Security Design with Status Concerns

Abstract

This paper provides a status-based explanation for convertible securities. We consider a dynamic setting in which a status-driven entrepreneur with a project idea decides what security to issue to finance the project and how to manage the project over time. We solve the problem analytically and find that the optimal security is considerably similar to a convertible security. Our model can also explain why relatively riskier companies, such as start-ups or small firms, resort to convertible securities more often, as well as why these securities differ in their conversion ratios. The dynamic nature of our model is key to our results whereas asymmetric information and ensuing agency conflicts play no role, which makes our explanation of convertible securities notably different from existing ones.JEL Classifications: G32, C61, G24, D86.