It’s rare that I’ll suggest investors watch any kind of television program, but you all must watch ABC’s Shark Tank, which airs Friday nights at 8 p.m.
Five wealthy tycoons (“sharks”) hear pitches from entrepreneurs. Every entrepreneur gets to show off the cool product they’ve come up with, and on that basis alone the show is worth watching. Nine out of 10 products are nifty or interesting in some way.
But that doesn’t mean they’d make a good business, and that’s why you need to watch the show. The sharks hit each person with a barrage of questions — the same questions investors should ask about whatever company they’re considering investing in.
Here are just some of those questions:
Is there a market for this product? If so, how big is it?
Is it a repeat-purchase business or a novelty, and does it matter?
Is the business scalable?
How much has been invested so far?
What are the product’s margins?
What pitfalls does the product have or face?
What is special about this product? What problem does it solve?
Is the product patented so it can’t be stolen?
How many sales have there been so far?
Is the entrepreneur totally committed to working on the company?
Is the valuation the entrepreneur places on the company realistic?
You must ask these same questions of any investment, particularly for IPOs, small-cap companies or even established companies that may be undergoing a turnaround or management change.
Let’s watch one segment from one show and see how the sharks react. (You’ll have to deal with a couple of commercials, then jump to the fifth segment — the one with the “wine balloon.”)
This is a great idea. It solves a problem.
Is it patented? Yes.
Does the product affect the wine it’s supposed to protect? No.
How does this product compare to other high-end items? It’s better. You can see that it works where others don’t.
What’s the inventor’s background? Construction, but he invents things. That’s a tip that he’s not a committed businessman.
How much has he invested so far? $65,000.
How many has he sold? 700, with no advertising.
At what retail price? $22.
At what cost? $6.50 (and it could be made for $2.50 in volume).
So you, the investor, should be thinking that this has potential. The market is huge (lots of serious wine drinkers out there, plus tons of other products serve this market). It’s a better product, the margins are fantastic, it’s proven to work, it hasn’t proven to sell, but my gut tells me that with proper marketing, it will.
If I were a shark, I’d be interested.
Kevin is interested, but he raises a good point. It’s going to cost money to manufacture, market and distribute this product into the retail market. That will cut into margins. One must also have to have expertise in marketing and have contacts with the right distributors.
Kevin wants to shortcut distribution and just go to the best-selling wine-preservation product company and replace its product with this one. That way, a marketing and distribution chain already exists, in exchange for a $40,000 payment and a perpetual 30% royalty.
I would have taken that deal because barring any exclusivity agreement on this license, that would get Eric the money he needs to further penetrate the market.
Laurie makes a shocking offer. She wants the whole company for $500,000. Now ask yourself — why? Because Laurie is the queen of QVC, the shopping network that’s the big cash-flow provider for its parent, Liberty Media (NASDAQ:LMCA). And if you’ve ever watched QVC, you know this product is perfect for the shopping network.
Furthermore, Laurie knows Eric is not a businessman who’s committed to growing this company. She rolls the dice, hoping he’ll be a sucker and take the buyout — because she knows she’ll easily make her money back on QVC alone. No marketing or distribution expenses. Manufacturing already in place.
Then Marc Cuban joins in by adding $100,000 to the offer to go in with her because he’s no dummy, either. Kevin wisely points out that Eric is giving up perpetual upside.
The interesting issue is that Eric asks for a 3% royalty in this deal. I think that’s totally reasonable. Marc is correct in saying that because he and Laurie are taking all the risk, there should not be any royalty beyond the cash buyout.
He can afford to be generous, but he refuses, and before we know it, the offer drops to $400,000. Eric takes it. He makes six times his money before taxes. Not a bad deal. But ask yourself this: If Marc and Laurie net $10 for each unit on QVC sales alone, they need to sell only 40,000 units to break even. Beyond that, it’s all profit — profit that Eric will never see.
I think Marc and Laurie stole this product from Eric, because if they were willing to buy him out completely, they obviously believe there was big money there and that Eric could eventually find someone else to invest.
This is exactly the train of thought you should engage in, and that even goes for a company that’s introducing a new product. Think about McDonald’s (NYSE:MCD) and its brilliant move into serving coffee. If you’ve heard about this strategic endeavor, your thought process might have gone something like this:
The coffee market is gigantic. Starbucks (NASDAQ:SBUX) charges four bucks for a premium cup of coffee. McDonald’s could offer it cheaper.
Plus, if the product works, it’s scalable by offering the same or similar flavors. They can do them iced, hot or blended. Then you ask how the stores will put the infrastructure in place to provide the product and do so at McDonald’s customary speedy pace.
Maybe you visit a store and see how they do it. You are impressed. You see that McDonald’s rolls out an aggressive marketing campaign, putting up a huge billboard across the street from Starbucks’ HQ with a picture of McDonald’s new coffee and the slogan, “Four bucks is dumb.”
McDonald’s has tens of thousands of stores all over the world, and the entire world is now drinking coffee, thanks to Starbucks. You must know that margins will be good, though subject to some commodity pressures on coffee-bean prices.
If you’re smart, you bought the stock.
I encourage readers to watch Shark Tank and catch up on previous episodes online. You’ll learn plenty about what questions to ask of your next investment.