19 Jun WHAT IS MEANT BY THE TERMS (A) CAPITAL CALL, (B) DEAL FLOW, AND (C) DUE DILIGENCE?
A venture capitalist wants to estimate the value of a new venture. The venture is not expected to produce
net income or earnings until the end of Year 5 when the net income is estimated at $1,600,000. A
publicly traded competitor or “comparable firm” has current earnings of $1,000,000 and a market
capitalization value of $10,000,000.
A. Estimate the value of the new venture at the end of Year 5. Show your answer using both the direct
comparison method and the direct capitalization method. What assumption are you making when using
the current price-to-earning relationship for the comparable firm?
B. Estimate the present value of the venture at the end of Year 0 if the venture capitalist wants a 40
percent annual rate of return on the investment
Describe the process for estimating the percentage of equity ownership that must be given up by the
founder when a new equity investment is needed.
What is meant by the terms (a) capital call, (b) deal flow, and (c) due diligence?
What is meant by the terms (a) lead investor, (b) SLOR, and (c) term sheet?
Why should entrepreneurs care what pressures venture capitalists face in carrying out their professional money management (intermediation) function?
Why do venture capitalists make quick decisions on the infeasibility of some business plans? When a business plan is not quickly determined to be infeasible, what happens next and why?
Why are venture capital funds typically organized as limited partnerships? In particular, why are they private firms instead of public firms?
Interact Systems
MINI CASE: Interact Systems, Inc.
Interact Systems, Inc., has developed software tools that help hotel chains solve application integration
problems. Interact’s application integration server (AIS) provides a two-way interface between central
reservations systems (CRS) and property management systems (PMS). At least two important trends in
the hotel industry are relevant. First, hotels are shifting away from the manual booking of room
reservations; electronic bookings will continue to increase as more bookings are made over the Internet.
Second, competitive pressures are forcing hotels to implement yield management programs and to
increase customer service. By integrating the CRS and PMS through Interact’s AIS, the company can
better manage inventories, improve yields, and enhance customer service
All reservation traffic is routed from the CRS to individual hotel properties. This allows Interact Systems
to create a database that can be used to track customers and to facilitate marketing programs, such as
frequent-stay or VIP programs, as a way of increasing customer satisfaction. Interact forecasts application
integration expenditures in the hospitality industry to exceed $1 billion by 2012.
Greg Thomas founded Interact Systems in 2006 and developed the firm’s middleware software and
hospitality applications. He has twelve years of systems applications experience and currently is Interact’s
chief technology officer. Eric Westskow joined Interact in early 2009 as president and CEO. He had worked
in sales and marketing in the software industry for more than twenty years.
Interact Systems’ AIS software development, which began in 2006, went through several design changes
in 2007. The first product was sold and installed in 2005. Sales were only $500,000 in 2006. However,
now that the firm has dependable market-tested AIS products ready to be shipped, revenues are expected
to reach $20.8 million in 2012.
Greg Thomas founded Interact Systems with $50,000 of his own savings plus $50,000 from friends. Two
private investors provided an additional $200,000 in 2007. In addition, $1 million was obtained from a
venture capital firm, Katile Capital Partners, in early 2009 in exchange for an equity position in Interact.
The firm currently is seeking an additional $5 million to finance sales growth.
A. A VC is considering providing the additional $5 million. What type of fund (stage specialization,
industry focus, etc.) would you approach? In what part of their investing cycle would you hope to
approach them?
B. Discuss how Interact Systems would expect to fare in the VC screening process involving each element
of Figure 11.5.
C. Discuss typical issues that might be addressed
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