Working Paper: CEPR ID: DP1735
Authors: Francesca Cornelli; Oved Yosha
Abstract: Venture capital financing is characterized by extensive use of convertible debt and stage financing. The paper shows 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 convertible debt contract, such behaviour reduces the likelihood of liquidation, but increases the probability that the venture capitalist will convert debt into equity, reducing the entrepreneur?s profits. With convertible debt, therefore, the entrepreneur will not engage in as much short-term behaviour in terms of signal manipulation in comparison to a situation where only straight debt-equity financing is used.
Keywords: venture capital; convertible debt; short-termism; window dressing
JEL Codes: G24; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| convertible debt (G32) | likelihood of signal manipulation (C58) |
| convertible debt (G32) | likelihood of project liquidation (G33) |
| convertible debt (G32) | likelihood of conversion to equity (G32) |
| convertible debt (G32) | entrepreneur's profits (P12) |
| convertible debt (G32) | alignment of interests between entrepreneurs and venture capitalists (L26) |
| convertible preferred equity (G12) | similar effects as convertible debt (G32) |
| structure of financing (G32) | entrepreneurial incentives (O31) |
| optimal capital structure (G32) | superior to straight debt-equity financing (G32) |