the debt is converted into equity, so that the venture capitalist’s claim becomes
a combination of debt D1 and an equity stake s in Firm 1. From Proposition
3 it follows that this is equivalent to paying the entrepreneur Rb in case of
failure and RH in case of success, with RL and RH defined as in Lemma 4. ■
In the basic model of section 4, we showed that holding debt plus an equity
stake in Firm 1 makes the investor less eager to fund Firm 2. Using a standard
debt contract would have instead provided maximal incentives to Firm 1’s
entrepreneur, but left room for the venture capitalist’s Coase problem. So,
the Coase problem had to be solved through equity at the cost of a lower
managerial effort.
When there is a verifiable signal about the likelihood of the Coase problem
arising, debt converting automatically on realization of the signal does better
than a simple equity claim or straight debt in dealing with this trade-off.29 It
gives the venture capitalist an equity claim and thus prevents him from funding
Firm 2 only when this temptation arises, that is, only after a good signal about
Firm 2’s profitability is observed. After a bad signal is observed, the Coase
problem is not an issue. Therefore, in that contingency it is preferable for the
venture capitalist to hold a debt claim to maximize entrepreneurial incentives.
Notice, however, that conditional on having observed the good signal, the
venture capitalist may not want to convert his debt into equity. It may be more
profitable for him to keep his relatively safe debt in the first firm, and instead
make a profit from funding the second firm. Of course, ex ante, the venture
capitalist would like to commit himself to solving the Coase problem when it
arises in order to extract better terms from Firm 1; but ex post, having signed
the contract with Firm 1, this consideration is no longer important. This is
why it must be agreed in advance that conversion will take place automatically
upon observation of the signal. If conversion is left to the venture capitalist’s
discretion ex post, this entails an extra incentive compatibility constraint for
the venture capitalist, which may not be met, so that voluntarily convertible
debt will not solve the overfunding problem. In this result, we make a signif-
icant advance over the previous literature, which has seen convertible debt as
designed to motivate entrepreneurs, and has thus been unable to differentiate
between automatic and voluntary conversion agreements.
29In this we differ from Gompers (1996) and Biais-Casamatta (1999). Because these
papers take an essentially static approach, convertible debt is equivalent to debt plus equity,
and it is not clear why the former should be preferred to the latter.
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