Contingent Profit and Loss Sharing (C-Pls) Contracts

This paper analyses the feasibility of profit and loss sharing (PLS) contracts in presence of moral hazard between the principal (financier) and the agent (entrepreneur). It shows that introducing a rule for sharing profits and losses in contingence with the outcome of the entrepreneur’s project enlarges the feasibility region of the PLS contracts by enabling more entrepreneurs to access external financing. More specifically, in the contingent profit and loss sharing contract (C-PLS) losses are shared according to the capital participation of each party. But, in case of success, the entrepreneur receives a higher share of the profit which is endogenously determined according to the opportunity cost of capital of the financier (risk-free rate of return) and the characteristics of the project. It is also interestingly shown that having two subsequent C-PLS contracts where the second-period expected profit of the entrepreneur is positively correlated to the first-period probability of success, has an even more incentive effect when the entrepreneur is sufficiently fore-sighted and the size of the project inferior to a determined threshold. Finally, the developed framework sets the rationale for a list of policy recommendations to enhance the use of the C-PLS contracts.