1. Valuation

Watch how the sharks deal with valuation. Every Shark Tank pitch starts with contestants asking for a specific amount of money in exchange for a specific percentage of ownership in their business. That establishes their proposed valuation. So for example, if they want to give 10 percent of the company for $100,000, that’s a valuation of $1 million; and 30 percent for $150,000 is a valuation of $500,000. It’s simple math.

Investors like valuation to relate to actual business numbers, such as sales, gross margin (price less direct costs), and burn rate or fixed costs. On the show, the sharks frequently object to unrealistically high valuations; sometimes they make their own offers based on much lower valuations. That’s a simple matter of making offers and counter offers. Very rarely, they’ll accept a valuation based on the value of proprietary technology, or brand impact, aside from actual business numbers.

Because the Shark Tank is about television entertainment, it keeps valuation simple. Angel investors, on the other hand, frequently use some more flexible options. For example, we’ve several times invested based on  what we call convertible notes, which is intended as a temporary loan to be converted to equity (ownership) based on a future valuation to be established by transactions with venture capital. But the importance of valuation is also always there. And every startup should understand the basics as it deals with potential investors.

2. Market Size

The sharks want businesses that appeal to interesting numbers of possible buyers. They want interesting niches that can grow, not very focused niches that look like they’ll remain small forever. In a recent episode, for example, they rejected a $500 gaming device that gamers climb on to ride because they thought it would appeal to a very small percentage of gamers.

3. Defensibility

Sharks often ask: “What do you have that I can’t just do myself? I can take the money you want, hire some people, and become your competitor.” That’s about defensibility. The sharks want to invest in a company that isn’t going to be blown away by competition in the near future.

Defensibility comes in different ways for different businesses. Occasionally it’s a matter of a strong patent. More often, it’s secret formulas, secret ingredients, trade secrets, and relationships with channels of distribution. Sometimes it’s progress made in branding. Without defensibility, the investment is not attractive.

In a recent episode the sharks rejected a doorbell connected to smartphones because they thought it would have been too easy to duplicate.

4. Scalability or Leverage

Scalability or leverage is easy to understand when you think about products compared to services. If you sell products it’s easy to imagine gearing up to make a whole lot more of them if sales grow. A product business is scalable. Some service businesses—web services are a great example—are also scalable, even though they sell services. But a service delivered by humans, that requires adding payroll and fixed costs in proportion to sales increases, is not scalable.

It’s not coincidence that very few of the Shark Tank contestants are selling services. Services are great for owner-operators, but not a great opportunity for investors. In a recent episode the sharks turned down a gift box for children business because it didn’t seem easy to scale up.

5. Industry Bias

The sharks frequently prefer industries and businesses that match their experience and previous investments. Shark Lorie Grenier tends to like businesses that would work on the QVC channel she knows well. Shark Daymond John knows retail and especially clothing business. Several sharks have high tech businesses. And that works both ways: Sharks are more likely to invest in types of business they know, and the contestants, when it turns out they have a choice, value certain sharks more for certain kinds of businesses.

I’ve seen this same phenomenon in the angel group. Investors will tend to be more comfortable investing in businesses they know.