ABC’s popular TV show, “Shark Tank,” shows negotiations between entrepreneurs and five Venture Capital (VC) investors (“the Sharks”). Before describing their company, business owners typically make a request in the following form: X thousands of dollars in exchange of Y percent ownership in the company. For example, in a recent episode, the two owners of Mistobox, a subscription coffee service, requested $75,000 for a 15% stake in the company. Aside from the being nationally televised, actual negotiations involving equity stakes and financing amounts between VC investors and company owners are not dissimilar from what is shown on the Shark Tank.
Like less famous VC investors, the Sharks typically deliberate over the company’s value implied by the equity stake offered. To calculate that value, the Sharks take the investment request divided by the proposed equity stake. Continuing with the Mistobox example, the owners’ request implies that the company is worth $500,000 ($75,000 / 15%). So far this calculation is basically the same as what VC investors call a “post money” valuation. The reason it’s post money is that the VC investor has claim to a portion of the entire investee company, including the money that was just invested. From the post money valuation, VC investors subtract the investment to arrive at the “pre money” valuation, which represents the value of the company before the current round of financing. The Mistobox example will flesh out the distinction: post money value was already calculated as $500,000 while pre money value is equal to $425,000 ($500,000 less $75,000).
What makes the Sharks different (and wrong), however, is that they fail (or deliberately omit) the distinction between pre and post money valuation. This omission allows the Sharks to overstate the pre-investment value of the company and subsequently balk at the high valuation requested by investee company. I’ve watched episodes intermittently from season 1 through the current season 4, but only once did I notice an instance when the pre/post money distinction was highlighted and it wasn’t by a Shark. Instead an entrepreneur made clear what his pre and post money valuations were, but this assertion was wholly ignored by the Sharks, who preferred to rely solely upon post money valuations.