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The Role of Convertible Securities in Venture Capital Financing

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  • Shih-Chung Chang

    (CCER)

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    Abstract

    In this paper we study the role of convertible securities in the financing of start-up enterprises when the entrepreneurs are better informed than the venture capitalists (VCs). We demonstrate that for a well-designed contract the conversion ratio of the securities can be used as a signaling device to overcome the problem of information asymmetry. If the variability of the return is sufficiently large, the entrepreneurs will find it desirable to rely on convertible securities with the conversion ratio revealing part of his information, that is, a separating equilibrium will arise. Such an equilibrium has the advantage of avoiding the incentive constraints that appear in the other pooling equilibrium, in which the privately held information is not revealed. We show that the time-lag of decisions between investment and conversion will also benefit the VCs, with the extra return as the time value. In addition, we study the impact of introducing technical shares with which the entrepreneurs are awarded equity shares without investment outlays. We compare the different financing devices with convertible securities and explain why convertible securities have become the most commonly used financial instrument for start-up enterprises.

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    File URL: http://www.eaber.org/node/22886
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    Bibliographic Info

    Paper provided by East Asian Bureau of Economic Research in its series Finance Working Papers with number 22886.

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    Date of creation: Jan 2009
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    Handle: RePEc:eab:financ:22886

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    Related research

    Keywords: Venture capitalists; Entrepreneurs; Convertible securities; Signaling;

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    References

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    1. Steven N. Kaplan & Per Str´┐Żmberg, 2003. "Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts," Review of Economic Studies, Oxford University Press, vol. 70(2), pages 281-315.
    2. Casamatta, Catherine, 2002. "Financing and Advising: Optimal Financial Contracts with Venture Capitalists," CEPR Discussion Papers 3475, C.E.P.R. Discussion Papers.
    3. Francesca Cornelli & Oved Yosha, 2003. "Stage Financing and the Role of Convertible Securities," Review of Economic Studies, Oxford University Press, vol. 70(1), pages 1-32.
    4. 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.
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