Convertible Securities and Venture Capital Finance

This paper offers a new explanation for the prevalent use of convertible securities in venture
capital finance. Convertible securities can be used to endogenously allocate cash flow rights
as a function of the realized quality of the project. This property can be used to mitigate the
double moral hazard problem be t ween the entrepreneur and the venture capitalist. It is
shown that an optimally designed convertible security outperforms any mixture of debt and
equity and that it can induce both parties to invest efficiently. The result is robust to
renegotiation and t o changes in the timing of investments and information flows.