By Arno Maierbrugger/Gulf Times Correspondent /Bangkok
Most people agree that venture capital has become a highly important economic driver globally over the past decades to facilitate the launch of innovative new businesses, to disrupt conventional industries and to transform intellectual capital into innovative start-ups. It is a preferred option for new companies with unconventional ideas, but limited operating history and little to no funds that are too small to raise capital from banks or the financial market.
However, venture capital has been part of the conventional finance ecosystem ever since it was created and was of limited significance in the Muslim world until the recent past. This has probably to do with the fact that in major Muslim countries, most key businesses used to rather be concentrated in large holding structures orchestrated by families and larger state entities, and for smaller companies and single entrepreneurs there was simply very little manoeuvring room, let alone much eligibility for high-risk capital debt in a Shariah-compliant environment. Islamic banks, in turn, were content with less risky financing modes such as murabaha and ijara, profit and loss sharing debt models with little possible side effects to consider.
But this changed in the past years as industries also in Muslim countries started facing the pressure of having to adapt to new digital ecosystems, the disruptions from innovative, non-traditional players and a rapidly rising number of digitally knowledgeable consumers who want more, better and smarter products than what they were used to in the past.
Things came into gear when Malaysia – in its undisputed role as innovation leader in Islamic finance – back in 2016 launched the world’s first Islamic venture capital fund endowed with $100mn to provide seed financing for startup companies and entrepreneurs, particularly aimed at the Islamic fintech industry.
So, how is Islamic venture capital different from conventional venture capital?
First of all, it of course must strictly follow the rules of Shariah. Secondly, it uses specific participatory financing models that are a bit more sophisticated than the normal venture funding plans.
Islamic venture capital funds therefore are not allowed to invest in or fund any business related to gambling, alcohol, tobacco and immoral activities. Evenly important, there can be no leverage, which means a company financed by Islamic venture capital cannot have conventional debt on its books or use debt in any way for expansion.
In a first step, a startup seeking Islamic venture capital needs to be checked very thoroughly because their financial backgrounds sometimes happen to be quite opaque which can be a challenge for Islamic finance scholars doing a first audit.
Next, suitable Shariah-compliant financing models need to be chosen.
“There are three common structures used in Islamic venture capital, namely mudaraba, musharaka and wakala,” says Ahmad Syahir Yahya, partner at Kuala Lumpur-based law firm Azmi & Associates, adding that the mudaraba concept being the most common.
In this model, venture financing involves a partnership investment contract under which the investors will provide financing, whereas the startup manager or entrepreneur will run the business venture and will be responsible for the daily management and work organisation. The two parties have to agree upfront on the profit ratio from the business venture. The working partner (the startup or the entity receiving venture capital) will manage the mudaraba partnership for all matters that concern the normal course of business. So, besides his own labour, the working partner will suffer no loss unless he becomes responsible 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 eventually fail. The risk to the provider of funds is limited to the capital funds invested. Under musharaka, the financing involves a partnership between two or more parties to finance a business venture whereby all parties have to contribute capital. Profits are to be shared between the musharaka partners according to a pre-agreed ratio. In the event of a loss, it shall be shared according to the capital contribution. The difference between mudaraba and musharaka is that entrepreneurs are allowed to contribute to the total funds requirement and the investors have the 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.
Another structure frequently chosen for Islamic venture capital financing is wakala, which is basically and agency contract. In a wakala model, an investor (acting as a principal) authorises the asset manager (as its agent) to act on his behalf and invest venture capital, based on agreed terms and conditions. A wakala contract confers the powers and rights to the agent to act on behalf of the initial investor, whereby both share the profit and the risk of loss. It is widely used by Islamic mutual funds as it offers a suitable model for Islamic venture capital.
A fourth concept, shirka, has also been suggested by some scholars. In this model, two or more partners invest a certain amount of capital in a start-up of whose business idea and business model they are convinced and share the benefits on a pre-agreed basis. The investing parties are equally involved in any decision to change the strategy of the company, even after the disbursement of funds. This allows the investor to place any number of restrictive covenants on the operations of fund managers and entrepreneurs.
However sophisticated those structures might seem, analysts agree on the notion that Islamic venture capital has become an important tool for economic development in developing regions of the world, quite a few of which are Muslim jurisdictions. It can contribute to their economies in that it supports technology advancement which would not otherwise be realisable and contributes to increased job opportunities and generally more innovation.