Second Round Financing for Start-ups with Convertible Notes Under Asymmetric Information: A Real Options Approach

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Convertible notes are commonly used in start-ups financing. Focusing on the relationship between two different types of investors, a second-round equity investor and a first-round convertible note holder, this paper simulates how the value of option to convert of the convertible note holder can be affected by the trustworthiness of the second-round equity investor to the entrepreneur’s ability to procure funds and to increase firm’s value in each financing round. The result of a real case simulation with a real options approach suggests, firstly, that the improvement of the investor’s trustworthiness to the entrepreneur’s ability has a great impact on the amount that the entrepreneur should offer and procure when the second-round equity investors are quite doubtful about the entrepreneur’s ability and the convertible notes are chosen more preferably than equity. Secondly, the preference of convertible notes over equity becomes less strong when the investor’s trustworthiness to the entrepreneur’s ability is improved, especially in the lower range of trustworthiness.

Author(s):

Yasuharu Imai    
IAE de Caen, University of Caen Normandy
France