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Venture Capital's Islamic Principles

Dr Oussama Tabbara, Gulf Venture Capital Association

September 2008

 

Shariah is Islam’s legal system. It differs from the legal traditions of the Western world in that Shariah represents a comprehensive system for all aspects of life. Its principles strike a balance between the interests of the individual and society. Universally, in any society, investment is the foundation of economic activity.

Islamic finance (IF) constitute three basic concepts: asset-based finance, partnership, and shared risk and reward. Profits form the basis of the IF system. It allows both the risk capital provider and the party that uses the capital to make profits, but the manner in which this is done is subject to conditions. For example, certain actions are prohibited because they are harmful to participants in the business or the economic activity. Profits must be shared by the provider and user of capital; both need to assume risk and share the rewards. Hence, in financial transactions, the interpretation of the Shariah applies to the products, processes and the systems.

Compliance has to be with respect to the framework, operations and methods being undertaken in the particular Islamic financial investment product. Thus, in the routine handling of Islamic investment products, there would generally be attributes of structure, process and the required documentation to show compliance with the Shariah principles. The evidence documentation concerns the processes and relationships that originate from the underlying structure of the financial product, such as the flow of assets and services, the roles and relationships of the participants in the transaction (principal/agent, buyer/seller) etc.

Financing in conformity with Shariah does not permit money to be the object of trade, because every transaction must involve a tangible and usable asset to the community. Essentially, instead of a return on capital being determined ex-ante (before the event) through a nominal interest rate (riba), which is prohibited under the Shariah principles, the return should naturally occur ex-post (after the event) on the basis of the favourable outcome of the economic activity for which the funds were invested.

To increase one’s income, the only permissible manner is through undertaking increased trade, manufacture or provision of services. Thus, as funds are transferred from the provider to the user, it must result in an increase in trade, manufacture, service provision and, eventually, meaningful employment. The increased economic activity, therefore, will provide the momentum for the development of infrastructure and the basic services to society such as security, education and health.

Venture capital (VC) is the equity financing of unquoted companies ranging from small early stage to large management buyouts. VC has a particular emphasis on entrepreneurial undertakings and less mature businesses. It has four categories: seed, start-up, expansion and replacement capital.

Venture Capital Funding Prerequisites

The typical approach to access VC:

  • Business plan should be short and to the point, preferably a one-page summary. Also, a proprietary model will help the venture company secure a sustainable advantage.
  • Funding is frequently through a very active merchant bank/VC/private equity funding network. Further, a single investor, preferably one who is a seasoned entrepreneur, could contribute money as well as contacts and ideas.
  • VC firms: There is an incredibly vibrant entrepreneurial atmosphere where people with ideas can get money. Competition is fiercer than ever among VC firms. Their principal activities are fundraising, investing and exiting.
  • The challenges facing those seeking VC are many; each must be overcome. There are entrepreneurs and people who know how to grow a company. Usually they are not the same people. It is a meritocracy. If you do excellent work, you get results.
  • Expectations: Generally, the expectation is that it will take five to seven years before there is any distribution of profit. This has since changed dramatically. Some VC funds are so flushed with funds that they look like investment banks. All the emphasis now tends to be on financial performance in a very short time, distinct from a viable product with sustainable growth potential.
  • The mistakes: Some venture companies are prone to make fundamental mistakes of judgment such as:
    • Under-capitalisation – not understanding how much money the venture company needs. This is the biggest mistake.
    • Not having the right management team.

    • Sustainable growth is a pillar of success. If you don’t continue to grow, you are left behind and will fall by the wayside.
Regulatory Controls

Islamic or traditional banks that provide Shariah-compliant financial products have to establish Shariah advisory councils to meet two objectives – advising the clients of the banks; and assuring them that the institutions comply with the stipulations of Shariah. These councils comprise religious scholars who are experts in Shariah as well as the financial markets. The application of Shariah principles is always evolving. Interpretations of rules can be different from time to time and in different parts of the world. This leads us to the aspects of quality and transparency in financial reporting in the IF industry – a key challenge for this fast-growing sector.

The International Financial Reporting Standards (IFRS) form the principal regulatory framework. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has issued accounting, auditing and governance standards for Shariah-compliant Islamic financial reporting.

In the application of Shariah-based principles for VC investments, the most common VC investment is structured on the principle of Mudarabah which gives rise to special types of relationships with particular terms, conditions and restrictions. Basically, Mudarabah is a partnership in profit between capital and work. The Mudarabah contract is consistent with a VC transaction whereby a financier provides capital to an entrepreneur for a percentage of future profits. The entrepreneur provides only his expertise and labour for the venture project while the financier agrees to bear the full loss if the venture fails.

This partnership arrangement could be structured for the transactions between investment account holders (the silent counterparty) as providers of funds and the Islamic bank as the working partner – a Mudarib – which only invests skill and labour. The Islamic bank and its investment account holders agree on how the profits are to be shared. The losses are also to be borne by the provider of funds, except where such losses are caused due to the misconduct, negligence or violation by the Islamic bank (the working partner), based on the conditions agreed upon and as determined by the Shariah Supervisory Board of the Islamic bank.

There can also be a Mudarabah contract between the Islamic bank as the provider of funds, on behalf of itself or on behalf of the silent counterparty, with business owners as well as craftsmen, including farmers, traders, etc (the party investing skills and labour).

The working partner (the VC company) will manage the Mudarabah partnership for all matters that concern the normal course of business. So, besides his labour, the working partner will suffer no loss excluding of course responsibility for fraud, wilful negligence, misconduct, wrongdoings or serious breach of his mandate. Usually the working partner is rewarded an agreed upon percentage of the profit. Where advances against profits are allowed, these will be subject to ultimate payback should the venture project fail. The risk to the provider of funds (the silent counterparty) is limited to the capital funds invested.

AAOIFI’s Financial Accounting Standard (FAS) No 6 – Equity of Investment Account Holders and Their Equivalent – sets the accounting rules for the Islamic banks and financial institutions in disclosing the transactions regarding equity of investment account holders as well as for funds received by the Islamic banks for investment, in their capacity as working partners (Mudarib).

The types of Mudarabah and the relationships between the investment account holders and the working partner (Mudarib) are:

Number of Counterparties

  1. Single Mudarabah – a single provider of funds and a single Mudarib. This type is not usually used by Islamic banks.
  1. Compound Mudarabah – many providers of funds and a single Mudarib. This type is most commonly used by Islamic banks.

Timing to Determine Profit

  1. A limited term Mudarabah where profits are accounted for when the venture is liquidated and the capital is returned to the providers of funds.
  1. A continuous Mudarabah where profits are accounted for on a periodical basis during the Mudarabah tenure, but without its liquidation and without returning the capital to the providers of the funds. All counterparties (the providers of funds and the working partners) must consent to this.

Ownership of Mudarabah Funds

  1. Non-commingled Mudarabah – Investment only by the providers of funds, hence, they own the invested funds.
  1. Commingled Mudarabah – Investment is by the providers of funds as well as by the Mudarib while the work is carried out only by the Mudarib, permissible only with the consent of both parties.

Limitations to Working Partner’s Actions

  1. Unrestricted Mudarabah – The Mudarib is authorised by the fund providers to invest the funds in the manner the Mudarib deems appropriate.
  1. Restricted Mudarabah – The Mudarib is restricted by the fund providers according to their contract.

Profits and Losses

  1. The profit share of each party must be stated in the Mudarabah contract as a common percentage rate rather than a fixed amount.
  1. The periodic distribution of profits is permissible only with the consent of both the fund providers and the Mudarib.
  1. Allocation of profit or loss could be on the basis of funds contributed by each party in the joint investment or according to the percentage agreed upon by the counterparties to the Mudarabah contract. The share of the Islamic bank as a Mudarib is deducted from the share of profits of investment account holders. The Mudarib shall not bear any part of the losses incurred in Mudarabah but only bear losses that were due to his misconduct, negligence or violation of the terms of the Mudarabah.

  2. A loss shall not be considered a decrease of the Mudarabah capital unless it is not set off against profits generated from other transactions of the venture.

Mudarabah differs from what is known as speculation which includes an element of gambling in transactions relating to buying and selling.

IF is only a part of a larger concept of Islamic economics that seeks to conform all of one’s economic activity to the tenets of Islamic teachings. It augurs well that with the continual demand for more oil and the resulting depletion of the oil reserves, the petrodollar revenues of the oil producing Islamic nations would be invested almost exclusively through the Islamic financial system worldwide.




Dr Oussama Tabbara is a co-founder, vice president and member of the Gulf Venture Capital Association (GVCA). GVCA covers all major aspects of the venture capital/private equity industry, investment models, management of fund raising and structures, technology evaluation and valuation, contracts and control rights, information/studies, early-stage funding and corporate venture capital.


This article first appeared in Islamic Finance news (Volume 5, Issue 22).

If you have any comments about or contributions to make to this newsletter, please email advisor@eurekahedge.com

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