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Convertible Preferred Stock in Venture Capital Financing

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  • Filippo Ippolito
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    Abstract

    We provide an explanation for the widespread use of senior convertible preferred stock in venture capital financing. We develop a model of cash constrained entrepreneurs who need an investor to finance their project. Investors can either be uninformed, such as small individual bondholders, or informed, such as venture capitalists and banks. There is an entrepreneurial moral hazard problem, which can be partially overcome through monitoring only by informed investors. However, monitoring is only e.ective if investors can commit ex ante to liquidate the project after observing a poor signal. We show that a capital structure that minimizes commitment and information costs requires entrepreneurs to contribute to the financing of the project with common stock and venture capitalists to hold senior convertible preferred stock.

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    Bibliographic Info

    Paper provided by Oxford Financial Research Centre in its series OFRC Working Papers Series with number 2005fe12.

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    Date of creation: 2005
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    Handle: RePEc:sbs:wpsefe:2005fe12

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