Venture capital (VC) has arisen mainly since World War II, but has, in that short time attained huge dimensions. It has mobilised capital for high-risk, high-gain projects and contributed substantially to the establishment of high-technology industry.
These firms are those which are too large to be self-financing but too small to attract loans from traditional banks, and, therefore, find it difficult to raise capital for their projects. VC companies provide seed finance to such firms in return for large numbers of their shares at a low price. The motivation of the VC companies is that the firms they help will grow large and eventually put their shares on the Stock Exchange at a high price, when the VC company will be able sell its shares at a substantial profit.
VC firms differ from traditional banks in that collateral, balance sheet and past performance are less important as criteria to them than the quality of the management team and of the product, the latter's marketability and the expected profits. The capital having been provided, the VC firm becomes a partner with the entrepreneur. About 80% of the investment is usually used in the first two years but the VC firm expects to wait about four years before reaping its profits.
Perspective of VC in Islamic Finance
From the above discussion, it is quite clear that 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.
VC history started with the Islamic 'mudaraba', a form of partnership used even before Islam by Arab traders. Later, the 'mudaraba' was formalised and embodied in Muslim law by the jurists. As Islamic culture spread across the world, the 'mudaraba' went with it and continued to be used by Islamic businessmen until the 19th century. Suddenly, about 25 years ago, a kind of quantum leap happened and the concept of the modern Islamic bank emerged from these roots.
VC has another branch in this history. In the 10th century, the Italians took up the 'mudaraba' and it spread through Europe. Although in Islam this partnership form remained undeveloped but in Europe ever-increasing numbers of entrepreneurs were financed by them, so that the organisations became larger and larger, which is now known as VC.
So, Islamic banks and venture capital(VC) companies have these common roots and that is why they are structurally similar. That is both are involved in profit-and-loss-sharing (PLS) and have a common history. Therefore, Islamic banks have a special role to play in the establishment of the VC sector in Islamic countries. On the second level, too, both Islamic banks and VC firms play the same role, that of 'mudarib' or agent. Acting as an agent for their investors, they invest in a multitude of entrepreneurial firms and pass a proportion of the profits back to the investors.
As mentioned above that the success of both 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. So, they use the same criteria in evaluating projects to invest in, namely, the ability of the entrepreneur and the profit potential of his project. 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.
Although Islamic banks, in order to compete in fund mobilising with the West, have tended to show a preference for 'murabaha' (cost-plus) financing, which is, of course, less risky than PLS. In order to introduce VC into Islamic countries, therefore, an effort will have to be made to persuade the Islamic banks to change their investment policies towards having more PLS contracts. Establishing VC sector in Islamic countries can be a best option for PLS contracts by providing financial and managerial support to entrepreneurs by means of 'mudaraba' / 'musharaka'.
These private VC companies should be financed mainly by Islamic banks. It would help if, for tax purposes, governments would consider treating the funds used by banks to buy shares in VC firms as 'mudaraba' financing and therefore exempt from taxation. Any loss of revenue would be more than compensated by the taxation of the new businesses being helped to develop by the VC companies.
Moreover, this structure would help the banks towards increasing the 'mudaraba'/ 'musharaka' investment ratio of their portfolios. Islamic banks could avoid illiquidity, by buying VC shares when they had surplus liquidity and selling them again when they needed more funds. The Stock Exchange would be expanded by the entry of the Islamic banks buying VC shares and the VC firms buying and selling shares of the entrepreneurs they had developed.
It has been argued that forcing Islamic banks to invest more in PLS projects within a definite target time would expose investment account holders to unacceptable risks. But putting the VC firms between the banks and the investors would create a buffer zone between them. It would divide the risk portfolios into two levels: the VC firms would have their own risk portfolios of entrepreneurs they were financing, while the banks would design their risk portfolios by choosing which VC firms to invest in. Thus if the proposed package were applied in its entirety, the risk to the investment account holders would be reduced to a minimum. 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.
Potentials of VC in Islamic Finance
There is no better example of Islamic mode of financing than venture capital equity investment. This type of equity financing is provided by affluent sophisticated individuals, pension funds, venture capital arms of banking institutions and, of course, the venture capital funds to young companies engaged in developing new technologies and products. Venture capitalists thus become partners and share in the losses and the profits with the founders. If the company being financed becomes successful, the founders and the venture capitalists take it public (through initial public offering or IPO) and make a great deal of money. On the other hand, should the company fail, there is no obligation on the part of the founders -- typically bright engineers and scientists -- to repay the investment. The sharing of risk, is the essence of Islamic banking, which regrettably exists in the United States but with few exceptions is absent in for what passes for Islamic banking in the Muslim world.
Hundreds of companies in the Silicon Valley were financed by the venture capital industry in the form of equity capital. All were created in the last 20 years from nothing. Partly as a result of the availability of this type of risk capital, the United States became a world leader in computer software, computer operating systems, and Internet technologies and helped create some $100 billion of wealth, the largest legal accumulation of wealth in history. Microsoft alone, through options to employees, has produced some 6,000 equity millionaires. Additionally, hundreds of thousands of new highly skilled and highly paid jobs were created. And this is just one of a dozens of venture capital firms. These companies would not exist today if it had not been for the venture capital firms who took the risk in backing talented engineers and scientists.
By contrast, Islamic banks in the Muslim world are very risk averse. No financing similar to the venture capital investment is available to bright and talented engineers and scientist in the Islamic world, despite being in this business for some 25 years and despite having some $60 billion in funds under management.
The readers can be assured that the problem is not with the intelligence and creative abilities of our youth because thousands of Muslim scientists and engineers have managed to excel in the West. Many own large computer companies, producing software or hardware as well other computer-related technologies and in the process have become multi- millionaires. Others have made significant scientific discoveries in medicine, and various technologies, for government, university and corporate labs. The ones who succeeded in business, in developing and bringing their products to the marketplace, were largely financed by venture capital firms. This then is the crucial difference between the United States and the Islamic countries. In the U.S. if a team of engineers or scientists have an idea about a new product or application, they can get funding from a venture capital firm, with the venture capital firm contributing risk capital and the scientists contributing brains and their labour. Sadly, in the Islamic countries, no such risk capital is available to talented and bright engineers, scientists, and entrepreneurs.
If the leaders in the Islamic world are truly interested in improving the living standards of their people, gaining economic independence, regaining their pride and days of glory, they must encourage original discovery, research and invention. And the Islamic banks are in a unique position to make a beginning. One idea would be for the leading
Islamic banks to set up a venture capital fund. The fund would assemble teams of engineers, scientists and entrepreneurs and finance them as partners. Most of these people can be found working in the Western world and some may be persuaded to come back, provided sufficient incentives are provided both with respect to working conditions as well as shares in respective companies. The U.S. venture capital funds make about 25 per cent to 50 per cent per annum on invested capital. There is no reason why the Islamic banks would make any less on their venture capital fund. More compelling is the rationale for engaging in this type of financing: it is the truest form of Islamic banking-the bridge between brains and capital.
(Summarized from an article written by Dr A Mizanur Rahman)
