Profit Sharing and Debt Contracts in Presence of Moral Hazard

This paper compares profit sharing and debt contracts in presence of moral hazard. Its originality relatively to the existing studies consists in performing the comparison between the two contracts in a more general context. Firstly, the internal funds of the agent (entrepreneur) are enabled to vary between 0% and 99%. Secondly, an incentive mechanism is incorporated to the sharing contract in the context of a two-period relationship. Both contracts are shown to be feasible for sufficiently high internal funds of the entrepreneur. The debt contract is shown to be characterized by larger financial access than the profit sharing contract. In addition, the extension of the financial-relationship to two periods reduces moral hazard and enhances financial access for both contracts, in case of sufficiently foresighted agent and fulfillment of two distinct conditions. For the sharing contract, the additional condition stated an upper bound on the size of the project. For the debt contract, the condition is related to the threat of non-renewal of the financing in case of first-period failure. It is interestingly shown that a more restrictive threat of financing non-renewal improves financial access but lowers the second-period investment. Finally, the paper suggests policy recommendations to enhance financial access without impeding investment through taxation and subsidizing policies.