Before you start pitching, know what kind of investor you’re looking for and what kind of deal they want

Startup founders: how many episodes of Shark Tank or Dragon’s Den have you watched?

I’m guessing every single one of you has watched at least a few episodes. And a not insignificant number have watched most every episode.

Everyone in the startup world loves the show. We enjoy watching the pitches by enterprising entrepreneurs, the sharp Q&A, the snarky remarks, and the banter as the sharks debate whether to invest and cut deals on the spot. It’s great TV. And it is reality. These are real founders with real businesses with real products we can buy; the sharks are real investors putting their money into these startups.

So it’s not surprising that first-time founders expect pitching to venture capitalists and especially to angel investors to follow the same game plan. It’s not unusual even to hear the Shark Tank language used in pitches— i.e. offering X% of the company for this many dollars, and propose the kind of complex arrangements of loans and royalties the sharks often counter with.

There’s also the expectation that once a deal is concluded, VCs and angels will become your partners, introducing you to customers and helping you run your business.

Shark Tank, while great, gives founders false expectations for how venture works. Not because the show is TV that distorts reality, though there is some of that. But because the sharks aren’t venture capitalists or even angel investors. They’re operators. And operators have a different business model from venture capital with different investment criteria.

What is Venture Capital?

In my definition (the only one that matters), venture capital is investing in high-risk startups with the expectation of high rewards from exponential growth leading to a large exit in a 5–10 year timeframe that generates a huge return.

This high level of risk and return differentiates venture capital from other types of investment. Both venture capital funds, raising investment from institutions, and angels investing their own money are venture capital.

Venture capital assumes 90% of early-stage startups will fail outright or at least fail to provide a positive return to investors. That means the 1 out 10 that succeeds needs to return 10x just to break even. But nobody invests to break after 10 years of waiting. Given the risk and lack of liquidity, investors want a return that beats the S&P 500. That means the successful investments need to return 50x, 100x, or even 1000x.

You’re not going to get those levels of returns building a profitable $20 million business. You’re not going to make VCs happy with dividends. Venture capital requires growing exponentially to a billion dollar IPO or a giant acquisition by an industry giant.

Because of the high failure rate, VCs and angels have to invest in at least 20–30 companies to have a reasonable shot at success. Which means it’s their process is about finding the right founders with the right products and business plan writing a check and checking in quarterly rather than concerning themselves with day-to-day operations.

Operators, like the Shark Tank crew, have a completely different mindset.

What are Operational Investors?

In my definition (the only one that matters since I haven’t seen many others), operational investors are industry specialists who invest in companies to generate a return from profits and fees.

Building a profitable small/med business is far, far easier than creating a billion dollar business in 5 years. The success rate is much higher. But the returns for minority investors are small. And the difference between profit and loss is in the details: winning deals, negotiating contracts, being frugal with salaries and expenses.

An investor expecting a dividend stream can’t just hand a founder a check. If they do, they shouldn’t be surprised when the managers pay themselves attractive salaries with ample benefits. Why would managers pay out dividends to investors when they can keep more for themselves?

That means investors focused on earning dividends rather than aiming for a big exit need to be actively involved in the company’s operations. And they can only do that if they understand the business and industry. These are Shark Tank-style investors. They partner with the owner to build and operate the business.

You’ll notice most of the sharks don’t just offer money. They offer expertise. They offer marketing services. They help you sign up customers. These services don’t come free. And they’re not optional. These really are owner-partner relationships rather than founder-investor.

Operational Investor Deal Structures

Although building profitable small businesses is far less risky than rocketship startups, the risk is still high. So a simple loan offering 10% interest won’t get any takers. (Venture debt requires significant revenues first, which both lowers the business risk and provides collateral.)

Hence the sorts of deal structures typical on Shark Tank.

  • The basic deal is usually structured as a hybrid of loan and equity. The investor gets their original investment back quickly as a large revenue share, limiting the downside. But they also keep the equity to receive dividends and participate in the potential upside if the business is ever acquired.
  • The investor (or the investor’s representative) actively works in the business, typically in finance, operations, or marketing. The investor is paid a fee for this work, bringing in personal income from the investment.
  • For a big name investors such as Mark Cuban and Daymond John whose name alone helps draw business, they’ll be paid a royalty on every sale.
  • If the investors are involved in sales activities such as introductions to their contacts, they’ll be paid a commission.

There’s generally only room for one operational investor in any company, which is why, unlike venture investors, the sharks battle among themselves for the opportunity.

But unlike a VC, an operational investor is more than a check. He or she is a partner in the business. They bring expertise and operational assistance to help build the business. Of course, they don’t do this for free.

They stack different ways of getting a return from the business to reduce their risk, generate a return from profits, and get paid for their efforts and contacts.

It’s a different investment model from venture capital for investing in a different type of startup.

Before pitching to venture or operational investors, make sure to understand what you’re building — is your business a venture-style startup shooting for a 1000x exit in 5 years or a solid, profitable business that though smaller, can generate healthy profits?

Then look for the right type of investor to match your business.

If your startup is building a teleporter, how do you keep the customers happy? For starters, they need to arrive in one piece and not get blown into individual atoms.

Is that what’s happening at the startup SüprDüpr? The company’s founder isn’t talking and the chief of police refuses to check. So when her brother goes missing, Sumire recruits her ex-boyfriend, the hacker, Ted Tatsu Hara, to find out.

See what happens in the award-winning startup mystery novel, To Kill a Unicorn.