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IPOs, Acquisitions and the Use of Convertible Securities in Venture Capital

  • Hellmann, Thomas F.

    (Stanford U)

This paper provides a new explanation for the use of convertible securities in venture capital, which is based on the trade-off between acquisition or IPOs. A key property of convertible preferred equity is that it allocates different cash flow rights, depending on whether exit occurs by acquisition or IPO. The paper builds a model with double moral hazard, where both the entrepreneur and the venture capitalist provide value-adding effort. The optimal contract gives the venture capitalist more cash flow rights in acquisitions than IPOs. This explains the use of convertible preferred equity, including automatic conversion at IPO. Contingent control rights are shown to be instrumental for achieving effcient exit decisions. The model also explains when to use simple versus participating convertible preferred equity.

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Paper provided by Stanford University, Graduate School of Business in its series Research Papers with number 1702r.

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Date of creation: Nov 2002
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Handle: RePEc:ecl:stabus:1702r
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  1. Casamatta, Catherine, 2002. "Financing and Advising: Optimal Financial Contracts with Venture Capitalists," CEPR Discussion Papers 3475, C.E.P.R. Discussion Papers.
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  3. Black, Bernard S. & Gilson, Ronald J., 1998. "Venture capital and the structure of capital markets: banks versus stock markets," Journal of Financial Economics, Elsevier, vol. 47(3), pages 243-277, March.
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  6. Cestone, G. & White, L., 1999. "Anti-Competitive Financial Contracting: the Design of Financial Claims," Papers 99.525, Toulouse - GREMAQ.
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  14. Kaplan, Steven N. & Strömberg, Per, 2003. "Characteristics, Contracts and Actions: Evidence from Venture Capitalist Analyses," SIFR Research Report Series 14, Institute for Financial Research.
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  19. Roberta Dessï¾’, 2005. "Start-Up Finance, Monitoring, and Collusion," RAND Journal of Economics, The RAND Corporation, vol. 36(2), pages 255-274, Summer.
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  23. Hellmann, Thomas, 2002. "A theory of strategic venture investing," Journal of Financial Economics, Elsevier, vol. 64(2), pages 285-314, May.
  24. Inderst, Roman & Muller, Holger M., 2004. "The effect of capital market characteristics on the value of start-up firms," Journal of Financial Economics, Elsevier, vol. 72(2), pages 319-356, May.
  25. Zingales, Luigi, 1995. "Insider Ownership and the Decision to Go Public," Review of Economic Studies, Wiley Blackwell, vol. 62(3), pages 425-48, July.
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  27. Neher, Darwin V, 1999. "Staged Financing: An Agency Perspective," Review of Economic Studies, Wiley Blackwell, vol. 66(2), pages 255-74, April.
  28. Leslie M. Marx, 1998. "Efficient venture capital financing combining debt and equity," Review of Economic Design, Springer, vol. 3(4), pages 371-387.
  29. Hellmann, Thomas & Puri, Manju, 2000. "The Interaction between Product Market and Financing Strategy: The Role of Venture Capital," Review of Financial Studies, Society for Financial Studies, vol. 13(4), pages 959-84.
  30. Green, Richard C., 1984. "Investment incentives, debt, and warrants," Journal of Financial Economics, Elsevier, vol. 13(1), pages 115-136, March.
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  33. Mark Grinblatt & Chuan Yang Hwang, . "Signalling and the Pricing of Unseasoned New Issues," Rodney L. White Center for Financial Research Working Papers 01-89, Wharton School Rodney L. White Center for Financial Research.
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