Convertible securities and optimal exit decisions in venture capital finance

We study the interaction between exit decisions and contract design in venture capital finance. One of the main characteristics of venture capital funds is that they need to divest their holdings in the portfolio firms after a limited period of time. However, venture capitalists and entrepreneurs often have diverging interests with respect to different exit solutions (e.g., IPOs or trade sales). We show that with convertible securities, the ex-ante agreed optimal exit policy can be implemented. Thereby, we give an explanation for the widespread use of convertible securities in venture capital finance. (C) 2001 Elsevier Science B.V. All rights reserved.