Stage financing and the role of convertible securities

Venture capital ficing is characterized by extensive use of convertible securities and stage ficing. In a model where an entrepreneur obtains funding for a project from a venture capitalist, we illustrate an advantage of convertible debt over a mixture of debt and equity in stage ficing situations. 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 shortterm performance of the project, reducing the probability that it will be liquidated. An appropriately designed convertible debt contract prevents such shorttermistic behavior since window dressing also increases the probability that the venture capitalist will convert debt into equity