Convertible Preferred Stock in Venture Capital Financing

Filippo Ippolito, School of Management Sda and Bocconi

No 2006-FE-12, Economics Series Working Papers from University of Oxford, Department of Economics

Abstract: We develop a model in which cash-constrained entrepreneurs seek a venture capitalist (VC) to finance a new firm. Costly monitoring is employed by VCs to reduce entrepreneurial moral hazard. When monitoring reveals poor performance, VCs want to punish the entrepreneur with liquidation. However, when assets are specific and liquidation would lead to a loss, VCs choose to renegotiate the terms of financing, rather than to liquidate. Renegotiation undermines the threat of liquidation. By giving VCs incentives to monitor and liquidate underperforming projects, the hybrid nature of convertible preferred stock helps reduce this problem. As potential equity holders, VCs are willing to absorb the costs of monitoring because this promotes managerial efficiency and increases expected profits. At the same time, as debt holders, VCs are sheltered from loss in a liquidation because they enjoy seniority with respect to common stock holders.

Keywords: Venture capital; Monitoring; Liquidation; Convertible preferred stock; Vesting (search for similar items in EconPapers)
JEL-codes: G21 G24 G32 G33 (search for similar items in EconPapers)
Date: 2006-12-01
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