Convertible Securities
and Venture Capital Finance
University of Munich, CESifo and CEPR, 2002
Klaus 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 state of the world and
the entrepreneur's effort. This property can be used to induce the entrepreneur and
the venture capitalist to invest effciently into the project. The result is robust to
renegotiation and to changes in the timing of investments and information flows.
The model is consistent with the observations that conversion is often automatic
and that convertible securities are rarely used by outside investors.
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