Exploring implementation of Islamic equity contracts in India

Two-Tier Mudarabah model is the basic theoretical model used by Islamic banks to structure Venture Capital (Iqbal and Molyneux; 2005). It is an equity-based structure used to create asset and liabilities where the Islamic bank is placed between investors and depositors who provide money and borrowers and beneficiaries who require money. On the liability side, the Islamic bank plays the Mudarib role for the suppliers of capital, while on the asset side it acts as the Rabb-al-mal (investor or venture capitalist role), and the business entrepreneur (Mudarib) is responsible for all business operations.

Since the current regulatory environment in India does not support Islamic banking, the question is: how can the two Islamic equity contracts viz., Mudarabah and Musharakah, be implemented in India? What could be the organization structure and covenants that govern the business transactions which are Shariah compliant?

With the growing number of AI/ VC firms in India and with the year 2013 investments totaling $688 million in Angel/ Seed funding (http://yourstory.com/2013/12/1600mn-invested-in-indian-startups-in-2013), the question is:

Can an understanding of how these firms operate helps us in building an organization structure with a set of covenants using the principles of Islamic finance in India?

We can understand how an AI/VC firm operates by organizing our study into three categories of methods/procedures viz.,

  1. Valuing
  2. Structuring and
  3. Monitoring

In other words, as long as the valuation methods, structuring of the capital and monitoring methods (post-valuation and structuring) are Shariah complaint, there is every possibility of implementing the Islamic equity contracts viz., Mudarabah and Musharakah in India.

From the project work done by this author (Title: Funding Pre-Revenue Companies Using Principles of Islamic Banking and Finance  – a feasibility study about the application of Mudarabah and Musharakah contracts in India), certain conditions of structuring the capital in the contract/ Term sheet/ Definitive Docs are NOT Shariah complaint. For example, excessive usage of Preference Shares by the Seed capital investors for early stage investments.

After studying the methods/ procedures of a few AI/VC firms operating in India, the author suggests to use the LLP model as the organization structure and frame covenants that are Shariah compliant.

The LLP act was enacted by Indian Parliament in 2008 and has come into effect since March 31st, 2009. It provides lot of freedom and flexibility in managing the firm (as in a partnership), and with less compliance as compared to a company. It is a legal entity with an ability to raise finances like a company and permits framing of rules and regulations by the partners themselves. The author sees it as an excellent vehicle to implement the two Islamic equity contracts. The following sketch suggests how these two contracts could be implemented in India:

LLPs

 

 

 

 

 

 

It is suggested that an LLP firm be formed between the investors looking for Shariah compliant investments in India and an intermediary organization (mostly an Islamic Financial Institution, which itself is an LLP) that is legally permitted to undertake commercial transactions in India. The terms of LLP agreement are derived from Mudarabah contract. Here the investor(/s) is Rabb-al-mal and the intermediary organization is Mudarib. The intermediary organization has a Shariah scholar on it’s board to advise on investments in pre-revenue companies.

Another LLP firm be formed between the intermediary organization and the pre-revenue company. The terms of LLP agreement are derived from Diminishing Musharakah contract. This contract seems to be more appropriate in Indian context because:

  • Risk of loss is reduced as the principal-agency conflict is considerably reduced.
  • For capital providers seeking an alternative to IPO and/or seeking a middle path between capital gains or profits, this contract could be an option as the ownership is transferred to the Entrepreneur in a mutually agreeable timeline.
  • It may be possible that the Entrepreneur is not spending full time in the venture being funded as most of the VCs/ AIs do not allocate capital for Entrepreneur’s sustenance, but expect him/her to work full time in the venture! One of our covenants in the model agreement factored this issue.
  • For further reducing the risk, pre-revenue companies that are in need of capital to purchase tangible assets may be considered as a priority investment. For e.g., Manufacturing start-ups.
  • Investment when organized in two phases as suggested in our valuation method (modified Expected Commercial Value method) could further reduce risk.

A complete report of the project work has a comprehensive list of Shariah complaint covenants that are suggested to implement the Islamic equity contracts in the two LLPs mentioned above.