A Theory of Profit Sharing Ratio Under Adverse Selection: The Case of Islamic Venture Capital

This paper presents a theory for Islamic venture capital namely ‘Mudharabah’ contract under adverse selection problem. In order to avoid selecting a low type entrepreneur for a given good project, the framework defines the profit sharing ratio (PSR) as a screening device. We then develop a Profit Sharing Ratio model for Islamic venture capital under adverse selection. We find the optimal PSR as function of the respective risk aversion degree of both the entrepreneur and the IVC (Islamic venture capitalist). Their risk aversion degrees influence their decisions to fix the PSR during the negotiation stage. We show that the high type entrepreneur will tolerate to the IVC a PSR higher than the PSR accepted by the low type. In the negotiation stage, whatever the entrepreneur type, the higher the management fee and the higher the PSR tolerated to the IVC.