Stage financing and the role of convertible debt

Cornelli, F and Yosha, O (1997) Stage financing and the role of convertible debt. Working Paper. London Business School IFA Working Paper.

Abstract

Venture capital ficing is characterized by extensive use of convertible debt and stage ficing. We show why convertible debt is better than a simple mixture of debt and equity in stage ficing situations. When the venture capitalist retains the option to abandon the project, the entrepreneur has an incentive to engage in "window dressing" or shorttermism, that is to bias positively the short term performance of the project in order to reduce the probability that the project will be liquidated. With a straight debtequity contract, the entrepreneur will always engage in signal manipulation. With a convertible debt contract, such behavior reduces the likelihood of liquidation, but increases the probability that the venture capitalist will convert debt into equity, reducing the entrepreneur's profits. Therefore, with an appropriately designed convertible debt contract, the entrepreneur will not engage in shorttermistic signal manipulation.