The risk-adjusted performance of convertible venture contracts

Abstract

We obtain additional insights on the risk-adjusted performance of convertible equity contracts widely used in the U.S., the diversity of venture capitalists (VCs) and their risk-return positioning. Our analysis uses a double-hazard agency framework in which VCs maximize the expected utility of their return from the convertible equity contract and the resulting Sharpe ratio incorporates both risks related to venture failure and valuation at exit. Theoretical results show that the convertible contract exhibits greater alignment with important venture characteristics relative to the pure-equity contract and provides a larger equity share to the entrepreneur as failure risk, VC productivity and development horizon increase, and when growth prospects and entrepreneur's productivity decrease. As failure risk goes to zero, it converges to the pure-equity contract. Our results further show that VCs with heterogeneous funding capacities and productivities can coexist in the venture finance market as they experience similar risk-adjusted returns. VCs with greater funding capacity can generate a competitive advantage by investing at later stages, which results in a higher Sharpe ratio and expected return from the convertible investment.