This paper presents a theory for Islamic venture capital namely ‘Mudharabah’
contract under adverse selection problem. In order to avoid selecting a low type entrepreneur for a given good project, the framework defines the profit sharing ratio (PSR) as a screening
device. We then develop a Profit Sharing Ratio model for Islamic venture capital under adverse selection. We find the optimal PSR as function of the respective risk aversion degree
of both the entrepreneur and the IVC (Islamic venture capitalist). Their risk aversion degrees
influence their decisions to fix the PSR during the negotiation stage. We show that the high type entrepreneur will tolerate to the IVC a PSR higher than the PSR accepted by the low
type. In the negotiation stage, whatever the entrepreneur type, the higher the management fee and the higher the PSR tolerated to the IVC.
