The private sector has a few examples of Islamic venture capital at work but the reality is that often these are misnamed Islamic private equity efforts, and yet venture capital and Islamic finance are tailor-made for each other.
Rather like its cousin private equity, venture capital is a mode of investing that seems
perfect for Islamic finance through the application of various Islamic financing concepts,
with the Mudarabah concept being the most common.
Venture capital here is defined as the provision of seed capital for a new venture in the process of being established, rather than the provision of capital to a small business to facilitate its growth.
As with its conventional counterpart, Islamic venture capital appeals most to investors
who understand a sector or an industry intimately and are prepared to risk a portion of their capital on the strength of a business plan, the management team of the proposed business, and their own ability to pick a winner.
Other similarities between Islamic venture capital and conventional venture capital include the fact that deal sizes are small when compared to private equity transactions, since the startup capital that is required for a burgeoning small businesses tends not to include monies for grandiose marketing and advertising plans but tends to be much more conservative in its outlook.
Some basic principles explained:
The principle of Mudarabah in venture investing
Mudarabah financing involves a contract under which the investor, or rabal-maal, brings financing to the table and the entrepreneur, the mudarib, brings expertise, effort, and in the case of Islamic venture capital, a business plan.
Collectively the parties share the proportionate profit from the results of the enterprise as per their pre-arranged agreement. The entrepreneur cannot be placed at risk of losing money since he has contributed only expertise. If the business venture fails, then the most the entrepreneur could lose is the investment he has already made in the business and the time and effort he had put into the venture.
In other words no one can come after the entrepreneur for cash compensation. In a similar way, no one should expect the venture investor to have any say in the management of the company or any responsibility for it, since his part of the deal is to providing financing only.
The principle of Musharakah in venture investing
In the context of Islamic venture capital Musharakah financing is a partnership formed
between parties to finance a business venture where the parties contribute capital either in the form of cash or in kind. Profits are distributed based on a pre-agreed ratio. Losses are shared on the basis of capital contribution to the venture.
The principle of Wakalah in venture investing
In Wakalah financing a contract from one party gives the power and rights to another party to act on his behalf, based on the agreed terms and conditions.
Venture capital in the context of Islamic finance
The sector of Islamic venture capital had been largely ignored in the GCC until recently because of the lack of an 'entrepreneur class' which is essential for the development of a healthy venture capital environment: young, bright people with great business ideas and a determination to make a success of 'their' business.