Stage financing and the role of convertible debt
Venture capital financing is characterized by extensive use of convertible debt and stage financing. We show why convertible debt is better than a simple mixture of debt and equity in stage financing situations. 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. With a straight debt-equity 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 short-termistic signal manipulation.
Publication Research Centre
Institute of Finance and Accounting