Convertible Debt with Costly Communication in Venture Capital Finance

Abstract

This paper examines the role of convertible debt when venture capitals invest in young companies. In venture financing, lenders do not have sufficient information to estimate the productivity of firm's projects.

We construct a model in which a borrower can communicate information about the productivity of his project to lenders by exerting effort and show that lenders can induce borrower's efforts to communication by using convertible debt which includes additional clauses that restricts lenders from converting debt unless the firm value reaches a predetermined value.

In addition, we show that such convertible debt give more payoffs to lenders than a combination of straight debt and equity when the entrepreneur has few initial assets to start his project.

Keywords: Convertible debt; Financial contracts; Costly communication.

JEL Classification: G32; D86.