Comparison of Islamic Finance and Venture Capital

Introduction

What is Islamic Finance

As the name implies, it is quite self-explanatory. It is essentially a simple banking system that obeys the Shariah Law and also looks into developing Islamic economies by application. This system consists of small conditions such as the ban of commodities that disobey the legal terms of Islamic practices but it may vary between Muslim countries. There are five models of Islamic banking they are as follows:

1. Mudarabah
2. Wadia
3. Musharakah
4. Murababah
5. Ijara

Islamic law forbids the payment of interest on financial loans where some Muslims fall into conflicts by thinking that the interest rates are heavier than it is supposed to be. Lot of banks have been formed to practice the Islamic ethics to remote or semi remote commercial institutions within the Muslim society since the late 20th century which represents the image of Islam. Since then the number of these institutions have constantly increasing until 2009 there were over 300 banks and 250 mutual funds around the globe observing with Islamic practices. By 2014, there were over $2 trillion of shariah compliant. These financial institutions contribute nearly 1% of total world assets, which is focusing on GCC countries like Iran and Malaysia.

Islamic principles understandings on lending with interest payments that favors the lender and also charges interest on expenses of the borrower. According to the Islamic principles, money is measuring tool for value but not for an asset. Addition to this, the IMF is planning to introduce new part called ‘Islamic finance’ in their assessments of financial sector in the beginning of 2019. It has been promised that when this system is being fully implemented then this system ensures that there would be no unemployment, no inflation, no poverty and no exploitation.

What is Venture Capital

It denotes to those investors who provide finance for the Small and medium sized enterprises (SME’s) where these companies have a trust that they might have potential for achieving goals in the long run. The invested money comes from wealthy investors and investment banks as well. Sometimes the returns might be higher as compared to new companies that has less than 2 years of experience in the field.

The dealings of venture capital are created and sold in such a way that large portion of the company or a group of companies is handed over to the interested investors. This leads to opening of a contract which is called partnership.

The main ideology is that to finance into company’s balance sheet and development of infrastructure unless it meets its satisfactory with the size of the business and creditability of the business. Therefore, it could be sold to a big corporation or even financing institutions could step into capital markets and offer liquidity to the company.

Review from Authors:

A. Sakouili and M. EL Azhari:

According to these authors, their analysis has five different parts that examines with the help of an example where an entrepreneur has signed a huge project but faces a dilemma that how to use the capital for his own thoughts. In order to give correct conclusion that which is perfectly suites for this such situation, there few things that might guides us to comparison and conclusion. those are:

1. Investment type
2. Partner type
3. Management
4. Profit and loss sharing
5. Partnership duration

This paper proposes, to compare two modes of financing namely: venture capital and certain practices of Islamic finance (Musharakah and Mudarabah). In this comparison, we will focus on the decision-making process to invest in a risky project and following the results found, we will evoke the notion of bounded rationality through its reliability models, with the aims of questioning the applicability thereof in the field of Islamic finance. The analysis carried out shows that these two modes are very similar, particularly in their approach to investment and their conception of partnership in business. Despite the undeniable advantages of the Musharakah and Mudarabah modes of financing, we noticed that these practices are rarely used the Islamic financial institutions because of the difficulties encountered by financial operators during the application of funds granting procedures. Also, this study shows that the modeling of decision-making process in participatory finance is a necessity and this will be the subject of our next paper.

Akhtar mohammed:

There has been large scope in Islamic finance and banking in Muslim countries and around the world during the last few years. This progress was caused by factors including the introduction of broad macroeconomic and structural reforms in financial systems, the liberalization of capital movements, privatization, the global integration of financial markets, and the introduction of innovative and new Islamic products. Islamic finance is currently in boom with new levels of sophistication. However, a whole Islamic financial system with its identifiable instruments and markets is still very much at an early stage of evolution. Many difficulties and challenges relating to Islamic instruments, financial markets, and regulations must be spoken and fixed. In this broadside, we provide a comprehensive comparative review of the literature on the Islamic financial system. Explicitly, we discuss the basic features of the Islamic finance and banking. They have come up with Islamic financial instruments in comparison with existing Western financial instruments and discuss the legal problems that investors in these instruments may encounter.

Sami Al-Suwailem

Venture Capital

From an Islamic perspective, venture capital depends on equity financing that falls within the system of Islamic finance as long as it invests in permissible sector and in organizations having a zero conventional debt capital structure. Therfore, it combines economic contingent and Islamic preference, which makes it a promising alternative for Islamic financial institutions. Indeed, the provision of equity-based capital for SMEs is in concordance with the Islamic objective for more economic development and a more equal distribution of wealth. That is the reason venture capital financing is applauded for its role in advancing development while keeping up financial stability. In spite of the fact that the details of practices of existing venture capital institutions that incorporate prohibited activities. For example, paying or accepting interest may not be totally consistent with Islamic standards, these details can be effectively altered without trading off the positive aspects of its standards.The structures of Islamic banks and VC organizations are same; they have common roots and are both engaged with PLS associations, for the most part in Mudarabah or Musharakah; these associations depend on active management that prompts improved corporate governance and generally arrangement of stakeholder interest with that of the management.

Islamic Finance

Islamic finance refers to the methods by which people and enterprises, including banks and other lending institutions, raise capital as per Shariah. hundreds of years old practice is picking up acknowledgment all through the world and is viewed as a unique form of socially capable investment. Islamic Finance covers a wide scope of financial products and services that are considered allowable under the Islamic law, and whose moral nature is even drawing the enthusiasm of non-Muslims. Central to Islamic finance is a comprehension of the significance of risk sharing as a major aspect of raising capital and the evasion of usury and vulnerability. In this way, the most widely recognized principles that oversee Islamic Finance are:

• Investment must not be in organizations related to liquor, pork items, gambling, pornography and weapons.
• Investment cannot involve the payment of interest.
• Investment cannot include speculation, or manages with outrageous vulnerability
• Risk must be shared between at least two parties.

Mansoor Durrani and Grahame Boocock:

• Venture capital

The most significant similarities between Islamic banks and VC organizations are at the level of funds gathering and agency configuration. In fact, financial specialists in both Islamic banks and VC organizations are partaking in a profit-sharing procedure; the two of them share in the subsequent profits according to an agreed proportion. Islamic banks and VC organizations also act as agents for their financial specialists/contributors; they invest the gathered funds in various organizations and share a percentage of the profits back to the investors. This is different in the case of conventional banks who are not so much effectively taking part in the organizations they invest in, nor are their depositors. Also Islamic banks and VC organizations utilize similar criteria in assessing tasks to invest in, in fact they both assess the ability of the entrepreneur and the profit capability of his project, though, conventional banks utilize the criteria of past execution, balance sheets and the credit-value of the entrepreneur (Venture Capital, Islamic Finance and SMEs by Grahame Boocock and Mansoor Durrani; 2008). Islamic banks likewise have a similar attitude as VC organizations 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 labor. Islamic banks may anyway be unique from VC organizations in the utilization of different types of financing, for example, Murabahah which is less risk than PLS, requires less assets, and can empower Islamic banks to contend in reserve assembling with the conventional banks.

• Islamic Finance

The way to deal with risk in Islamic Finance is very extraordinary to the conventional framework. So, while an Islamic Finance product may have the similar goal to a conventional finance product, it is probably going to have a different risk/reward profile. At times, this unconventional risk/compensate profile is alluring to potential investors, even when they are not motivated by religious reasons. While the basic principles of Islamic Finance are well-understood and generally accepted, there can be some variation in viewpoint between Islamic scholars on how these principles apply in certain situations. So, it is possible that certain deals may be regarded as acceptable in some places (jurisdictions/ Shariah boards), but not acceptable in others.

Paul McNamara:

The part of Islamic venture capital had been to a great extent disregarded in the GCC until recently because of the absence of a ‘entrepreneur class’ which is fundamental for the improvement of a healthy venture capital environment: youthful, splendid individuals with extraordinary business thoughts and an assurance to make an accomplishment of 'their' business. As the world turns out to be all the more a worldwide commercial centre, and as the education and skills of youngsters in the area expands, at that point venture investing along with Shariah-compliant lines may turn out to be more common.

It is not necessarily the case that the more prominent Middle East and North Africa district has been deprived of venture capital. Nations, for example, Egypt, Lebanon and even Turkey have long had a entrepreneur class of their own and the VC business is subsequently progressively created in these nations. In a great part of the GCC there have been hindrances to outsiders owning their very own organizations out and out and this normally prompted a nonappearance of such organizations in the commercial centre. As nations like the UAE have presented 'free zones', for example, Dubai Internet City, Dubai Media City, Dubai International Financial Centre, Jebel Ali Free Zone, etc where outside nationals and corporates can claim 100 % of their own business then the market for investment has opened up. Normally the business idea that will draw in Islamic venture capital needs to work within the requirements of Shariah and must not fiddle with haram regions. In any case, having a youthful entrepreneur class is just 50% of the condition. The other portion of the condition is having venture investors with the risk craving to back the marketable strategies displayed to them with hard money. This isn't just an issue of having the cash, it is likewise about having the apparatuses to break down the strategy, organizing a deal, and ensuring that the short, medium, and long-term investment interest of both the entrepreneur and the investor are the same. This requires a level of education and expertise that had been missing until moderately but has arrived in the region on the back of the tidal wave of oil incomes and expanding globalization.

The combined effect of this has been that the Islamic venture capital industry was virtually non-existent, except for a few cases where Angel investors in the guise of ultra-wealthy merchant families have funded new start-up businesses with their own cash, after ensuring that the business had no likelihood of straying into haram areas of business practice. The arrival of financial centres such as Dubai International Financial Centre, Malaysia International Islamic Financial Centre, Qatar Financial Centre, and Bahrain Financial Harbour has opened up the possibility that expert venture capital talent from more mature financial markets could be transplanted into rapidly emerging Islamic finance markets and bring with it the intellectual wherewithal to do lucrative Islamic venture capital deals.

R. Chroqui and S. Hattab:

Islamic Finance, which is also known as Islamic banking is a Banking or Financing activity that follows the Islamic law (sharia Law). Some modes of Islamic Financing include:

• Mudarabah (profit-sharing and loss-bearing)
• Musharaka (joint venture)
• Murabahah (cost-plus)
• Wadiah (safekeeping)
• Ijara (leasing).

The sharia law mainly prohibits Riba, which is known as “Interest”. Receipt or payment of interest is prohibited throughout the Islamic law, moreover, investments in businesses that provide sinful or prohibited products or services, such as alcohol or pork are considered Haram and is prohibited.

Venture capital is a type of financing which are provided to Small scale and start-up organizations, since these organisations have very limited history, it becomes very difficult to assess their profitability, hence they have very limited or almost no access to bank loans, Capital markets and other debt instruments. Venture capital investment need not always be in monetary terms, it also includes provision of managerial or technical Support. Venture capital are usually provided by:

• investment banks
• well-off investors
• financial institutions

The similarities between venture capital companies and Islamic bank are the method of funds collected and the agency facility. Both Islamic banks and venture capital companies take active part in the operations, and the profit-sharing process, they also become an agent for their investors/depositors, by collectively investing their funds and sharing profits back with them. In the case of conventional banks, they do not involve in the operations much, instead they depend upon past performance, credit worthiness and so on.

Both Islamic banks and the venture capital companies have similar treatment on event of a capital loss, wherein the lender alone will bear the loss, and the entrepreneur only looses his time and effort spent on the project. Islamic banks may differ from venture capital companies in the usage of Murabahah mode of Financing, which is an acceptable form of credit sales, it’s also less risky.

Conclusion

As far of this report concerned, we have been looking at two components namely, Islamic finance and venture capital. Through this report we will be helpful in deciding which source of instruments best suited for business activities. Comparatively speaking there no much difference between both Islamic finance and venture capital, but the main difference lies in the partners of the both sides i.e., in one hand both parties contribute their capital but on other hand only shows up his/her capital in the business and other one involves in business activities.