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Convertible Preferred Stock in Venture Capital Financing

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  • Flippo Ippolito

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    Abstract

    We develop a model in which cash-constrained entrepreneurs seeks a venture capitalist (VC) to finance a new firm. Costly monitoring is employed by VCs to reduce entrepreneurial moral hazard. When monitoring reveals poor performance, VCs want to punish the entrepreneur with liquidation. However, when assets are specific and liquidation would lead to a loss, VCs choose to renegotiate the terms of financing rather than to liquidate. Renegotiation undermines the threat of liquidation. By giving VCs incentives to monitor and liquidate underperforming projects, the hybrid nature of convertible preferred stock helps reduce this problem. As potential equity holders, VCs are willing to absorb the costs of monitoring because this promotes managerial efficiency and increases expected profits. At the same time as debt holders, VCs are sheltered from loss in a liquidation because they enjoy seniority with respect to common stock holders.

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    Bibliographic Info

    Paper provided by Oxford Financial Research Centre in its series OFRC Working Papers Series with number 2006fe12.

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    Length: 34
    Date of creation: 2006
    Date of revision:
    Handle: RePEc:sbs:wpsefe:2006fe12

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    Web page: http://www.finance.ox.ac.uk
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    Keywords: venture capital; monitoring; liquidation; convertible preferred stock; vesting;

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