One thing I enjoy doing in my spare time when I am not busy being nerdy with economics is watching YouTube clips of ABC’s hit show, Shark Tank. In this show, entrepreneurs are the contestants and the “sharks” are big ballin’ investors. The contestants enter the “tank” and present their small business to the panel of sharks hoping for a nice lump sum of money. Depending on how viable, awesome, and profitable their business will supposedly be, the sharks may grant them their wish with a handsome cash injection to get their business rolling. Often, the sharks are crude and have no problem kicking the contestants out of the tank.
On numerous occasions, the sharks will argue with the contestants about the valuation of the company. For example, this entrepreneur wanted to lure the sharks into his deal where he wanted a 25 million dollar valuation. Unfortunately for him, the sharks could not get to that valuation and he would not budge on his equity position. He ended up walking away from the tank without a deal. We need an arbitrator for this process to avoid this type of situation from occurring! Well you need not fear anymore, let me introduce the man, the myth, the legend, Franco Modigliani…wait who?
Franco Modigliani was the winner of the Nobel Prize in economics in 1985 for “for his pioneering analyses of saving and of financial markets.” So he is definitely more than qualified to handle this negotiation.
His backstory is quite fascinating. He was born in 1918 in Italy, and was basically a genius. By age 20, he was a well known and published pro-fascist economist. He even received a medal for his work in economics from Benito Mussolini, how bout them apples?!? Benito Mussolini was the Italian fascist who served as the ‘Prime Minister’ of Italy from 1922–1943. He wrote a seventy-five page article talking about how production would look under a socialist economy. Interestingly enough, his support for fascism waned as World War 2 transpired. As a result, his Jewish background and growing anti-fascist views pushed him to flee Italy.
However, it was during his time in the United States where his contributions to the field of economics helped him win the Nobel. One of his most noteworthy papers applies directly to our Shark Tank situation. Many of the contestants place a high premium on their ownership in their business, kind of like how we love our old car so much that we think the Kelly Blue Book value on it is waayy too low. Similarly, that business is the entrepreneur’s baby and it is hard to give up any portion of their business, especially to a money-hungry shark. One of the sharks, Kevin O’Leary, is empathetic to the entrepreneur’s feelings about the business and typically crafts a different type of deal to cater to that rationale. He offers deals that are focused on venture capital debt, with royalties. Let me explain…
Entrepreneurs have a hard time getting a business loan from a bank, especially a loan that runs into the million dollar range. Banks use deposits from people like you and me, to loan out to others. But with new startups and entrepreneurial ventures, putting depositors money at risk like that is highly frowned upon. The odds are definitely against the entrepreneur. However, venture capitalists, like these sharks, are willing and able to take on that risk. They are not subject to any depositors as it is their own hard-earned money. What’s appealing about the venture capital debt is that entrepreneurs keep their equity, or full ownership, in their business. Instead of offering part ownership of the company, where the shark would have the right to dictate how to run the business, the entrepreneur just has to make sure to pay the shark back.
Here is what Modigliani’s research said: Whether a business gets the cheddar by issuing debt or by offering a stake in the company through stock options, the value of the business will not be impacted. However, this is based on a few simplifying assumptions. For this theory to hold, there can’t be any taxes, agency costs, bankruptcy costs, no lack of information — basically, it would have to be a perfect world, or what economists call an “efficient market.”
So, you’re probably thinking Modigliani is nuts. To assume these very important, real-life factors of doing business is absurd.
For example, in a world where taxes exist, you can deduct the interest paid on any debt from your taxes. If we assume business is doing well, it’s possible that having a load of debt in the books could actually increase the value of your company. This makes Kevin O’Leary’s offer much more appealing to the entrepreneur.
Nonetheless, Modigliani’s role as an arbitrator would be to show that there are a variety of ways in which a business can get the much-needed funding. Providing this kind of information to the entrepreneur can alleviate some of the tension and allow the entrepreneur to have more of an opportunity to not leave empty-handed.
The Cost of Entrepreneurship
Shark Tank features entrepreneurs of all ages, many of whom have invested a significant portion of their life savings into their company. Modigliani also had some thoughts on the process of how people save and consume their disposable income. He was one of the originators of the life cycle theory. What this theory suggests is that during our younger years, we will opt into saving more money rather than consuming. However, later in life, we will trade out saving towards consuming more, drawing down on our savings. This was a much longer-term view than Milton Friedman’s permanent income hypothesis, which also tries to explain people’s consumption from period to period.
From the outside looking in, entrepreneurs seem to be going against this theory as they take the plunge and put their savings at risk of being wiped out. However, from their eyes, this is a necessary risk to be able to increase their spending later on. Arguably, entrepreneurs should be held in the same realm of prestige as war veterans, in that 75 percent of venture-backed startups fail. The failure rate of companies in the U.S. after five years is 50 percent, and after 10 years, it’s 70 percent. Those kind of numbers are disheartening at the very least, and frankly, very scary for the entrepreneur. It takes a special person to be a successful entrepreneur. Here’s to hoping their business brings in the big bucks!