Fund — Entrepreneurship

The introduction of the venture capital industry into a country encourages and supports entrepreneurs, creates jobs and tax revenue and makes possible the development of high technology. This being the case, no government would want to oppose it and there is no reason why Islamic countries should not benefit from it as much as the West has done.

Their history started with the Islamic mudarabah, a form of partnership used even before Islam by Arab traders. Later the mudarabah was formalised and embodied in the Shari?ah law by the Muslim jurists. As Islamic culture spread across the world, the mudarabah went with it and continued to be used by Islamic businessmen until the 19th century. In about the 1970s, a kind of quantum leap happened and the concept of the modern Islamic bank emerged from these roots.

But there was another branch in this history. In the 10th century, the Italians took up the mudarabah and it spread through Europe. But while in Islam this partnership form remained undeveloped, in Europe, ever-increasing numbers of entrepreneurs were financed by them, so that the organisations became larger and larger. They became, in effect, what we now call VC companies.

So Islamic banks and VC companies have these common roots and that is why they are structurally similar. The similarities are briefly discussed below. The first level can be said to be the collection of funds. In Islamic banks, the investment account holders are people who participate in the bank?s investments in order to share in the resulting profits under mudarabah. This is called profit-and-losssharing (PLS) and the profits are shared according to an agreed ratio. In Turkey, for example, the ratio used to be 20/80, that is, the bank retains 20% of the net profits and 80% is distributed to the account holders.

In the VC sector, also, those who invest are taking part in a profit-sharing process. A ratio similar to that of the banks is used. On the second level, too, both Islamic banks and VC companies play the same role, that of mudarib or agent. Acting as an agent for their investors, they invest the investors? funds in a multitude of entrepreneurial companies and pass a proportion of the profits back to the investors, along with capital and gain where appropriate.

The similarity between Islamic banks and VC companies is closest when they use these PLS partnerships (either mudarabah or musharakah) with businesses. But the Islamic banks also use other forms of financing such as murabaha (renting equipment on a cost-plus basis) and there they differ from VC companies.

In other words, the similarity between Islamic banks and VC companies lies in the fact that they have the same philosophy of financing, that of sharing in the profit and loss of their investments and passing the results on to their depositors. For this reason, they use the same criteria in evaluating projects to invest in, namely, the ability of the entrepreneur and the profit potential of his project. As against this, conventional banks use the criteria of past performance, balance sheets and the credit-worthiness of the entrepreneur.

In case of loss, the Islamic banks have the same attitude as VC companies in that the capital loss is borne by the lender, the entrepreneur losing only to the extent that his labour has been lost.

Theoretical Models and Acceptable Structures

The basic theoretical model of an Islamic bank, according to Iqbal and Molyneux (2005), was developed on the lines of the Two-Tier Mudarabah (TTM) model. The rate of interest brings the asset and liability sides of conventional banking intoequilibrium, whereas mudarabah is the primary profit and loss sharing (PLS) vehicle of asset and liability creation in Islamic banking. The bank is positioned between surplus groups (investors/depositors) and deficit groups (borrowers/beneficiaries).

The TTM is an equity-based structure. On the liability side, the Islamic bank is assumed to play the role of Mudarib for the suppliers of capital (Rabb al-mals), while on the asset side it acts as the equity financier (Rahb al-ma!) for entrepreneurs (Miidaribs). The bank?s return is therefore determined by a share of the profits on both sides of the TTM; banks share profits with their depositors and also with their beneficiaries. If a business venture fails, the capital provider (bank) loses its capital and labour provider (entrepreneur) loses his/her time and efforts.

Another prominent form of Islamic finance is musharakah; in this equity-based structure, two or more partners with a given amount of capital come together in a business venture. They share profit in a predetermined ratio (Siddiqi, 1985). Entrepreneurs are permitted to contribute to the total funds requirement, but it is only in musharakah that the partners may incur a financial loss, strictly in proportion to their capital contribution.

Both mudarabah and musharakah are equity -based, profit sharing structures, although there are some key differences between the two forms of funding. The main difference is that the entrepreneur offers no capital contribution in mudarabah, and therefore s/he is not liable to incur any financial loss apart from losing his/her effort (cost of labour) if the venture fails. Moreover, the bank is not authorized to participate in the management of a mudarabah project hence this form of financing carries a greater degree of risk. In a project financed by musharakah, the bank has right to participate in management unless it deliberately waives the right to do so. The key question is where the contemporary practice of VC financing fits within the PLS techniques of Islamic finance. Two alternative approaches that might be used for Islamic VC are now explored in greater depth.

In an effort to overcome the problems described above, mudarabah has been combined with another financial structure, wakalah, whereby clients authorise a bank or fund manager to invest funds on their behalf, in return for a predetermined fee. This structure is widely used by Islamic mutual funds (Iqbal and Molyneux, 2005) and a combined TTM-Wakalah structure could offer a suitable model for an Islamic VC initiative.

However, there is a major problem to be addressed in mudarabah, deals. In the mudarabah structure, both the financial institution and the recipient can agree on any covenants at the time of the disbursement of the funds. If the project does not proceed as originally planned, then covenants cannot subsequently be changed unless both parties agree. It would be difficult for investor and entrepreneur to resolve disputes on (say) product development, replacing the CEO and so on. The Islamic resistance to changing the terms of the deal stems from the principle that the outcome of the entrepreneur?s efforts should not be at the mercy of the capital provider. In rnudarabah structures, therefore, all possible outcomes and their consequences have to be agreed upfront. This arrangement could present problems for the way in which venture capitalists structure the contracts with their investee companies.

The second option for the development of Islamic VC stems from the shiir?ka al-man financial structure (Siddiqi, 1985). In the Ottoman State, the manufacture and tradeof fabrics, the production of pillows and shoes were funded in this way (Cizacka,1996). In shir?ka al-man, two or more members invest a certain amount of capital andshare the benefits on a pre-agreed basis. This approach permits the capital providerto place any number of restrictive covenants on the functioning of fund managersand/or entrepreneurs (Fethi, 2000). In the VC context, shir?ka aI-inam is a genuinepartnership hence both parties are equally involved in any decision to change thestrategy of the investee company, even after the disbursement of funds.

The analysis above demonstrates that a hybrid of mudarabah and shir?ka al-man would give capital providers many of the powers available to established venturecapitalists; in particular, the investors can insist upon the inclusion of covenants inthe contract and they can make post-investment adjustments/interventions to ensurethat the investee company stays on course for success. Likewise, mudarabah inconjunction with wakalah provides another option for venture capitalists (albeit lessflexible), because the wakeel (representative) may be allowed to carry out businessactivities within mutually agreed parameters.

The critical question is whether Islamic profit-sharing contracts (musharakah or mudarabah) can provide the required flexibility for efficient risk management. This question can be explored in relation to two fundamental dimensions of the structuring process: contractual structuring (the covenants included in shareholders? agreements and any staging agreements); and, the selection of financial products, namely the choice between equity, debt or hybrids.

In Islamic jurisprudence, parties are free to structure a contract to achieve their mutual economic interests, provided that basic Islamic principles are not violated (Ahmed, 2004). The commonly used covenants in VC shareholders? agreements and/or the conditions tot investment staging could he applied to mudarabah and musharakah structures, provided that such instruments were used in conjunction with shir?ka al-inan or wakalah.

The idea of differential or disproportionate revenue sharing between two classes of ?equity? investors has already been approved in Islamic jurisprudence (Ahmed, 2004). This concession applies provided that the party offering finance also contributes to the management of the project. A modified version of preferred stock could create two classes of shares, with each being entitled to different percentages of profit beyond a defined threshold (Zarqa, 1992). Another financial product that meets the needs of entrepreneurs while simultaneously limiting investment risk is ?diminishing musharakah,? (Bendjijali and Khan, 1985). This structure can be fully secured by using company assets as collateral, thus protecting the original capital to some extent until the project achieves profitability. From cash generated through profits, the entrepreneur can begin to repurchase the equity issued to the venture capitalists. (This arrangement resembles the option in VC deals that gives the entrepreneur the right of first refusal to ?buyback? equity held by outside investors.) Overall, the venture capitalists? return varies according to the investee company?s profitability. This gain plus a gradual redemption of part of the invested capital appears Islamically acceptable.

Shari?ah View of Some Key Practices in Venture Capital Financing (Ahmed, H. (2004)

Conventional Venture Capital Practice Shari?ah View

Limited partnership structure Acceptable

Long terms contracts Acceptable

Contracts can be nullified Acceptable

Restrictions placed on the activities of fund managers Acceptable

Equity ratchets to entrepreneurs Acceptable

Investments in equity, fully convertible bonds (zero coupon) Acceptable

Preferred stocks, preference shares of convertible debt Not acceptable

Greater control rights through restrictive covenants Acceptable

Board Seat Acceptable

Staged Financing Acceptable

Replacement of management (CEO) Acceptable

Liquidation rights Acceptable

Provision of non-financial services (strategic advice, etc.) Acceptable

Application of discount rate for valuation Acceptable

Structuring Issues

Even though investing in a venture is an acceptable financial transaction, some aspects of the conventional venture capital structure are not in line with Shari?ah rulings. These aspects are mainly related to preferred stocks and shares that act like a debt instruments. A Shari?ah compliant structure aims to balance the risk/reward benefits to all parties involved in a deal. As such, any financial instrument that acts like a debt security, where the investor can get a ?riskless? reward is prohibited. However, if the burden of risk is placed unevenly on the investor, the investor will not have the incentive to participate in a high risk venture. Two factors aspects are discussed briefly below:

(a) Preferred Stock

In order to minimise the downside risk to Islamic investors, workable preferred stock has been suggested. This ?Islamic? preferred stock acts like a pure preference share with pre-determined varying profit ratios. There can be no accumulation of profits and no liquidity preference to one investor over another in case of sale or liquidation of the venture. Thus it is more like common stock with pre-determined profit rates.

(b) Valuation

Since private equity deals are by nature risky transactions, true valuation of the deal is vital to achieve the target rate of return which is bench-marked against some risk free security, such as US Treasury bonds. Such benchmarks are performance goals against which a company’s success is measured, and does not necessarily involve the actual application of riba to a transaction. However, Islamic investors tend to value a company based on two important factors for Shari?ah compliance:

? Returns on a project with a similar risk profile

? The average return on a well diversified equity portfolio

Written by Zia Ahmed
Investment Banker, Islamic Banker

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