Gross profit margin — how efficiently is the product being produced? Net profit margin — how efficiently is the company operating as a whole?
With an average viewership of 7.9 million, Shark Tank is one of the most popular TV shows airing today. The investment “reality” show pits entrepreneurs with investors (the Sharks) such as Mark Cuban, Kevin O’Leary, and now, Ashton Kutcher.
Entrepreneurs give a two minute elevator pitch about their innovative product or service, followed by the investors interrogating the founders with questions about sales, manufacturing, and distribution. The drama of the show comes from the tension between the entrepreneur-investor relationship, where both parties need each other equally but are looking to get the better deal at the cost of the other.
This post tells the story of the season 6 episode 29 Spikeball on Shark Tank and how the sharks avoid a blunder by asking for the net profit margin instead of the gross profit margin.
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. Directly asking a company’s profit upfront is like asking someone’s full-time salary so the sharks get the profit numbers in a roundabout way.
In every episode, after the sharks listen to the pitch, without skipping a beat they ask the question: “What are your sales?”
The number they are seeking is revenue — how much money are customers paying the startup annually. The revenue number indicates to the sharks 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.
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 two ways:
- Cost of Good Sold (COGS)
- COGS, operating expenses, taxes, interest, etc.
These two cost pictures give two different results. In the first case, revenue minus the COGS returns the gross profit. This number, divided into revenue, is the gross profit margin.
Gross profit margin tells the VCs how efficiently the product is being manufactured.
Can the entrepreneurs use cheaper materials or faster equipment to reduce the COGS and therefore increase 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. On this larger scale, the net profit margin indicates how efficiently the company as a whole is operating. It takes into account the COGS but also 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 the initial revenue number and subtracting costs, the sharks piece together a ballpark idea of a company’s profit margin.
But without specifying, the sharks will not know whether they are dealing with gross profit margin or net profit margin. And 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 they retail 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.”
Then Mark Cuban asked him point blank, “You’ve got to be killing it because it’s all margin. How much are you netting?”
Ruder replied, “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 as compared to the gross profit margin. Something was eating into the wide profit margin.
Mark Cuban dug into this.
Mark 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 says, “So how much are you paying yourself?”
Ruder: “My salary? $175,000.”
Mark 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.
All the sharks pull out, except for Kevin “Mr. Wonderful” O’Leary and Daymond John. Daymond John counteroffers to invest $500,000 for 25%.
Daymond John’s valuation of Spikeball is $2 million. After a job well done negotiating, Ruder and Daymond John agree to a deal of $500,000 for 20%, which puts Spikeball at a valuation of $2.5 million ($3 million postmoney).
This story 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?
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.