This Is Why the Sharks Get So Hung Up on Valuation During 'Shark Tank'

When QVC Queen Lori Greiner offered Tara Brown $75,000 for a 30% stake in her company, The Sleep Styler, Brown had a choice to make, and quickly. With all of the Shark Tank cameras on her, should she take Greiner's investment?

Brown came prepared with a counteroffer: $75,000 for 25%. Enthused, Greiner accepted and, with some TV magic, the deal was done. But unless you went to business school or are deep in the startup world, you might have thought: Where the hell did those numbers come from?

"Valuation" is a word frequently tossed around when talking about startup companies, and, if you've seen more than 10 minutes of the show, you know it's a number that often trips up the sharks. (Remember when they scoffed at a $25 million valuation?) Surprisingly, it's not a measure of how much the company will eventually be worth, or even what it's worth today, especially since there's so much unrealized potential in the types of early-stage companies mostly featured on Shark Tank. Instead, it's used to figure out how much ownership an investor should receive in exchange for cash to help that company grow.

For The Sleep Styler, Greiner gave Brown $75,000 in exchange for a 25% ownership stake. That means that before including her investment, Greiner determined the company was worth $300,000 -- 75k divided by .25. But how Greiner came to that number, and what it means in a practical sense, is altogether different. (Don't worry, there's no more math in this article.)

We asked Sue Heilbronner, angel investor and CEO of MergeLane, how she values a company, but she admits there's no easy answer. "Ascertaining a company's valuation is not a straightforward, linear process," she says. "Imagining that there may be an exact computation to get the 'right valuation' of a very early-stage company doesn't make sense."

This was echoed by David Cohen, an entrepreneur, early investor in some obscure app called Uber, and founder of the legendary accelerator Techstars, which gives startups $120,000 in exchange for a 6% share of the company. Sounds a little Shark Tank-y, no? As it happens, a few companies he's invested in have appeared on Shark Tank, and some have even cut deals with the sharks.

"Valuations are not science," Cohen says. "They're art. And if you're looking for how the formula is produced with early-stage startups, there is none." OK, guess the article's over now. Thanks for reading!

Though there's no precise formula, there's data that can help investors like Mark Cuban (Mr. Basketball), Daymond John (Mr. FUBU), and Mr. Wonderful (Mr. Wonderful) figure out a company's valuation. According to Heilbronner, those factors include the quality of the entrepreneurs, the size of the market, the scale of the "problem" the company solves, and the company's future earning and revenue potential. Cohen also notes that you can value a company based on market norms.

For many companies, whether it's one that produces an app or book lamps, a path has already been blazed for how much they're worth. Tech companies generally have a higher potential valuation than consumer products -- things like The Sleep Styler cost money to produce and require kept inventory. There are supply-chain issues to worry about, and manufacturing costs can go up without warning. On the tech side of things, an app like Instagram doesn't have to worry about any of those old-school business problems. It famously sold to Facebook for a billion at a time when it had just 13 employees.

But if you think that post-valuation the company's founders are suddenly swimming in McDuck-like pits of gold coins, think again. "In a practical sense, it doesn't change anything," Cohen says. It does, however, give the company's founders an idea of how much money they'll make if they eventually sell. Which, for many startups, is the endgame of all this. Finding an investor on Shark Tank isn't the goal for these companies -- it's the beginning of a long journey. What comes next, hopefully, are huge jumps in sales, followed by one big sale. Like Shark Tank alumnus Groovebook, which sold for $14.5 million to Shutterfly.

To make things more complicated, achieving a high valuation isn't necessarily a good thing for the business either. Startups often have investors loan them money multiple times (called "rounds"). If your company starts out with a super-high valuation, there's often nowhere to go but down.

"We live under the impression that you're always pushing for the highest possible valuation," notes Heilbronner. "But when a valuation is too aggressive, even if [you find] investors, you run a substantial risk of a 'down round.' If you don't grow fast enough to accelerate your valuation at a pace that makes sense for the next round, you may have a flat round at the same valuation."

And since perception is reality in the world of valuation, a flat round (or worse, a down round) is not a positive experience. Investors want to put their money in startups currently experiencing (or about to experience, with the help of a cash influx) exponential growth. If they're not seeing that growth, there's another company Barbara Corcoran and her pals can invest in after the next commercial break.

Before Greiner offered The Sleep Styler entrepreneur $75,000 for 25%, ABC showed the sharks getting financial data from Brown: total sales, sale price, the cost to make the product, and the amount she'd already invested in the company. While we've already determined that there's no tried-and-true formula for a valuation, you might think you can deduce a ballpark valuation with that information. But no! "You're flying blind," says Heilbronner.

Now, keep in mind that Shark Tank doesn't air the entire pitch, in which financial minutiae are discussed. Certainly every little bit of data helps the sharks formulate a valuation. They also have the benefit of listening to thousands of pitches over their lifetimes, and they're aware of market norms in many industries. But oftentimes on Shark Tank, the valuation is lower than what the company is likely worth -- the sharks have all the leverage.

"I'll watch the show and say to myself, 'Wow, they're really lowballing these guys,'" Cohen says. "And the entrepreneur will take it! And I'll think, 'They're crazy! They just sold half their company for $50,000, when it could be worth $10 million someday.'" But, he says, the shark does offer invaluable PR and marketing help, and the entrepreneur might badly need the cash to keep the business afloat.

In another recent episode, shark Chris Sacca invested in PopUp Play, a Techstars-funded company that helps kids build custom playhouses and toys. But instead of giving PopUp a pile of cash in exchange for equity, he gave it a convertible note up to $3 million. This would allow Sacca to loan the company money in exchange for equity, but it also buys some time to devise and gather more data, which helps inform the valuation in the coming rounds of funding, according to SeedInvest.com. Basically, Sacca and PopUp are admitting that it's tough to determine the company's valuation at such an early stage, and they'll figure it out later.

Maybe PopUp Play will turn into the next Hasbro, sell for $100 million, and make Sacca an even richer man. Or maybe it'll go under. It's tough to tell -- even for the shark.

Sign up here for our daily Thrillist email, and get your fix of the best in food/drink/fun.