Sadly, ABC’s “Shark Tank” is giving private equity investing a bad name. The "Sharks" are not the wise old investors they appear to be, but truly dangerous "Loan Sharks" that are out to eat entrepreneurs alive.
Comparing the show's Sharks to real-world Angel Investors is, well, like comparing fish to fowl. Real "Angel Investors" are in it for the long-haul. They want to give an entrepreneur cash to grow the companies -- and they stick around until the business is large enough to sell. The Sharks, however, are looking for short-term gains that threaten to ruin the very businesses they invest in.
Need proof? Here's one deal that I think will sink the company:
Last week, the sharks were in a bidding war over the Rapid Ramen cooker. Two offers emerged that were deceptively similar: both included $300,000 "investment"; and both had the potential to bankrupt the entrepreneur.
Would you have taken the bait?
- Robert Herjavec, the older technology mogul offered a $300,000 cash investment for 25% of the company. But his offer came with a “royalty” clause that would pay him back $0.75 for each item sold.
- Mark Cuban countered with a $150,000 cash investment and $150,000 convertible loan…for the same $300,000 total and the same 25% share of the company… with no royalty.
Interestingly, each Shark saw the danger in the other's offer, but neither would admit their own guilt:
- "If you can’t pay Mark back, he will end up owning your whole company,” said Herjavec
- “If you grow as fast as you think, you’ll end up paying Robert a lot more — and a lot faster too,” said Cuban
Its crazy, but they were both right. Both offers stink like three-day-old fish. Let’s break it down:
WHAT IS A ROYALTY?
A royalty payment is either a percentage of sales, or a fixed dollar amount per unit sold. Either way, the royalty might go on forever. Repayment is based on actual sales: Do well and the shark could make more than he gave you just on the royalties.
WHAT'S A CONVERTIBLE LOAN?
A business loan from a private investor will includes the investor's right to “convert” the loan value to stock. So, unless you pay back the loan exactly as agreed, the investor could end up with a very large ownership interest in your company and leave you with little or nothing.
FROM BAD TO WORSE
If these were your only options, then you'd have one that penalizes you when the business does very well and one that bankrupts you if you do poorly: neither is a good solution.
- If the business takes off quickly, the royalty (paid on every sale) would rob the company of vital cash flow just when it needs it the most. (Growth can require much more cash than failure!)
- On the other hand, if sales take off more slowly than you expect, the loan must still be repaid at the agreed upon rate. In this case, paying the loan back could drain you of the little you have left, and if you miss a payment? Poof, Mark Cuban owns your company.
The result of either is the same -- you're out of cash and out of business.
If you're looking for a true win-win investment, throw both of these offers back into the shark tank where they came from.
On “Shark Tank” it's rare that anyone turns down an offer -- no matter how unfair or unreasonable. And this week was no exception. Rapid Ramen took the loan from Mark Cuban. The business owner had sights set on rapid growth and believed that a loan from Cuban would leave more available in the short term. But to me, he still got robbed.
WHY SHARKS ASK FOR ROYALTIES
It is interesting how often the Sharks include sizable royalties or loans in their offers. Why? Because as the show continues season after season, the Sharks are collecting quite a portfolio of small businesses and not seeing much success. In fact, FastCompany recently reported that the sharks have spent $28 million on 116 small companies -- with only one return to speak of! With that many investments pending, the Sharks have turned to royalties and loans to get their money back faster and with less risk -- despite what hardship it may be causing the entrepreneurs.
In short, Shark Tank has forced these sharks to make a cash-flow business out of what should be long-term investing. I think they often care less about the company’s future than about how fast they can get their money back — and how long they can continue to get paid royalties.
In my experience (in the real world — not on reality TV!), investors rarely ask for royalties. That’s the difference between a “shark” and an “angel.” Angels, with more reasonable terms, are more likely to deliver a simple cash equity investment. Frankly, its a bit sad how blood-thirsty the sharks on “Shark Tank” appear. Real world angel investors are rarely so antagonistic, aggressive or anxious to get their money back.
In any case, royalties and loans have no place in a win-win equity negotiation. If your investor offers one, think hard about the impact it would have in multiple future scenarios (success, failure, and in-between) before accepting.
Don’t let your long-term business turn into a short-term score for a cash flow investor. If you're looking for an angel ... don't settle for a shark.
Dedicated to your royalty-free profits, David
PS: Before you go out to raise money -- from sharks, angels, banks or "the crowd" -- please get a CFO on your team who can explain your options and help you navigate the waters of this unforgiving business. If you don't have a CFO already, please contact me and let's talk about whether one of our FUSE advisors can help guide you.