On the Popularity of and a Comparison of Convertible Preferred and Participating Preferred Equities in Venture Financing

In this paper, we focus on two unique information/incentive problems in venture financing: the difficulty of screening out bad ventures before they are funded and venture capitalists' effort problem in helping new ventures to succeed. Five commonly used financing methods are analyzed in terms of their effectiveness in dealing with these two problems. We show that convertible preferred and participating preferred equities generally dominate any combination of preferred and common equities. That is because their optional and automatic (forced) conversion features essentially make contracts contingent on the quality (type) of ventures and allows them to solve the two problems simultaneously. When the venture is bad, these two securities retain liquidation preferences and extract much of the liquidation value. When the venture is good, they are converted into common equity. The optional conversion feature provides venture capitalists with incentives and the automatic (forced) conversion feature gives the key employees of good ventures needed compensation. Unlike most theories in the literature, we also compare the use of convertible preferred and participating preferred. We predict that participating preferred will be used when the liquidation value of the bad venture is relatively high