Abstract

Venture capital financing is characterized by extensive use of convertible debt and stage financing. In a model where an entrepreneur obtains funding for a project from a venture capitalist, we illustrate an advantage of convertible debt, over a mixture of debt and equity, in stage financing situations. Essentially, when the venture capitalist retains the option to abandon the project, the entrepreneur has an incentive to engage in “window dressing ” or short-termism, that is, to bias positively the short-term performance of the project in order to reduce the probability that the project will be liquidated. Such behavior reduces the likelihood of liquidation but, at the same time, it also increases the probability that the venture capitalist will convert debt into equity, reducing the entrepreneur’s profits. An appropriately designed convertible debt contract succeeds in preventing short-termistic signal manipulation (window dressing) by the entrepreneur.

Citations