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The Role of Convertible Securities in Venture Capital Financing

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  • Shih-Chung Chang

    (CCER)

Abstract

In this paper we study the role of convertible securities in the financing of start-up enterprises when the entrepreneurs are better informed than the venture capitalists (VCs). We demonstrate that for a well-designed contract the conversion ratio of the securities can be used as a signaling device to overcome the problem of information asymmetry. If the variability of the return is sufficiently large, the entrepreneurs will find it desirable to rely on convertible securities with the conversion ratio revealing part of his information, that is, a separating equilibrium will arise. Such an equilibrium has the advantage of avoiding the incentive constraints that appear in the other pooling equilibrium, in which the privately held information is not revealed. We show that the time-lag of decisions between investment and conversion will also benefit the VCs, with the extra return as the time value. In addition, we study the impact of introducing technical shares with which the entrepreneurs are awarded equity shares without investment outlays. We compare the different financing devices with convertible securities and explain why convertible securities have become the most commonly used financial instrument for start-up enterprises.

Suggested Citation

  • Shih-Chung Chang, 2009. "The Role of Convertible Securities in Venture Capital Financing," Finance Working Papers 22886, East Asian Bureau of Economic Research.
    • Handle: RePEc:eab:financ:22886
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    References listed on IDEAS

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    More about this item

    Keywords

    Venture capitalists; Entrepreneurs; Convertible securities; Signaling;
    All these keywords.

    JEL classification:

    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • M21 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Business Economics - - - Business Economics
    • M13 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Business Administration - - - New Firms; Startups

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