Two-Sided Asymmetric Information and Convertible Securities in Venture Financing

This paper presents a new explanation for the prevalence of convertible security in venture capital finance. By modeling two-sided asymmetric information between entrepreneur and venture capitalist, we prove that convertible security can implement the optimal contract. Comparative statics shows that the optimal conversion ratio increases when the difficulty of attracting a venture capitalist increases, or when the adverse selection problem in the venture capital financing market worsens