IPOs, Acquisitions and the Use of Convertible Securities in Venture Capital

This paper provides a new explanation for the use of convertible preferred equity in venture capital. It explains that the key feature of the convertible security is to create different cash flow rights for acquisitions and IPOs. It shows how the convertible security implements an optimal trade-off between the need to allocate cash flows to the venture capitalist and the desire to make efficient exit decisions. This approach also explains some puzzling contract features, such as automatic conversion in case of an IPO, or the use of participating preferred equity, where conversion never benefits the investors. ∗For correspondence please use: Thomas Hellmann, Graduate School of Business, Stanford University, Stanford, CA 94305-5015; Email: [email protected]; Tel: (650) 7236815; Fax: (650) 725-9932. The latest version of this paper can always be downloaded from: www.stanford.edu/ ̃hellmann. †I would like to thank Marco Da Rin, Peter DeMarzo, Manju Puri, Klaus Schmidt and seminar participants at Berkeley, London School of Economics, Stanford University, Universitat Pompeu Fabra and Yale University for their valuable comments. All errors are mine.