Stage Financing and the Role of Convertible Debt

London Business School Working Paper No. 253-1997

37 Pages Posted: 23 Feb 1998

See all articles by Francesca Cornelli

Francesca Cornelli

London Business School; Centre for Economic Policy Research (CEPR)

Oved Yosha

Tel Aviv University - The Eitan Berglas School of Economics (Deceased)

Date Written: August 1997

Abstract

Venture capital financing is characterized by extensive use of convertible debt and stage financing. We show why convertible debt is better than a simple mixture of debt and equity in stage financing situations. When the venture capitalist retains the option to abandon the project, the entrepreneur has an incentive to engage in "window dressing" or short-termism, i.e. to bias positively the short term performance of the project in order to reduce the probability that the project will be liquidated. With a straight debt-equity contract, the entrepreneur will always engage in signal manipulation. With a convertible debt contract, such behavior reduces the likelihood of liquidation, but increases the probability that the venture capitalist will convert debt into equity, reducing the entrepreneur's profits. Therefore, with an appropriately designed convertible debt contract, the entrepreneur will not engage in short termistic signal manipulation.

JEL Classification: G3, G24

Suggested Citation

Cornelli, Francesca and Yosha, Oved, Stage Financing and the Role of Convertible Debt (August 1997). London Business School Working Paper No. 253-1997 . Available at SSRN: https://ssrn.com/abstract=48581 or http://dx.doi.org/10.2139/ssrn.48581

Francesca Cornelli (Contact Author)

London Business School ( email )

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HOME PAGE: http://www.lbs.ac.uk/faculty/fcornelli/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Oved Yosha

Tel Aviv University - The Eitan Berglas School of Economics (Deceased)

N/A

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