond The Tank offers many other interesting and valuable insights on the world of business by documenting what happened to the companies after the deal. If you enjoyed this article, you might also enjoy this discussion of Business Lessons From Beyond The Shark Tank . * * *

Thanks for reading - If you enjoyed the post, please click the thumbs up icon above and let me know! (and if you like it, why not share it?)

Love to hear your thoughts as well - Please comment below.

You might also like these related articles:

About the Author:

Dave Bookbinder is a Senior Director at CFGI. Known as a collaborative consultant, Dave has conducted valuations of the securities and intellectual property assets of public and private companies across all industries for various purposes.

Working closely with business owners, CFOs, Controllers, and CEOs, Dave strives to build relationships that add value for the long term.

Dave is also the host of Behind The Numbers, the show that digs deeper to understand what matters in business. Available wherever you get your podcasts.

For future insights and articles, connect with Dave on LinkedIn, like him on Facebook , follow him on Twitter , #NEWROI .

You might also enjoy some of Dave's other articles .

Do you believe that people are a company's most valuable asset?

You might enjoy Dave's #1 best-selling book, The NEW ROI: Return on Individuals, which explores the impact that people have on the value of a business.

The book is available in hard copy at Amazon , Barnes & Noble , and everywhere books are sold.

Available for download in these digital formats: Kindle - iTunes - Nook - Kobo - Google Books

Views and comments are always my own.

_________________________________________________________________

Copyright 2015 - Dave Bookbinder