convertible preferred stock.pdf

Convertible Preferred Stock in Venture Capital Financing∗ Filippo Ippolito Säıd Business School, University of Oxford March 1, 2006 Abstract We provide an explanation for the widespread use of senior con- vertible preferred stock in venture capital financing. We develop a model of cash constrained entrepreneurs who need an investor to fi- nance their project. Investors can either be uninformed, such as small individual bondholders, or informed, such as venture capitalists and banks. There is an entrepreneurial moral hazard problem, which can be partially overcome through monitoring only by informed investors. However, monitoring is only effective if investors can commit ex ante to liquidate the project after observing a poor signal. We show that a capital structure that minimizes commitment and information costs requires entrepreneurs to contribute to the financing of the project with common stock and venture capitalists to hold senior convertible preferred stock. JEL Classification: G21, G24, G32, G33 Keywords: venture capital, monitoring, liquidation, seniority, con- vertible preferred stock ∗I am greateful to Fabio Bertoni who provided a significant contribution during the early stages of this research. My thoughts on the subject were stimulated by Alan Morrison, for which I am deeply grateful. I also appreciate helpful comments from Colin Mayer, Alexander Gümbel, Tarun Ramadorai and seminar participants in Oxford, SIFR, Bocconi, University of Washington, UV in Amsterdam, Paris Dauphine and Lisbon for providing interesting comments about this work. All remaining errors are mine. Correspondence address: Filippo Ippolito, Said Business School, Park End St., OX1 1HP, Oxford, U.K. Tel. +44 - (0)1865 - 288513 Fax. +44 - (0)1865 - 288805 Email: filippo.ippolito@sbs.ox.ac.uk 1 1 Introduction Recent empirical research on venture capital has provided a wealth of in- formation about financial contracting in newly established entrepreneurial ventures. Kaplan and Strömberg (2003) find that the most commonly used securi