The optimal financing strategy of a high-tech firm: The role of warrants

The paper presents a signalling model in three periods where bad (firms in high-tech sectors with no intermediate results and risky projects), medium (firms in high-tech sectors with less risky projects and intermediate results) and good firms (firms in traditional sectors with safe projects) choose among five potential financing strategies (straight bond, bond-plus-equity warrant, convertible, straight equity, short-term bond in t(0) and equity in t(2), venture capital). It shows that a bond-plus-equity warrant (BW) issue is the optimal strategy ensuring a separating equilibrium between medium firms and other types of firms. It also shows that departures from basic model assumptions, such as lower expected value of the innovation and exposure to non-diversifiable risk, may lead to a pooling equilibrium with adverse selection effects for high-tech firms and explains how these negative consequences may be avoided. The empirical part of the paper confirms the insights of the theoretical model showing that the ranking of firm types in terms of cumulative average abnormal returns after the issue is respected for BW issuers and straight bond issuers. Published by Elsevier Science B.V.