Stage Financing and the Role of Convertible Securities

Francesca Cornelli · Oved Yosha

531 citations0/0 files storedThe Review of Economic Studies

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Private Equity and Venture Capital Corporate Finance and Governance Capital Investment and Risk Analysis

Abstract

Venture capital financing is characterized by extensive use of convertible securities and stage financing. In a model where a venture capitalist provides staged financing for a project, we illustrate an advantage of convertible debt (or warrants) over a mixture of debt and equity. Essentially, when the venture capitalist retains the option to abandon the project, the entrepreneur has an incentive to engage in window dressing and bias positively the short-term performance of the project, reducing the probability that it will be liquidated. An appropriately designed convertible security prevents such behavior because window dressing also increases the probability that the venture capitalist will exercise the conversion option becoming the owner of a substantial fraction of the project's equity.

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References

2010Review of Economic Studies 1990The structure and governance of venture-capital organizations 1989Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior 1995Optimal Investment, Monitoring, and the Staging of Venture Capital 1999The venture capital cycle 1995Venture Capitalists and the Oversight of Private Firms 1998Venture capital and the structure of capital markets: banks versus stock markets 1989What do venture capitalists do?

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