Stage financing and the role of convertible securities

Venture capital financing is characterized by extensive use of convertible securities and stage financing. In a model where a venture capitalist provides staged financing for a project, we illustrate an advantage of convertible debt (or warrants) over a mixture of debt and equity. Essentially, when the venture capitalist retains the option to abandon the project, the entrepreneur has an incentive to engage in window dressing and bias positively the short-term performance of the project, reducing the probability that it will be liquidated. An appropriately designed convertible security prevents such behaviour because window dressing also increases the probability that the venture capitalist will exercise the conversion option becoming the owner of a substantial fraction of the project's equity.