Stage Financing and the Role of Convertible Debt

Venture capital financing is characterized by extensive use of convertible debt and stage financing. The paper shows 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, i.e. to bias positively the short-term performance of the project, in order to reduce the probability that the project will be liquidated. With a convertible debt contract, such behaviour reduces the likelihood of liquidation, but increases the probability that the venture capitalist will convert debt into equity, reducing the entrepreneur’s profits. With convertible debt, therefore, the entrepreneur will not engage in as much short-term behaviour in terms of signal manipulation in comparison to a situation where only straight debt-equity financing is used.