Introduction to Corporate Finance

20: Entrepreneurial Finance and Venture Capital

20-3c WHY VENTURE CAPITALISTS AND PRIVATE EQUITY

MANAGERS USE CONVERTIBLE SECURITIES

Most people assume that when VCs invest in a company, they receive shares of ordinary shares in

exchange for their capital. In fact, US venture capitalists almost always receive some type of convertible

security instead – either convertible debt or, more frequently, convertible preferred shares. There are

several reasons for this marked preference. First, venture capitalists could exercise effective voting control

with ordinary shares only if they purchased a majority of the company’s ordinary shares, which would be

extremely expensive and would place far more of the company’s business risk on the venture group than

on the entrepreneur. Because convertible debt or preferred shares is a distinct security class, contract

terms and covenants specific to that issue are negotiable, whereas all ordinary shareholders must be

given the same per-share voting and control rights. Furthermore, because companies can create multiple

classes of convertible debt or preferred shares, they can use these securities to construct extremely

complex and sophisticated contracting arrangements with different investor groups.

Seniority offers a second reason why venture capitalists generally demand convertible debt or preferred

shares rather than ordinary shares: it places the VC ahead of the entrepreneur in the line of claimants on

the company’s assets should the company not succeed. However, preferred shares or subordinated debt

leaves the company the option to issue more senior debt, thereby preserving its borrowing capacity and

making it easier for the company to arrange trade credit or bank loans. The convertible securities held

by VCs typically pay a low dividend, suggesting that VCs use these securities for control rather than to

generate steady cash flows.

LO20.3

seniority

This refers to the order in

which repayments must

be made to investors, in

the event of loan defaults,

liquidations, bankruptcy or

similar negative events. In

general, bondholders (or debt

investors) must be repaid

before equity investors;

senior debt must be repaid

before subordinated debt

and preferred equity must be

repaid before ordinary equity.

This is why equity investment

is considered much riskier

than debt investment

FIGURE 20.3 US RETURNS TO VENTURE CAPITAL INVESTING VS. US PUBLIC MARKETS

This figure details US five-year rolling average annual returns at 31 December 2008.

1990

–10

0

10

Return (%) 20

30

40

50

60

1991 1992 1993 1994 1995 1996

Venture capital S&P 500 NASDAQ

(^199719981999200020012002200320042005200620072008)
Note: The returns on venture capital investments tend to outperform investments in listed shares, according to industry sources.
Source: National Venture Capital Association Yearbook 2009, National Venture Capital Association.