DP2317 Convertible Securities and Venture Capital Finance

Author(s): Klaus M. Schmidt
Publication Date: December 1999
Keyword(s): Convertible Securities, Corporate Finance, Double Moral Hazard Problem, Incomplete Contracts, Venture Capital
JEL(s): D23, G24, G32
Programme Areas: Industrial Organization
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=2317

This paper offers a new explanation for the prevalent use of convertible securities in venture capital finance. Convertible securities can be used to endogenously allocate cash flow rights as a function of the realized quality of the project. This property can be used to mitigate the double moral hazard problem between the entrepreneur and the venture capitalist. It is shown that an optimally designed convertible security outperforms any mixture of debt and equity and that it can induce both parties to invest efficiently. The result is robust to renegotiation and to changes in the timing of investments and information flows.