The Research On The Application Of Convertible Securities In The Venture Capital Industry

The paper first presents classical research literature regarding the application of convertible securities in venture capital industry. Basically, the papers discuss the incentive mechanism, allocation of control right and cash flow right, staged financing, optimal stake percentage, etc. Meanwhile, a number of empirical studies demonstrate the wide use of convertible securities in the venture capital industry. Most of the researches agree that convertible securities played a positive role in venture capital financing, especially under the circumstances of information asymmetry and great uncertainty of the venture firms.In most of the cases, venture capital fund is organized in the form of limited partnership, which generally includes two kinds of partners: limited partner and general partner. Limited partners are the main fund contributors and only have limited liability. General partners run the fund but have unlimited liability. From June 1st 2007 the new Partnership Enterprises Law took effective in china, and for the first time in history recognizes the legality of limited partnership organizations in China.Then the paper examines the staged financing in venture capital industry. Because of the high uncertainty, usually, venture capitalists applied staged financing strategy to control risk. This paper will establish a two-stage financing model and compare the efforts spend by entrepreneurs in staged financing and one-time financing situation. Our model clearly demonstrates, staged financing will provide incentive to entrepreneurs to spend more efforts on the firm.The core part of this paper is the model in chapter 3, which is an extension of Hellmann (2006) double moral hazard model, where both entrepreneurs and venture capitalists provide value-adding effort, and include an auto-conversion convertible securities. Venture capitalists will choose the exit between an acquisition and an IPO. The model explains how the convertible securities solve the incentive problems in venture firms, how venture firms make the exit decision, and a brief discussion of auto-conversion provisions. This paper also includes 2 case studies, which are Little Sheep and Jiangxi LDK, to explore more areas for further research from practical cases. The paper studies the contract provisions between the entrepreneurs and venture capitalists for these two companies. The paper found that there are some provisions might worth further studying, includes: IPO deadline provision, interest/dividend payout provision, qualified IPO provision, conversion ratio adjustment provision, among which IPO deadline provision provides venture capitalists compensation if the venture firms fail to complete the IPO before the stated deadline, interest/dividend payout provision controls the dividend payout to ordinary shareholders, qualified IPO provisions define the required IPO per share price and market value etc, and conversion ratio adjustment provision provide incentives to entrepreneurs to meet certain profitability goal by offering favorable conversion ratio.The conclusion of this paper reiterates that, convertible securities could mitigate moral hazard of the agency problem in venture capital industry and provide optimal financing solution. The research of the paper provides strong theoretical framework for further empirical research. As to the launch of growth enterprise market in China and development of venture capitals in China, this paper suggests formulating policies to approve the issuance of convertible securities and preferred stock in China. Currently, the reform of the venture capital industry still focuses on systematic structure; however, the availability of different financing products is also imperatively demanded.