Shark Tank revealed how looking at Gross profit margin ( how efficiently is the product being produced) against Net profit margin (how efficiently is the company operating as a whole) can affect your chances of investment.
With an average viewership of 7.9 million, Shark Tank is one of the most popular TV shows on air. The investment show pits entrepreneurs in front of investors (the Sharks) such as Mark Cuban, Kevin O’Leary, and Ashton Kutcher.
The entrepreneurs kick things off with a 2 minute elevator pitch about their innovative startup. The investors follow up by interrogating the founders about sales, manufacturing, distribution, and more. The drama of the show comes from the tension between the entrepreneur-investor relationship. Both parties need each other equally but are also both seeking the better deal at the expense of the other.
This post examines season 6 episode 29, “Spikeball,” and how the sharks avoid a blunder by asking for the net profit margin instead of just the gross profit margin.
Understanding Average and Marginal Cost is Key
Before we jump in to the example,
it is important to know that in every episode, the sharks want to find the company’s profitability. After every pitch, the sharks begin by asking “What are your sales?”
The number they are seeking is revenue . How much money are customers paying the startup annually? Revenue indicates the size of the business. A company with $5,000 in sales is newborn and in its very early stages with a lot of unknowns. A company with $1 million in sales is established and has a customer base with a proven product.
How Customer Discovery Determines Startup Success
After determining sales, they go after the costs. This is where gross profit margin and net profit margin come into play.
The question, “What are the costs?” is a vague and general question, because costs can be defined in 2 ways:
- Cost of Good Sold (COGS)
- COGS plus operating expenses, taxes, interest, etc.
These 2 cost pictures give 2 different results. In the first case, revenue minus COGS returns the gross profit. This number, divided into revenue, is the gross profit margin.
One more time:
Revenue – COGS = Gross Profit
Gross Profit / Revenue = Gross Profit Margin
Gross profit margin tells the VCs how efficiently the product is being manufactured.
Can the entrepreneurs use cheaper materials / faster equipment to reduce the COGS; therefore increasing the gross profit margin?
In the second case, revenue minus the total expenses results in net profit. This number, divided into revenue, is the net profit margin.
Revenue – Total Expenses = Net Profit
Net Profit / Revenue = Net Profit Margin
Net profit margin indicates how efficiently the company as a whole is operating.
In addition to COGS, net profit margin takes into account the cost of financing, the cost of buildings, personnel, marketing, and distribution. The net profit margin tells the greater story of the company and ultimately how well it is being managed.
By taking initial revenue and subtracting costs, the sharks piece together a ballpark idea of a company’s profit margin.
However, without specifying, the sharks will not know whether they are dealing with gross profit margin or net profit margin. This is a vital difference.
For example, on May 15th 2015, when Chris Ruder, founder of backyard sports game Spike Ball, pitched his company on Shark Tank, he asked for $500,000 for 10% of his company. Instantly, the sharks calculate the valuation Ruder had determined for his company — $5,000,000. This was big. The camera pans to Daymond John writing this figure down.
Discussion takes place around how the product works, buyer profiles, and tournaments. The sharks ask how much the product retails for. Ruder says $59. Then, like a one-two punch, the two questions get asked:
Mark Cuban (interrupting Chris): “Chris, how many units are you selling in a year?”
Ruder: “This year we’ve sold 29,000 units.”
Daymond John: “And how much does it cost to make?”
Ruder: “A little over $14 a unit.”
Daymond: “So last year total gross sales…”
Ruder: “$1.4 million.”
Daymon: “And this year you expect it to be around 3 — ”
Ruder: “Around $3.2-$3.5 million.”
Cuban: “You’ve got to be killing it because it’s all margin. How much are you netting?”
Ruder: “Last year we netted $170,000-$180,000.”
The sharks cringed, surprised at the remarkably low net profit.
Had Mark Cuban not asked the net profit question point blank, the gross profit margin looked amazing ($14 COGS divided by $60 retail= 76% gross profit margin), and the investors would have had no clue about what was really happening inside the company. When Ruder said the net profit for last year was $170,000-$180,000 when gross sales were $1.4 million, that is a 12.5% net profit margin, which is shockingly low compared to the gross profit margin. Something was eating into the wide profit margin.
Cuban dug into this.
Cuban: “Why so little?”
Ruder: “Retail has been going like crazy. Ecommerce business is really good. But retail has really been eating in.”
Mark Cuban was not satisfied. He waves his hand, cutting off Ruder.
Cuban: “So how much are you paying yourself?”
Ruder: “My salary? $175,000.”
Cuban: “There you go. That makes it up. Good for you.”
What caused the low net profit margin?
The high cost of getting into retail stores like Dick’s Sporting Goods and Walmart and a personal salary of $175,000. These expenses were unaddressed in the gross profit margin but became apparent in the net profit margin.
Shark Tank illustrates the importance of knowing the difference between gross profit margin and net profit margin when assessing an investment in a startup. Both financial equations reveal critical information about the business. Remember the differences this way:
Gross profit margin — how efficiently is the product being produced?
Net profit margin — how efficiently is the company operating as a whole?
The Holy Grail of Entrepreneurship: The Term Sheet, Part 3 – Capitalization Table
We hope you found this helpful. If you have any questions about this topic or any capital funding subject, we would love to hear from you in the comments below.