Profit ratio Negotiability model in Entrepreneurial Financing Using Game Theory and Agent Based Simulation as an Aid to Decision Making

Profit and Loss (PLS) sharing contracts in Islamic finance are considered to be fair economic practices as they focus on sharing profits and losses between the project’s participants. This mode, however, suffers from asymmetric information in the form of moral hazards and adverse selection. The purpose of this paper is to reduce moral hazards by developing an equilibrium profit sharing ratio’s span of negotiation in a PLS contract involving a financier and a entrepreneur. We aim to establish an agent based model that will help the financier decide whether to accept financing a contract. We make use of game theory techniques and we test our results using an agent based simulation tool (Netlogo). We found theoretical evidence that a Nash equilibrium span of negotiation, for both profit sharing ratios, can be developed which is both rational and incentive compatible to both participants. However, the simulation tool suggests that despite the existence of an average positive span of negotiaton , financial contracts might not be extendes if the number of void contracts in a simulation exceeds a specefied threshold. The usefulness of the agent based simulation tool has added value to our theoretical finding by suggesting when PLS contracts can or con’t be signed

Adverse selection and moral hazards reduction in corporate financing: A mechanism design model for PLS contracts

In this paper , we apply game theory to corporate financing using profit and loss sharing (PLS) contracts. We employ mechanism design theory using two agents, a bank and a corporation which seeks financing through PLS mode. We seek to find the usefulness of mechanism design in helping the bank separating low type from high type corporations by designing two bundles of contract with each contract directed in a compatible way towards the appropriate type of corporation. We found theoretical as well as simulation evidence that our model helps in minimizing asymmetric information in the form of adverse selection by forcing the corporation to reveal its type. The model also helps in reducing asymmetric information in the form of moral hazards. This is achieved by having the selected high type corporation select a high type contract using a moral hazard premium as an incentive

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

Does Empathy Matter in Entrepreneurial Financing? A Dynamic Game Theoretic Mode (abstract only)

This paper tries to reduce moral hazards in an entrepreneur-Angel financing relationship. This relationship is usually characterized by mutual empathy as opposed to it being absent in a VC relationship. We seek to identify optimal payments to an entrepreneur under effort shirking in a contract where terms of payments are set at the beginning of the project. We use multi-period game theoretic approach and compare the results under VC and angel financing. The study founds similar insights to VC financing where optimal contracts lies in back loading the payments to the entrepreneur. However, if mutual empathy exists, then the preference to back-load payments is lessened. Another distinguishing feature under angel, as opposed to Vc financing, is that increased mutual empathy induces the entrepreneur to be less concerned about the back-loading of payments. This leads to the conclusion that, due to empathy, the entrepreneur becomes more patient in receiving compensations. We also found that mutual empathy leads to higher effort excreted by the entrepreneur under angel financing than under Vc financing. Another finding is that mutual empathy leads to the entrepreneur being less sensitive to changes in payments as compared to Vc financing. The findings shed lights on the importance of investing in developing a mutual empathetic relationship in entrepreneurial financing. The fact that the entrepreneur is less sensitive to payments changes, under an empathetic relation, gives the financier an opportunity for cost savings. The fact that the entrepreneur is less sensitive to payments timing gives the financier the opportunity to even backload the payments and extend the exit stage

A hybrid profit and loss sharing model using interest free debt and equity financing : an application of game theory as a decision tool

In this paper two models are contrasted whereby a corporation is seeking to finance the purchase of a merchandise from a supplier through a profit and loss sharing contract. The first mode consist of financing the purchase totally through equity. The second model is a new hybrid model that engages the supplier in the process as a shareholder. Both models are based on the principle of profit and loss sharing which suffers from the issue of moral hazard. This is manifestedin the form of the corporation shirking (providing low effort) and/or misreporting profits. It is argued that under equity financing, where the financier is the only shareholder, the corporation can hide part of the merchandise it sold and therefore misreport profits. This is, however, not possible under hybrid financing where, in addition to the financier, the supplier is interested in the financial reporting of the corporation. We apply a game theoretical approach where, under a hybrid financing, the financier and the supplier have mutual interest in true revenue reporting and therefore constitute a coalition (one player) against the corporation. Our game incorporates the effect of sharing markets and corporations’ discounts between the game participants under each model. We show theoretically that a non-conditional good Nash equilibrium exists under hybrid financing. This case does not apply to an all equity financing where the existence of a good Nash equilibrium is conditional upon the financier and the supplier sharing ratios. This shows that under the hybrid model the corporation is always induced to provide more effort (not shirk) and truly report profits

Entrepreneurial financing under uncertainty : Performance comparison between ROMCA and conventional microloans using agent based simulation

In this research we create a complex simulation environment where we compare the performance of two micro-financing modes in a group lending context under uncertain market and price conditions : A classical conventional mode and a proposed Profit and loss sharing model called ROMCA (Rotating Musharakah). Both models are based on group lending of entrepreneurs over a specified period. We identify four cases of market and price conditions and use Netlogo as a simulation tool to assess the performance of the two modes in terms of employment , enterprises , investment , tax proceeds and wealth creation. We found a simulation evidence that ROMCA performs better than conventional lending in terms of creating wealth, new enterprise (and therefore new employment opportunities) and better consumption level even under adverse market conditions. On the other hand, Conventional lending is found to dominate ROMCA in terms of employment under favorable market conditio

A multiagent game theoretical approach to adverse selection in corporate financing

In this research the authors tried to solve the adverse selection problem in the Mudaraba contracts with respect to the projects privately known prospects. The authors introduced a model of two contracts characterized by an adverse selection index for each contract. They have managed to find that a case of market breakdown can occur because the efficient agent might mimic the inefficient agent. The authors, then, managed to develop a ‘Mimicking Likelihood Index’ whereby one can infer whether a type of an agent has a tendency to mimic the other type. In the same context, the authors developed a “Relative Adverse Selection” index to measure which type of agents has more tendencies to select a specific type of contracts. These findings should help Islamic financial institutions in their agent selection process and hedge its risky Mudaraba contract

Can Real Options Reduce Moral hazards in Profit and Loss sharing contracts?: A Behavioural Approach Using Game Theory and Agent Based Simulation (Abstract only)

Agency problems between corporate managers and financiers/banks are common issues in corporate governance literature. In this paper we try to reduce the moral hazards problem of corporate managers’ profit misreporting as an agency problem in Profit and loss sharing contracts (PLS). To minimize this risk, we propose that the financier/bank sell a real option to the corporate manager giving her the right to gradually own the corporation. Since the share of the financier diminishes periodically we refer to this mode as diminishing PLS. We use a repeated game theoretical approach by combining diminishing PLS with real options. To test our model, we code a program in Netlogo to create an agent-based simulation environment where we compare case of diminishing PLS with real options and the case without. We found evidence that under real options cooperation can be sustained by having Managers not misreporting profits. On the other hand, defection occurs under no real option. We also found that there exists a higher social value under real options than under the case without. To promote this case of high social value, it is necessary to provide the manager with a specified monetary incentive. This model is of practical use as it allows for the calculation of the real option premium and the monetary incentive to sustain true profit reporting. Practicality: • This model is of practical use as it allows for the calculation of the real option premium and the monetary incentive necessary to sustain true profit reporting. • This Model can be used as a decision tool to monitor profit misreporting behaviour for institutions engaged or willing to engage in PLS contracts. • This Project was partially funded by the IDB development Bank and supported its paracticality. Contribution/originality • No previous model has combined real options with PLS contract and agent-based simulation

A development bank choice of private equity partner: A behavioural game theoretic approach

We develop a formal game-theoretic analysis of the economic (value-adding abilities) and behavioural factors (empathy, emotional excitement, passion) affecting a development bank’s choice of private-equity partner when investing into emerging market entrepreneurship. Triple-sided moral hazard (TSMH) problems occur in the form of effort-shirking, since the bank, the PE-manager, and the entrepreneur all contribute to value-creation. The bank’s investment choices are crucially affected by a) the relative abilities and the potential level of empathy, excitement and passion that may be generated between a PE-manager and an entrepreneur, and b) the personal emotional attachment that the bank develops towards a PE. The severity of TSMH increases inefficiencies in decision-making. Finally, we consider, in addition to political risk mitigation, an additional impact that the bank may have on PE/E value-creation: the bank may have a coaching/mentoring role. Our analysis has implications for academics and practitioners alike

Moral Hazard Reduction in Entrepreneurial Financing An application to Profit and Loss Sharing Contracts

In profit and loss sharing contracts, profits are shared according to a specific ratio while losses are shared according to each partner contribution ration in the project’s capital. We aim to reduce entrepreneurial effort shirking in a profit and loss sharing contract involving a VC and an entrepreneur. We use a game theoretic approach and try to find the profit-sharing ratio that would reduce the moral hazard risk of effort shirking. The game theoretic approach allows for the development of a profit-sharing ratio span of negotiation that fulfil both the incentive and participative constraints of the PLS participant