Tuesday, September 9, 2014

Shak Tank or Loan Sharking Tank

A good friend of mine, Farzad, is a fan of shark tank.  After a discussion with him I decided to start watching shark tank.  Frankly, it is painful.  Having worked at two VCs, shark tank is, ehhh, borderline idiotic.  But there is a something that really bothers me about the deal -- besides valuation.
Kevin Oleary's royalty deals are basically loan sharking!  Here how it goes.

I give you the money you want -- say $100K (on $1Mil post money).  But I don't want any equity.  Instead, you give me $2.50 on each item you sell  for $10, until I am fully paid.  Then the royalty goes down to $1.25 per item after that forever!

Here are just a few problems with that deal.  Lets say your product has a 50% profit margin.  you need to sell 40K units to give O'Leary his money back, so far no problem.  But in effect O'Leary now owns 50% of your business while he is getting paid back!   People who take equity are entitled to sharing the profits and not the revenue;  and that is after the debts are paid.  With the royalty deal, everything is suddenly debt.  Even if not, the initial $2.50 royalty out of the $5 profit amounts to 50% equity.  The later $1.25 royalty will be 25% of the company long term.

Doing a quick math, the initial post money is only $200K, and later it is $400K in valuation!

But what is worse is that the royalty stops anyone from doing an M&A!  Anyone who wants to buy the company will now have to pay the royalty, a complete deal killer.  The royalty holder can take the company hostage and demand any percentage of the deal they want.