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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.

Suggested Citation

  • Flippo Ippolito, 2006. "Convertible Preferred Stock in Venture Capital Financing," OFRC Working Papers Series 2006fe12, Oxford Financial Research Centre.
  • Handle: RePEc:sbs:wpsefe:2006fe12
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    File URL: http://www.finance.ox.ac.uk/file_links/finecon_papers/2006fe12.pdf
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    Keywords

    venture capital; monitoring; liquidation; convertible preferred stock; vesting;

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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