IB1005 DEPOSITS AND FINANCING PRACTICES OF ISLAMIC FINANCIAL INSTITUTIONS CHAPTER 9 : MUSYARAKAH JOINT- VENTURE FINANCING COMPILED BY HAMDAN HJ IDRIS, BSc Econs, MBA (Islamic Banking & Finance) Certified Professional Trainer (MIM) Industry Expert INCEIF PRESENTED BY HJ MAHMUD HJ BUNTAT, MBA (AUOL, UK), DBM (Swansea Inst., UK), CIL (UIA) Part-time Lecturer (INCEIF) Former Head of Islamic Banking Division, OCBC Bank (Malaysia) Bhd

Chapter 9 : Musharakah Joint Venture Financing When Islamic banks are not allowed to make profit by making loans to customers, what are the alternatives available? Theoretically, Islamic banking can offer two categories of financial contracts. First, it deals with asset-based financing such as, such as murabahah, salam, istisna’ and al-ijarah. Secondly, an Islamic bank can pursue business on the basis of partnership such as mudarabah and musyarakah.

How would Islamic finance respond to the requirement of capital and risks associated with the new business? To answer this question, the musyarakah contract can be useful. It is useful to remember that musyarakah is not a financial contract meant for banking alone. In fact it is meant for any ordinary financial transaction.

In Islamic jurisprudence, the term shirkah is commonly used to denote musyarakah. Shirkah means “sharing.” It can be classified into two, namely shirkat-ul- milk and shirkah-ul-aqd. Shirkat-ul-milk is a joint ownership of two or more persons in a particular property.

Shirkat-ul-aqd means a partnership affected by a mutual contract, which can be translated as a ‘joint commercial enterprise.’ Shirkah-ul-aqd is divided into three categories:- 1. Shirkat-ul-amwal - All partners invest some capital as well as expertise into the new business. 2. Shirkat-ul-‘amal - Involves only services rendered by partners. 3. Shirkat-ul-wujuh - Where no capital input is required. The business purchases goods on credit and sell them cash.

The profit generated from the business of shirkat will be distributed among the partners at an agreed ratio or percentage. Of the three types of shirkat-ul-‘aqd, the first kind, namely shirkat-ul-amwal, is associated with musyarakah financing. In fact, the term musyarakah is not readily found in books of Fiqh. It was casually used in Islamic banking literatures to imply shirkat-ul-amwal as it deals with capital investment

Let us look again at the role of musyarakah/ shirkat-ul-amwal in all business set up. In fact, all forms of modern business organisation today are based on musyarakah with the exception of sole proprietorship and a sleeping partnership. In musyarakah all partners are required to take active role in running the business.

Shirkat (Partnership) Musharakah Financing Shirkat-ul Milk (Holding Partnership Shirkat-ul ‘Uqud (Contractual Partnership Inheritance (Faraid) Wills (Wasiyat) Shirkat-ul Mufawada (equals shares) Shirkat-ul ‘Inan (unequals shares) Shirkat-ul-Wujuuh (Receivable Partnership) Shirkat-ul ‘Amal (Abdan) (Partnership in work) Al-Mudarabah (Trustee Partnership) Shirkat-ul Amwal (Partnership in capital)

What are the rules available in musyarakah on the distribution of profit? There is no single definite rule available but here are some opinions of Muslim jurists. According to Imam Shafi’i, each partner receives a profit exactly in the proportion of his investment.

Imam Ahmad contented that the ratio of profit may differ from the ratio of investment if it is agreed between partners with their free consent. A middle view was adopted by Imam Abu Hanifa that the ratio of profit may differ from the ratio of investment under normal conditions. Despite the differences in opinion on profit distribution, the jurists are unanimous with regard to two principles:-

First Principle, The distribution of profit cannot be determined in an absolute or lump sum amount. This is because there is no certainty of profit in the venture. In other words, in a financing contract Islam only allows a predetermination of profit in ratios but not in the absolute sum.

Second principle; All jurists agree that each partner shall suffer loss exactly according to his capital investment. However, this does not imply that musyarakah is only confined to a limited liability company. If the loss exceeds the paid-up capital, the balance could be raised from the partners’ personal assets.

Application of Musharakah Contract for Venture Capital Venture capitalists provide equity funds to small business, especially start-ups. At a later stage, they provide capital for a company that expects to go public within a year. Venture capitalists supported entrepreneurs with capital in exchange for an ownership stake of the business.

Unlike banks and unit trust investors, venture capitalists work closely with entrepreneurs and investee companies. In this manner, the venture capital business elucidates the Islamic system of profit-loss sharing Not only it injects risk capital, venture capitalists also provide value-addition such as reviewing business plan, giving financial advice and improving networking.

The essential element in Islamic venture capital is the profit-loss sharing system (PLS) than runs on the principle of al-ghurm bil ghonm (i.e. the entitlement to return is related to the exposure of risk). One of the highlights of venture capital investments is the due-diligence process conducted by the venture capitalists.

It serves to investigate the characteristics of the entrepreneur who is seeking financing. Both the behavioural and mental traits of the entrepreneur will be assessed to measure his level of trustworthiness (amanah). Conducting the due-diligence on the entrepreneur is therefore compulsory (wajib) to prevent undue moral hazards that may undermine the venture.

A venture capitalist usually makes profits through capital gains generated from sale of shares upon exiting either via public listing or by stock repurchase by the investee company. They are not interested in a venture on permanent basis. In this way, one must closely studies the nature of the venture capital partnership and see whether it fits in the musyarakah framework.

Division of ownership in venture capital is not based on relative monetary investment of the two parties. Rather, determining percentage of ownership usually involve a number of uncertain investment outcomes such as expected revenues, profit margin and price-earning ratio in order to obtain the current value of the company.

Most of the rules on musyarakah are fiqh i.e. they are derived from human understanding of the Quranic teachings about justice and equity. The fuqaha (Islamic jurists) uses reason (‘aql) when they exercise ijtihad (independent thinking) on pertinent issues involving welfare (maslahah) of the people. When exercising Ijtihad they are guided by the Quran and will not make opinions based on whims and fancies.

The fuqaha must look into this issue on ownership determination as it (i.e. owneship shares) is a parameter bearing legal claims once profits are realized The issue of gharar (ambiguities) is a cause for concern since ownership is determined by estimated and projected variables such as: - Projected profit of venture - Price-Earning ratio (P/E) - Venture capital return (VCR)

Gharar must be avoided in Islamic law of contract (‘aqd), otherwise the contract is deemed null and void.

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