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Islamic finance provides two basic mechanisms for any corporate or legal entity to be adapted for raising required capital against any underlying project. One of those methods is equity financing, through the issuance of shares to public, especially by listed companies. The second method is debt financing through the issuance of bonds in the stock market or loan from banks or private investors.As far as Islam financial system is concerned, all those adapted methods of financing shall be with Shariah compliant, or at least, there are some restrictions in using the mode of financing specifically in the case of debt financing where the avoidence of riba or any other haram elements such as uncertainty (Gharar) or gambling (Maisir) shall be observed in any deal. Many scholars are of the opinion that buying, selling or holding shares is lawful given that the company’s core businesses are in line with the Islamic law.
Islamic venture capital is a type of equity financing through the use of Musharakah (Partnership). In fact, venture capital as a concept is not a new, but it had a historical track record. It can be said: “although the concept (venture capital) as such is not new, a formal market for venture capital in the U.S. started only after World War II. Venture capital institutions currently manage over $50 billions in the U.S and over $60 billions in Western Europe".
Investors involve in venture capital to finance projects, which may require a large amount of capital and, it may not be available with the project’s owner. In common practice, businesses adapt venture capitalization through financing technology based projects fully or partially.
Thus, it is strongly advisable for G2G cooperation with mutual contracts or
win-win strategy to help each other in the era of globalization. Furthermore,
some Muslim nations have enough recourses, but they are in many sectors possess
lack of skills and expert in managing projects. Mean while several other Nations
possess standard skills & resources.
Therefore, it will be of great
advantage for Muslim countries to establish mutual cooperation in tech-resources
& skill exchange deals to florish nations with mutual cooperation. For
example, The United Arab Emirates and Malaysia had built jointly a Technological
City in Dubai. We need to take the hands of each other to live in the new era of
globalization.
However, Islamic Venture Capital is operated generally based on the principles of Musharakah (Partnership or Joint venture), which is going to be illustrated further in the following sections.
Corporate Idea of Musharakah based Venture Capital
Musharakah means sharing or partnership. In the context of business and trade it refers to a joint enterprise in which all the partners share profit or loss in the joint venture. It is a contract based on mutual consent, whose validity does not depend only on conditions of a valid contract, but the parties herein shall have the legal capacity in entering in to a valid contract, with mutual consent, and shall be free from duress, fraud or misrepresentation.
Governing Principles & Terms of Reference of al-Musharakah backed Venture Capital
The governing rules & terms of reference shall be spelt out during the formation of the Musharakah contract. Thus, the principles of distribution of profit and loss, the nature of capital, management and termination of Musharakah illustrated as follows:
Distribution of Profit
The share of profit ought to be distributed in a Musharakah backed Venture Capital contract shall be transparent and agreed upon by contracting parties. If any aspect of the profit clause is not determined, then the contract is in invalid. The profit sharing ratio shall be based on actual profit accrue to the business not on how much each contributed. If the profit is distributed on capital ratio and at predetermined rate then such contract is invalid, but a question may arise as;
Does it necessary that, the ratio of profit of each partner shall correspond to the ratio of the capital invested by the partner? There are differences of opinion among Islamic jurists on the issue.
According to the Imam Malik and Imam Shafi', the contract is valid if the distribution of profit is based on the capital contribution. For instance, if “A” contributed 40% of the capital in Musharakah, he is entitled to 40% of the profit generated from such business. If he receives more or less than the ration he contributed then, the contract is invalid. However, the view of Imam Ahmad, the contract still valid even if the ratio of profit differs from the ratio of capital invested provided that the partners are mutually agreed upon.
However, Islamic Venture Capital is operated generally based on the principles of Musharakah (Partnership or Joint venture), which is going to be illustrated further in the following sections.
Corporate Idea of Musharakah based Venture Capital
Musharakah means sharing or partnership. In the context of business and trade it refers to a joint enterprise in which all the partners share profit or loss in the joint venture. It is a contract based on mutual consent, whose validity does not depend only on conditions of a valid contract, but the parties herein shall have the legal capacity in entering in to a valid contract, with mutual consent, and shall be free from duress, fraud or misrepresentation.
Governing Principles & Terms of Reference of al-Musharakah backed Venture Capital
The governing rules & terms of reference shall be spelt out during the formation of the Musharakah contract. Thus, the principles of distribution of profit and loss, the nature of capital, management and termination of Musharakah illustrated as follows:
Distribution of Profit
The share of profit ought to be distributed in a Musharakah backed Venture Capital contract shall be transparent and agreed upon by contracting parties. If any aspect of the profit clause is not determined, then the contract is in invalid. The profit sharing ratio shall be based on actual profit accrue to the business not on how much each contributed. If the profit is distributed on capital ratio and at predetermined rate then such contract is invalid, but a question may arise as;
Does it necessary that, the ratio of profit of each partner shall correspond to the ratio of the capital invested by the partner? There are differences of opinion among Islamic jurists on the issue.
According to the Imam Malik and Imam Shafi', the contract is valid if the distribution of profit is based on the capital contribution. For instance, if “A” contributed 40% of the capital in Musharakah, he is entitled to 40% of the profit generated from such business. If he receives more or less than the ration he contributed then, the contract is invalid. However, the view of Imam Ahmad, the contract still valid even if the ratio of profit differs from the ratio of capital invested provided that the partners are mutually agreed upon.
For example A may
invest 40% of the capital in the business, but the investor may receive above
60% of the profit provided that, the partners accept it. Imam Abu
Hanifah shares the same view with Imam Ahmed that, ratio of profit
to the capital contributed may differ, but with condition that, all partners are
active participants. If there is a sleeping partner in the venture, the profit
shall correspond with the ratio of the capital invested by such sleeping partner
otherwise invalid. (Taqi Usman, 2004).
Sharing in Loss
There is no disagreement among jurists in case of sharing in loss. All Muslim jurists unanimously agreed that, in case of loss, partners must share it accordingly to the amount of capital each partner has invested in to the business. This argument is based on principles of a legal maxim as follows:
“Profit is based on the agreement of the parties, but loss is always subject to the ratio of investment.”
Nature of Injected Capital
Most of the jurists are of the opinion that, the capital shall be in monetary form, but not on commodities. However, there are differences of views on the issue.
Imam Malik argued that, partners can contribute capital in a form of money since it is not a condition for the validity of a Musharakah, but it may also be permissible to invest in kind with condition that, the partners' share is subject to market price of that, commodity.
According to Imam Abu Hanifah and Imam Ahmad who disagreed while ruled out that, no contribution in kind is acceptable in a Musharakah. Their arguments are base on the following two reasons:
(i) commodities are naturally not the same, even if the same in form but differ in qualities and values, hence Musharakah is invalid if the propertties in the deal are distinguished from one another.
(ii) the share-capital redistribution cannot be possible, since commodities are subject to price fluctuations. But he agrees on commodities as capital if the commodities are dhawat-ul-amthal. A Dhawat-ul-amthal is a type of commodity, which if destroyed can be compensated by similar commodity like rice. Imam shafi is also of the same opinion that if the commodity is dhawat-ul- amthal then is acceptable on the ground that it can be mix with other commodities of the same type, but he disagreed on dhawat-ul-qeemah (commodities, which can not be compensated with similar commodities like cattle). (Taqi Usman,2004).
To conclude here that, the share capital can be in form of money or commodities, the market value of the commodities shall determine the share of the partner in the venture capital.
Management of Musharakah backed Venture Capital
In a common practice of partnership, all partners have the right to take part in the management as well as to work for it. However, there are two possibilities that, a management can be in the hand of one partner due to mutual consent of other partners. But in this case the sleeping partners will receive their profit in accordance with the ratio of the their respective invested capital. Alternatively, all partners can work as a team and each shall be treated as an agent of the other in the venture, in which all shall enjoy with equal rights in day-to-day dealing of the business.
Termination of Musharakah Backed Venture Capital Deal
Underlying circumstances where a Musharakah backed Venture capital deal may be terminated:
1. Every partner has the natural right to terminate a partnership at any time on own wish. If the contract is terminated at will, and the asset is in a form cash, then it will be distributed according to the contributed ratio of shares of each partner.
But if the asset is in form of non-liquid, then there are two options:
(a) to distribute the physical asset based on the value of that asset.
(b) incase of dispute, then the physical asset will be sold and the cash shall be distributed on contributed ratio.
2. In case one of a partner dies, the partnership shall be liquidated. However, if the legal heirs of the diceased partner accept to continue with Musharakah then is also permissible with any terms mutually agreed upon by all new partners.
3. If one of the parties becomes insane the partnership shall be terminated. But if all remaining partners agreed to continue the venture along with the shares of the insane partner the partnership can be continued and the share of prfits shall be distributed to the insane's guardian accordingly.
Those conditions are considered both express & implied terms, which shall also be stipulated in the contract at the time of its formalization (Taqi Usman, 2004). As the holy Prophet (SAW) ruled out to the effect:
“All the conditions agreed upon by the Muslims are upheld, except a condition which allows what is prohibited or prohibits what is lawful”.
Modern Operation of Musharakah Backed Venture Capital Model
In this Musharakah backed Venture Capital model, the bank identifies potential companies with approval upon due diligence.
Short listed Companies issue Musharakah preference shares to the bank at discount if the bank wants to buy the paper through Wadiah or discount sale. Incase the bank does not intend to buy the paper, the companies can sell it directly to the investors via the Musharakah deposits.
For example, the bank may require $ 70 million to finance four short and medium investments projects. Bank will issue $ 70 million worth of Musharakah shares to investors at $ 1 each. In this case the bank acts as an agent for both investors and the companies for which the bank shall hold the right to charge some fees for services rendered. If in case the project gains $ 105 million, the net asset value per unit will increase to $ 1.5. In this case investors will enjoy capital gains. However if the project fails to succeed the investors will suffer loss in their capital accordingly.(Rosely, S. A. 2001).
Practical Phenomena of Musharakah backed Venture Capital
In realty, venture capital is a real business deal in which both parties venture capitalists (the venture capital company) and the financed company work together and share efforts and returns, because simply there is no gain without pain, where the rejection of riba (usury) begins.
Furthermore, the minimization of the use of banking services specially the loan facilities while moving towards investments companies, which offer asset backed risk sharing facilities based on Musharakah, may protect all parties involve in the venture better with sustainable results. The following some steps are highlighted to be noted in an Islamic venture capital deal.
• the Company “Sharikah” is of a pharmaceuticals in nature, it has the relevant skills to develop a new type of product and has no enough capital to finance the project.
• the company found a venture capital company, which is going to finance about 90% of the total cost based on Musharakah contract, and later on the profit or loss, which shall be divided according to the principle of Musharakah.
• After the establishment of the venture capital, and the investment opportunities identified, the venture capitalist has the right to monitor the investment and analyze it step by step to make sure the project is successful and beneficial for both parties.
• The contribution of the venture capital company can be converted into common stock, but it is not Islamic to be converted to preference stock, which allows its holder to receive fixed dividend and that is, resemblance to riba.
• The full amount of the agreed capital may not necessarily be provided at lump sum, but by progress payments as per the development of the project.
• The Board of Directors shall contain members from both the venture capitalist & the financed company as per mutual agreement.
• To minimize the risk, the venture capital firm can build a portfolio investment by investing in other companies (Diversification).
• After the project completion the recipient company has the chance to go for public upon satisfying the venture capitalist as per agreement.
• The profit earned from the project will be shared between the involved parties based on pre-determined ratios.
Final Remarks
Indeed, the the paradigm of Islamic venture capital is a timely for the benefit of the corporate Ummah in particular, as a mechanism for raising of funds through the use of the Islamically accepted concept of Musharakah. It may help to a sustainable development not only among the sectors of Muslim owned, but also non-muslim owned projects with much safe guard equally to economy, soci-cultural, human value with professionalism and personality & environmental.
Sharing in Loss
There is no disagreement among jurists in case of sharing in loss. All Muslim jurists unanimously agreed that, in case of loss, partners must share it accordingly to the amount of capital each partner has invested in to the business. This argument is based on principles of a legal maxim as follows:
“Profit is based on the agreement of the parties, but loss is always subject to the ratio of investment.”
Nature of Injected Capital
Most of the jurists are of the opinion that, the capital shall be in monetary form, but not on commodities. However, there are differences of views on the issue.
Imam Malik argued that, partners can contribute capital in a form of money since it is not a condition for the validity of a Musharakah, but it may also be permissible to invest in kind with condition that, the partners' share is subject to market price of that, commodity.
According to Imam Abu Hanifah and Imam Ahmad who disagreed while ruled out that, no contribution in kind is acceptable in a Musharakah. Their arguments are base on the following two reasons:
(i) commodities are naturally not the same, even if the same in form but differ in qualities and values, hence Musharakah is invalid if the propertties in the deal are distinguished from one another.
(ii) the share-capital redistribution cannot be possible, since commodities are subject to price fluctuations. But he agrees on commodities as capital if the commodities are dhawat-ul-amthal. A Dhawat-ul-amthal is a type of commodity, which if destroyed can be compensated by similar commodity like rice. Imam shafi is also of the same opinion that if the commodity is dhawat-ul- amthal then is acceptable on the ground that it can be mix with other commodities of the same type, but he disagreed on dhawat-ul-qeemah (commodities, which can not be compensated with similar commodities like cattle). (Taqi Usman,2004).
To conclude here that, the share capital can be in form of money or commodities, the market value of the commodities shall determine the share of the partner in the venture capital.
Management of Musharakah backed Venture Capital
In a common practice of partnership, all partners have the right to take part in the management as well as to work for it. However, there are two possibilities that, a management can be in the hand of one partner due to mutual consent of other partners. But in this case the sleeping partners will receive their profit in accordance with the ratio of the their respective invested capital. Alternatively, all partners can work as a team and each shall be treated as an agent of the other in the venture, in which all shall enjoy with equal rights in day-to-day dealing of the business.
Termination of Musharakah Backed Venture Capital Deal
Underlying circumstances where a Musharakah backed Venture capital deal may be terminated:
1. Every partner has the natural right to terminate a partnership at any time on own wish. If the contract is terminated at will, and the asset is in a form cash, then it will be distributed according to the contributed ratio of shares of each partner.
But if the asset is in form of non-liquid, then there are two options:
(a) to distribute the physical asset based on the value of that asset.
(b) incase of dispute, then the physical asset will be sold and the cash shall be distributed on contributed ratio.
2. In case one of a partner dies, the partnership shall be liquidated. However, if the legal heirs of the diceased partner accept to continue with Musharakah then is also permissible with any terms mutually agreed upon by all new partners.
3. If one of the parties becomes insane the partnership shall be terminated. But if all remaining partners agreed to continue the venture along with the shares of the insane partner the partnership can be continued and the share of prfits shall be distributed to the insane's guardian accordingly.
Those conditions are considered both express & implied terms, which shall also be stipulated in the contract at the time of its formalization (Taqi Usman, 2004). As the holy Prophet (SAW) ruled out to the effect:
“All the conditions agreed upon by the Muslims are upheld, except a condition which allows what is prohibited or prohibits what is lawful”.
Modern Operation of Musharakah Backed Venture Capital Model
In this Musharakah backed Venture Capital model, the bank identifies potential companies with approval upon due diligence.
Short listed Companies issue Musharakah preference shares to the bank at discount if the bank wants to buy the paper through Wadiah or discount sale. Incase the bank does not intend to buy the paper, the companies can sell it directly to the investors via the Musharakah deposits.
For example, the bank may require $ 70 million to finance four short and medium investments projects. Bank will issue $ 70 million worth of Musharakah shares to investors at $ 1 each. In this case the bank acts as an agent for both investors and the companies for which the bank shall hold the right to charge some fees for services rendered. If in case the project gains $ 105 million, the net asset value per unit will increase to $ 1.5. In this case investors will enjoy capital gains. However if the project fails to succeed the investors will suffer loss in their capital accordingly.(Rosely, S. A. 2001).
Practical Phenomena of Musharakah backed Venture Capital
In realty, venture capital is a real business deal in which both parties venture capitalists (the venture capital company) and the financed company work together and share efforts and returns, because simply there is no gain without pain, where the rejection of riba (usury) begins.
Furthermore, the minimization of the use of banking services specially the loan facilities while moving towards investments companies, which offer asset backed risk sharing facilities based on Musharakah, may protect all parties involve in the venture better with sustainable results. The following some steps are highlighted to be noted in an Islamic venture capital deal.
• the Company “Sharikah” is of a pharmaceuticals in nature, it has the relevant skills to develop a new type of product and has no enough capital to finance the project.
• the company found a venture capital company, which is going to finance about 90% of the total cost based on Musharakah contract, and later on the profit or loss, which shall be divided according to the principle of Musharakah.
• After the establishment of the venture capital, and the investment opportunities identified, the venture capitalist has the right to monitor the investment and analyze it step by step to make sure the project is successful and beneficial for both parties.
• The contribution of the venture capital company can be converted into common stock, but it is not Islamic to be converted to preference stock, which allows its holder to receive fixed dividend and that is, resemblance to riba.
• The full amount of the agreed capital may not necessarily be provided at lump sum, but by progress payments as per the development of the project.
• The Board of Directors shall contain members from both the venture capitalist & the financed company as per mutual agreement.
• To minimize the risk, the venture capital firm can build a portfolio investment by investing in other companies (Diversification).
• After the project completion the recipient company has the chance to go for public upon satisfying the venture capitalist as per agreement.
• The profit earned from the project will be shared between the involved parties based on pre-determined ratios.
Final Remarks
Indeed, the the paradigm of Islamic venture capital is a timely for the benefit of the corporate Ummah in particular, as a mechanism for raising of funds through the use of the Islamically accepted concept of Musharakah. It may help to a sustainable development not only among the sectors of Muslim owned, but also non-muslim owned projects with much safe guard equally to economy, soci-cultural, human value with professionalism and personality & environmental.
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