Agency Problems in Venture Capital Contracts: Islamic Profit Sharing Ratio as a Screening Device

Both Islamic and classical venture contracts suffer from information asymmetry and incentive problems. Venture capitalist and Entrepreneur have an agency relationship because of the insufficient information about the funded project and/or the entrepreneur type. Referring to the literature, this paper presents a theory of Profit Sharing Ratio (PSR) for PLS contracts with adverse selection about the entrepreneur type. In order to avoid the agency problem, this paper proposes a theoretical framework in which the negotiated profit sharing ratio (PSR) acts as a screening device. We show that agency problems are signaled when the entrepreneur accepts a PSR set beyond a given threshold. This critical value of the PSR corresponds to the maximum payoff to the venture capitalist. We suggest that the optimal PSR level may complete the carried interest in classical venture contracts and offers a new tool for screening entrepreneurs’ type