Edited by M. Kabir Hassan
Chapter 25: Profit- sharing ratio as a screening device in venture capital
Both Islamic and conventional venture contracts suffer from information asymmetry and incentive problems. The venture capitalist and the manager have an agency relationship because of the insufficient information about the financed investment and/or the manager type. This chapter presents a literature review of agency problems in venture contracts and proposes a theory of profit sharing ratio (PSR) with information asymmetry about the manager type. In order to avoid the adverse selection, the negotiated PSR acts as a screening device in this theoretical framework. We show that adverse selection is signalled when the manager accepts a PSR set beyond a given critical value. This threshold of the PSR corresponds to the maximum payoff to the venture capitalist. Likewise, the negotiation of the PSR offers a new tool for the screening managers’ type. We suggest that the PSR level may complete the carried interest in conventional venture contracts.
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