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<p style="text-align: justify;">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&rsquo;s effort will be first-best since&nbsp;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&nbsp;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&nbsp;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.</p>

NCAF.2025.13.02.pdf

Original Research 

NCAF.2025.13.02.xml

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