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Convertible Securities and Venture Capital Finance

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  • Klaus M. Schmidt

    (University of Munich, CESifo, and CEPR)

Abstract

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 state of the world and the entrepreneur's effort. This property can be used to induce the entrepreneur and the venture capitalist to invest efficiently into the project. The result is robust to renegotiation and to changes in the timing of investments and information flows. The model is consistent with the observations that conversion is often automatic and that convertible securities are rarely used by outside investors. Copyright 2003 by the American Finance Association.

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Bibliographic Info

Article provided by American Finance Association in its journal The Journal of Finance.

Volume (Year): 58 (2003)
Issue (Month): 3 (06)
Pages: 1139-1166

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Handle: RePEc:bla:jfinan:v:58:y:2003:i:3:p:1139-1166

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  1. Nöldeke, Georg & Schmidt, Klaus M., 1998. "Sequential investments and options to own," Munich Reprints in Economics 19327, University of Munich, Department of Economics.
  2. Grossman, Sanford J & Hart, Oliver D, 1986. "The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration," Journal of Political Economy, University of Chicago Press, vol. 94(4), pages 691-719, August.
  3. Sahlman, William A., 1990. "The structure and governance of venture-capital organizations," Journal of Financial Economics, Elsevier, vol. 27(2), pages 473-521, October.
  4. Leslie M. Marx, 1998. "Efficient venture capital financing combining debt and equity," Review of Economic Design, Springer, vol. 3(4), pages 371-387.
  5. Gorman, Michael & Sahlman, William A., 1989. "What do venture capitalists do?," Journal of Business Venturing, Elsevier, vol. 4(4), pages 231-248, July.
  6. Repullo, R. & Suarez, J., 1998. "Venture Capital Finance: a Security Design Approach," Papers 9804, Centro de Estudios Monetarios Y Financieros-.
  7. Green, Richard C., 1984. "Investment incentives, debt, and warrants," Journal of Financial Economics, Elsevier, vol. 13(1), pages 115-136, March.
  8. Thomas Hellmann, 1998. "The Allocation of Control Rights in Venture Capital Contracts," RAND Journal of Economics, The RAND Corporation, vol. 29(1), pages 57-76, Spring.
  9. Cornelli, Francesca & Yosha, Oved, 1997. "Stage Financing and the Role of Convertible Debt," CEPR Discussion Papers 1735, C.E.P.R. Discussion Papers.
  10. Gompers, Paul & Lerner, Josh, 1996. "The Use of Covenants: An Empirical Analysis of Venture Partnership Agreements," Journal of Law and Economics, University of Chicago Press, vol. 39(2), pages 463-98, October.
  11. Cornelli, F. & Yosha, O., 1997. "Stage Financing and the Role of Convertible Debt," Papers 23-97, Tel Aviv.
  12. Berglof, Erik, 1994. "A Control Theory of Venture Capital Finance," Journal of Law, Economics and Organization, Oxford University Press, vol. 10(2), pages 247-67, October.
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