Venture Capital

Venture capital (VC) companies and funding mechanism have much similarity to Mudarabah and Musharakah Islamic investment contracts offered through Islamic banks. Both VC and Islamic banks generate business through profit and loss sharing (PLS) schemes. Venture capital companies pool capital resources from investors and find high growth investment opportunities. VC is highly beneficial form of investing as it allows small and medium sized companies to obtain financing for high risk and high return projects where normal funding options are not accessible.

The similarity between VC companies and Islamic banks start with the mobilization of funds through PLS or Mudarabah based on an agreed ratio. VC companies or Islamic banks would keep certain percentage of the profits while transferring the rest to the investors. For investments, VC companies or Islamic banks play the role of Mudarib or agent and invest the funds in growth opportunities. If the business loses money, the VC company or the Islamic bank along with the investor suffers the loss of capital while the business owner loses the fruit of this labor. There is a difference between this scheme and the operations of a conventional bank. The bank issues loans to a business and charges a fixed interest and pass on a lower interest to the depositor for using their money. Where VC companies and Islamic banks share in the risks of the business, conventional bank makes profit out of difference in interest rates between the business and depositor.

Even though Mudarabah and Musharakah have been the recommended modes of finance for Islamic banks, this has not been realized. For Islamic VC to succeed, these modes of financing require more development, innovation, marketing and implementation plans. The banks have had to compete with traditional banks for the mobilization of deposits. Most investors are risk averse and do not like the idea of risking their capital. Consequently, the banks have resorted to less riskier Murabaha (cost-plus profit) or Ijarah (leasing) type arrangements. These modes of financing are different than VC. They are acceptable for short term deposits or as an alternative to a traditional bank account.

VC is a healthier strategy and closer to Islamic form of investing. Islam promotes trade and risk taking, which is at the heart of VC investing. There is tremendous scope for development of VC in developing Islamic world. VC encourages entrepreneurship, creates job, increases tax revenue, and helps in development of high technology. These are essential ingredients of a growing economy. Supporting small and medium sized enterprises through VC promotes economic development and wider distribution of wealth. Only condition for Islamic VC is Shari’ah compliance, avoiding prohibited business and interest based financing. Aggressive promotion of VC in the Islamic countries could help them master certain technologies and be recognized in the world for their expertise. This could also help them become developer of technology instead is mere importers, which is the situation today.

Basic venture capital concept of investing in business and sharing profit and loss is in line with Islamic principles. But since modern VC has mostly evolved in the West, its structures require evaluation and comparison against established Islamic mode of financing. Conversely, Islamic structure also require innovation to meet the requirements of VC investing. Basic structures of profit and loss sharing (PLS) in the form of Mudarabah and Musharakah are quite adaptable for Islamic VC. Some VC structures though are not acceptable in Shari’ah. These relate to preferred stock and debt like instruments. Guaranteed return is prohibited in Islam. A preferred stock could only have a pre-determined profit ratio but no preference for liquidity or accumulation of profits.

Mudarabah is the most applicable and acceptable structure for Islamic VC. The bank pools the capital resources from investors and funds business ventures based on a set profit ratio. The bank would keep certain portion of the profit for itself while passing on the rest to the investors in an agreed ratio. In case of loss the bank and its investor will suffer losses and the entrepreneur will lose his/her efforts. Another structure that is conducive to VC is Musharakah. In this case all partners invest in the venture and share the profits or losses. The agreement on distribution of profits between venture investors the entrepreneur will have to clearly outlined to avoid undue uncertainty.

Though Mudarabah is well suited for Islamic VC, most bank depositors are not willing to take the risk of loss. Hence most Islamic bank investments tend to be lower risk and set return structures of Murabaha, Ijarah, Istisna’a and other deb-like instruments. Mudarabah requires transparency of information and utmost trust between the investors and business operators. Musharakah resolves this problem by allowing the investors to engage in the management of their investment. However, since the banks are investing on behalf of the investors and usually cannot afford the expertise or the resources to get involved in management of a business, they tend to waive this right. Another structure worth considering is diminishing Musharakah which allows the investment to be secured using company assets. As the company generates profits, the entrepreneur can buy back the assets from the investors.

A hybrid structure of Mudarabah combined with Wakalah where the investors authorize the bank to invest on their behalf could be valid structure for Islamic VC. Islamic contracts also require that all agreements should be upfront and cannot be changed. In case of a project not performing as planned, it becomes difficult to change the contract. For Islamic VC to succeed all scenarios have to be evaluated and put in the contract. This may cause a problem. The solution proposed is to use a combination of Mudarabah and Shirkah al-Inan where the investor and the entrepreneur can go into a partnership and keep the provision to change the business strategy to handle any accommodate any new situation.

VC companies in the developed world use discounted cash flows based on benchmark interest rates to arrive at the net present value of the proposed investment. Due to prohibition of riba there might be objections to this technique. It needs to be understood that the interest rate is only used to assign a risk factor to the investment when comparing similar projects. It is not being used to generate income which is prohibited. Beyond using interest rate benchmarks, the debate comes down to the question of applicability of Islamic modes of financing for VC. Islamic principles are flexible enough to allow any structuring as long as it does not involve riba based financing and earnings and does not involve prohibited businesses.