Profit and loss Sharing Negotiations involving a VC and an entrepreneur: A Game Theoretic Approach with Agent Based Simulation [abstract only]

Profit and Loss Sharing contracts (PLS) are forms of financing where profits are shared according to a predetermined ratio and losses are shared according to each participant’s ratio in the project’s capital. We try to reduce moral hazards by solving for an optimal profit sharing ratio that inhibits the entrepreneur from exerting a lower managerial effort. We follow a game theoretical approach under observable and unobservable entrepreneurial effort. We found theoretical evidence, on one hand, that a specific profit sharing ratio can be developed under observable effort. On the other hand, due to asymmetric information under the unobservable efforts case, a profit sharing span of negotiation was developed. This span of negotiation satisfies the participation and the incentive constraints of the game participants. Within this span of negotiation, we propose a model that helps in identifying an optimum profit sharing ratio based on the participants’ bargaining power. Due to the stochastic nature of the model parameters, we develop a simulation of the game in an agent based platform using Netlogo. Besides serving as a quick tool for numerical calculations and analysis, this platform serves as a decision tool for the VC to decide whether or not to extend the funding contract to the entrepreneur.