Nonlinear Profit-and-Loss-Sharing Contracting versus Equity in Entrepreneurial Finance: Risk Sharing and Managerial Incentives in a Principal-Agent Relationship When the Agent Is Risk-Neutral

An entrepreneur raises capital to finance their business and extends the effort to facilitate its success. If financing is possible solely with risk-free debt capital, the entrepreneur’s effort will be first-best since they will not share the outcome of their business with an outside financier. However, risk-free debt is usually unavailable due to the significant risk involved in starting any business. Therefore, other financing arrangements involving risk sharing have to be considered. Such arrangements will result in a moral hazard problem and dilute the entrepreneur's managerial incentives to exert effort. Financing with equity capital from an outside partner will result in a second-best level of effort, and there will be no advantage from risk sharing if the entrepreneur is risk-neutral. Since risk-free debt financing is not always possible and financing with equity capital is not optimal for a risk-neutral entrepreneur, a third alternative is considered in this paper. It is shown that a nonlinear profit-and-loss-sharing arrangement can be structured so that the incentives of the risk-neutral entrepreneur to extend effort are not diminished. As such, the nonlinear PLS contract considered in this paper, which is based on Islamic profit-and-loss-sharing contracts, is a feasible alternative to risk-free debt financing.