Two-sided asymmetric information and convertible securities in venture financing

Abstract

This paper presents a new explanation for the prevalence of convertible securities in venture capital finance. Modeling two-sided asymmetric information between an entrepreneur and a venture capitalist, we demonstrate that convertible securities can result in the optimal contract. Our theoretical findings also provide some testable predictions. Specifically, the optimal conversion ratio rises when the information asymmetry problem worsens. We also reveal that the conversion ratio becomes smaller during economic booms since the adverse selection problem is less relevant.