Venture capital
From an Islamic point of view, venture capital is based on equity financing falls within the framework of Islamic finance as long as it invests in permissible sectors and in companies having a zero conventional debt capital structure. It therefore combines economic viability and Islamic preference, which makes it a promising option for Islamic financial institutions. In fact, the provision of equity-based capital for SMEs is in harmony with the Islamic goal for wider economic development and a more equal distribution of wealth. That is why venture capital financing is praised for its role in promoting growth while maintaining financial stability. Although the details of practices of existing venture capital institutions that include prohibited activities, such as, paying or receiving interest may not be totally consistent with Islamic rules, these details can be easily modified without compromising the positive aspects of its principles (Venture Capital: A Potential Model of Musharakah by Sami Al-Suwailem; 1998). The structures of Islamic banks and VC companies are very similar; they have common roots and are both involved in PLS partnerships, generally in Mudarabah or Musharakah; these partnerships are based on active management that leads to improved corporate governance and overall alignment of stakeholder interests with that of the management.
The most important similarities between Islamic banks and VC companies are at the level of funds collection and agency configuration. In fact, investors in both Islamic banks and VC companies are taking part in a profit-sharing process; they both share in the resulting profits according to an agreed ratio. Islamic banks and VC companies also act as agents for their investors/depositors; they invest the collected funds in different businesses and share a percentage of the profits back to the investors. This is different in the case of conventional banks who are not really actively participating in the businesses they invest in, nor are their depositors. In addition Islamic banks and VC companies use the same criteria in evaluating projects to invest in, in fact they both evaluate the ability of the entrepreneur and the profit potential of his project, whereas, conventional banks use the criteria of past performance, balance sheets and the credit-worthiness of the entrepreneur (Venture Capital, Islamic Finance and SMEs by Grahame Boocock and Mansoor Durrani; 2008). Islamic banks also have the same attitude as VC companies in case of loss that is the capital loss is only borne by the lender, while the entrepreneur only loses time and efforts spend in labour. Islamic banks may however be different from VC companies in the use of other forms of financing such as Murabahah which is less risky than PLS, necessitates fewer resources, and can enable Islamic banks to compete in fund mobilising with the conventional banks.
The most important similarities between Islamic banks and VC companies are at the level of funds collection and agency configuration. In fact, investors in both Islamic banks and VC companies are taking part in a profit-sharing process; they both share in the resulting profits according to an agreed ratio. Islamic banks and VC companies also act as agents for their investors/depositors; they invest the collected funds in different businesses and share a percentage of the profits back to the investors. This is different in the case of conventional banks who are not really actively participating in the businesses they invest in, nor are their depositors. In addition Islamic banks and VC companies use the same criteria in evaluating projects to invest in, in fact they both evaluate the ability of the entrepreneur and the profit potential of his project, whereas, conventional banks use the criteria of past performance, balance sheets and the credit-worthiness of the entrepreneur (Venture Capital, Islamic Finance and SMEs by Grahame Boocock and Mansoor Durrani; 2008). Islamic banks also have the same attitude as VC companies in case of loss that is the capital loss is only borne by the lender, while the entrepreneur only loses time and efforts spend in labour. Islamic banks may however be different from VC companies in the use of other forms of financing such as Murabahah which is less risky than PLS, necessitates fewer resources, and can enable Islamic banks to compete in fund mobilising with the conventional banks.
Islamic Venture Capital
Mudarabah is the core of Islamic financing and the Two-Tier Mudarabah model is the basic theoretical model of used by Islamic banks to structure Venture Capital (Iqbal and Molyneux; 2005); the Two-Tier Mudarabah is an equity-based structure used to create asset and liabilities where the Islamic bank is placed between investors and depositors who provide money and borrowers and beneficiaries who require money. On the liability side, the Islamic bank plays the Mudarib role for the suppliers of capital, while on the asset side it acts as the plays the Rabb-al-Mal investor or venture capitalist role, and the business entrepreneur (Mudarib) is responsible for all business operation. The two-tier Mudarabah can be compared to the conventional VC funds. Profit sharing is predetermined to a set ratio between the Islamic bank, the depositors and the beneficiaries. In this model, the bank is not authorized to participate in the management of a Mudarabah project and the entrepreneur does not contribute to capital, and therefore he is not liable to incur any financial loss. In case of business venture fail the bank loses its capital and entrepreneur loses his time and efforts. Musharakah is another important equity-based form of Islamic financing that consists on a partnership where two or more persons combine either their capital or labour together, to share the profits, enjoying similar rights and liabilities (islamic-world.net; 09.2009). The difference between Mudarabah Musharakah is that entrepreneurs are allowed to contribute to the total funds requirement and the Islamic bank has right to participate in management unless it deliberately waives the right to do so. If the business venture fails, the partners incur financial loss, strictly in proportion to their capital contribution.
However, Two-Tier Mudarabah and Musharakah is habitually ignored by many banks, because Mudarabah represent a higher risk since they have less control on management and the degree of their involvement in Musharakah would be too costly. To overcome these issues, Mudarabah can be combined with 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 as it offers a suitable model for an Islamic VC initiative. Another feasible option is to develop Islamic Venture capital using Shirka al-man, where two or more partners invest a certain amount of capital and share the benefits on a pre-agreed basis. In Shirka aI-inam the two parties are equally involved in any decision to change the strategy of the investee company, even after the disbursement of funds (Siddiqi, 1985). This allows the investor to place any number of restrictive covenants on the functioning of fund managers and entrepreneurs (Fethi, 2000). Besides, a hybrid form of Mudarabah and Shirka al-man can be used to give capital providers many of the powers available to established venture capitalists; in fact, investors can include covenants in the contract and make post-investment adjustments to ensure that the investee company achieves its objectives. Mudarabah in conjunction with Wakalah can also provide a possible option for VC, since the Wakeel may be allowed to carry out business activities within mutually agreed parameters.
However, Two-Tier Mudarabah and Musharakah is habitually ignored by many banks, because Mudarabah represent a higher risk since they have less control on management and the degree of their involvement in Musharakah would be too costly. To overcome these issues, Mudarabah can be combined with 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 as it offers a suitable model for an Islamic VC initiative. Another feasible option is to develop Islamic Venture capital using Shirka al-man, where two or more partners invest a certain amount of capital and share the benefits on a pre-agreed basis. In Shirka aI-inam the two parties are equally involved in any decision to change the strategy of the investee company, even after the disbursement of funds (Siddiqi, 1985). This allows the investor to place any number of restrictive covenants on the functioning of fund managers and entrepreneurs (Fethi, 2000). Besides, a hybrid form of Mudarabah and Shirka al-man can be used to give capital providers many of the powers available to established venture capitalists; in fact, investors can include covenants in the contract and make post-investment adjustments to ensure that the investee company achieves its objectives. Mudarabah in conjunction with Wakalah can also provide a possible option for VC, since the Wakeel may be allowed to carry out business activities within mutually agreed parameters.
