Access to Finance and Investment: Does Profit Sharing Dominate Debt?

This paper compares sharing (equity) and debt contracts in presence of moral hazard which manifests as the hidden effort undertaken by the entrepreneur. The originality of this paper relatively to the existing studies consists in performing the comparison between the two types of contracts while considering a more general context along two dimensions. The first dimension is enabling the internal funds of the entrepreneur to vary between 0% and a level just inferior to 100%. The second dimension is the incorporation of an incentive mechanism to the sharing contract in the context of a two‐period relationship. I showed that the sharing and debt contracts are feasible when the internal funds of the entrepreneur are superior to determined thresholds. These thresholds depend on the characteristics of the project (size, payoffs, and probability of success/failure) and the opportunity cost of the financier. The debt contract is shown to be characterized by larger financial access than the sharing contract. I have also shown that the enlargement of the financial‐relationship to two periods has an incentivizing effect on the entrepreneur and enlarges the region of financial access for the two types of contracts, if a common condition of sufficiently foresighted entrepreneur is satisfied. However, two distinct conditions are also necessary for the enlargement of the financial access to occur. For the sharing contract, the second condition is related to the size of the project which should be inferior to a determined threshold. For the debt contract, the second condition is related to the threat of non‐renewal of the financing in case of first‐period failure, which should be sufficiently stringent. In addition, it has been shown that the more restrictive the threat of non‐renewal the larger the region of financial access. However, this is realized at the expense of the second period investment which decreases, and represents the economic efficiency’ effect of the debt contract. Finally, I discussed the effect on the financial access of taxing the “risk‐free” financial operation and subsidizing the “higher effort” of the insufficiently‐capitalized entrepreneurs.