The Role of Convertible Securities in Venture Capital Financing

Shih-Chung Chang
JEL codes: 
2009-12, No. C2009009

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.