Pecking order of convertible security financing for start-up ventures and overinvestment

Abstract

This study develops a parsimonious theoretical model to investigate the pecking order in financing for start-up ventures, especially with convertible securities, under adverse selection where a firm’s investment possibly has a negative value. While the role of convertible securities is limited and the cross-subsidy enables inefficient business in the competitive market, the signaling in relationship financing prevents inefficient investment and convertible securities are useful in situations with more volatile cash flow distributions. Considering the interrelation between competitive markets and relationship financing without investors’ monopolistic positions, signaling with convertible securities from profitable firms is likely to occur when market conditions are uncertain or the economy is stagnant, thereby possibly explaining boom and bust.