Working Paper: CEPR ID: DP2317
Authors: Klaus M. Schmidt
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 Codes: D23; G24; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| convertible securities (G12) | mitigate double moral hazard problem (D82) |
| convertible securities (G12) | efficient investment levels (G31) |
| entrepreneur's effort (L26) | venture capitalist's conversion of debt into equity (G24) |
| quality of the project + entrepreneur's effort + venture capitalist's involvement (O36) | success of high-potential entrepreneurial firms (L26) |