Convertible Securities and Venture Capital Finance

35 Pages Posted: 18 Jun 2001

See all articles by Klaus M. Schmidt

Klaus M. Schmidt

Ludwig Maximilian University of Munich (LMU) - Faculty of Economics; CESifo (Center for Economic Studies and Ifo Institute); Centre for Economic Policy Research (CEPR)

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Date Written: June 14, 2001

Abstract

This paper offers a new explanation for the prevalent use of convertible securities in venture capital finance. Convertible securities can be used to endogenously allocate cash flow rights as a function of the realized quality of the project. This property can be used to mitigate the double moral hazard problem between the entrepreneur and the venture capitalist. It is shown that an optimally designed convertible security outperforms any mixture of debt and equity and that it can induce both parties to invest efficiently. The result is robust to renegotiation and to changes in the timing of investments and information flows.

Keywords: Convertible securities, venture capital, corporate finance, double moral hazard, incomplete contracts

JEL Classification: D23, G24, G32

Suggested Citation

Schmidt, Klaus M., Convertible Securities and Venture Capital Finance (June 14, 2001). CESifo Working Paper Series No. 217, Available at SSRN: https://ssrn.com/abstract=273642

Klaus M. Schmidt (Contact Author)

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Centre for Economic Policy Research (CEPR)

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