InvestmentPersonal Finance

How to Calculate Zakat on Startups

This is the first year in which a number of investors will need to work out zakat on startups invested in through IFG.vc, and so we have been preparing notes for our investors.

As there is wider benefit for the Muslim community, we thought we’d share around these notes on how to calculate zakat on startups.

In this article we cover:

  1. A brief outline on how to calculate zakat on businesses.
  2. Two methods to calculating zakat on startups.
  3. Additional zakat considerations for founders of startups

Zakat on Businesses Generally

Generally, zakat is calculated on businesses by totalling up cash plus certain receivables, the value of stock and deducting short-term liabilities. The resulting amounts are the zakatable assets. You only pay zakat on your percentage of ownership over these zakatable assets.

So for example:

Cash: £50

Receivables: £500

Stock: £50

Short-term liabilities: £100

Total zakatable assets: £500

Zakat due (2.5%): £12.50

This is of course just a high-level overview of business zakat. For further details on zakat on investment see here. For guidance on zakat on business assets see here.

Zakat on Startups

There are two main approaches to take when calculating zakat on startups.

In one you take an approximation on the cash/zakatable assets sat in the company, and in the other you get a precise number.

  1. Approximation: Take an approximation based on the duration that has passed from the previous fundraise to indicate the cash that the startup will have in the bank. The idea is that the longer that has passed, the less cash the startup will have. All you have to do then is work out 2.5% of that cash, work out your percentage holding of the company and pay your portion of that amount.
    For example, you know a startup has just raised so pretty much all its money is in the account. Let’s say it has raised £1m, so it’ll have £1m in the bank. Zakat payable is £25,000. You own 1% of the company. You pay £250.

Please note that as a rough guide, we would typically expect a startup to burn about 50% of its last raise every year.

  1. Precise number: You find out from the startup exactly what proportion of their assets are zakatable. This means you get them to add up their cash plus receivables and deduct short-term liabilities. Then you just work out your ownership of the company and pay zakat on your portion of zakatable assets.

Let’s give an example for approach 2. If a startup says, based on their last post-money valuation, that they have 10% zakatable assets, then you need to work out how much you pay on that. Your investment at the last round was £10,000. You will therefore work out 10% of £10,000 which is £1,000. This is the portion of the zakatable assets that you are responsible for. So you work out 2.5% of that and pay £25.

As a reminder, a premoney valuation is what valuation the company goes out to fundraise on. It might be fundraising at a £4m valuation for example and looking to raise £500,000. Once it has raised that £500,000, it now has a post-money valuation of £4.5m, which is simply the premoney valuation and adding the cash investment to it.

So, for the startup to work out its zakatable assets percentage, it will use this post-money valuation. Overall, if the startup has £450,000 in cash in the account on the zakat date, the calculation is £450,000/£4.5m = 10%

 

Zakat Considerations for Founders

There are specific considerations for founders to consider when it comes to zakat on their portion of the zakatable assets.

The standard approach set out above can also work for founders in that it will give a number that they have to pay.

But that number may be so large as to lead to counterintuitive conclusions.

Bear in mind that founders are on very low salaries and typically are young and low on savings.

Let me give a few examples.

  1. The company has cash of £1m and a post-money valuation of £5m, so zakat due is £25000. As a founder, Abdul owns 60% of the company. This means that Abdul needs to pay 60% of £25000, which is £15,000. That adds up to £1250 as a monthly direct debit.
  2. The company has cash of £10m and a post-money valuation of £50m, so zakatable assets are 20% and zakat due is £250,000. As a founder, Abdul owns 30% of the company. This means that Abdul needs to pay 30% of £250,000. So Abdul now needs to pay £75,000, or £6250 monthly
  3. The company has cash of £100m and a post-money valuation of £1bn. Zakat due is £2.5m and Abdul now owns just 10% of the company. So he needs to pay £250,000. This amounts to a monthly direct debit of £20,833.

The point should be obvious. Founders are only rich on paper and cannot realistically afford to pay zakat in many cases.

So what to do?

Here are a few solutions:

  1. Pay as much as you can, but then defer the payment of the zakat you cannot pay until an exit (e.g. you get bought out and everyone cashes in their shares).
  2. Pay only on your salary and consider the money in the company as not truly yours due to the existence of preference shares and other controls as to what you can spend that money on.
  3. Exceptionally for founders only, take a full-year approach to the startup assets after the fundraise has been finalised. This shall mean that you calculate your zakat on your zakat day for all other assets, but for your startup assets in particular you keep to a strict annual timetable so as to enable the startup’s cash to deplete over a year. The reasoning behind this is that a typical startup will burn about half of its cash in that time period, thus making zakat more affordable.
  4. Pay out of the business if your investors are amenable to that.

The reasoning behind (2) is that, if the company were to liquidate today, you would typically not get the entire pot of money. Typically, this would go to preference share holders first, and, even where there are no preference shares, founders will usually pay out that money to investors out of a sense of fair play.

The entrepreneurs are contributing their labour to the project while investors contribute money. It so happens that under the limited company structure this contribution of labour to the project results in the attribution of a large amount of money to them directly.

Our preferred approach at this moment in time is a combination of (1), (3) and (4) as this allows the startup founder sufficient flex to make her zakat affordable, but also sticks to the essence of zakat. (4) might also actually add value to the business commercially too as a corollary of the donation (though of course that should not be the intention).

If this is throwing up some really counter-intuitive results for you, then please feel free to drop us a line or comment in the fatwa forum as this is a topic we are continuing to learn about collectively as a community of Muslims startup founders and investors.

Mufti Faraz Comments

As a principle, a Muslim shareholder is only responsible for paying Zakat on his share of net Zakatable assets in a startup. A startup is unique in the sense that its founders can be average people from modest backgrounds who have developed a convincing proof-of-concept and raised an astronomical amount in the seed round or series A, B etc. At present, my view is that a shareholder in a startup should consider the following:

  1. Pay Zakat if it is within their means and capacity.
  2. If for whatever reason Zakat is challenging, they may delay and see if they can pay Zakat at a later stage.
  3. In the odd scenario where the Zakat calculation results in an unreasonably high amount and is relatively much higher than their income and personal finances can bear, then one may consider doing their calculation based on the minimum amount held for an entire year above the Nisab. So, for example, if a founder had £5000 for the first six months and raised £1,000,000 hypothetically which made his share worth £500,000 mid-Zakat year but he still had £200,000 at the end of his Zakat year, Zakat will not be due on the £200,000. It will only be due on the initial £5,000 as that is the minimum amount he held for 12 months. 2.5% of £5,000 is £125. This is the Maliki, Shafi’i and Hanbali approach to Zakat calculation.
  4. If scenario 3 still results in a Zakat amount which is relatively beyond one’s means and the Zakat payment cannot be genuinely paid any time in the near future, one may consider the startup to have a separate Zakat cycle which starts from the point of raising capital. Thereafter, one year later, the Muslim shareholder will be responsible to discharge Zakat at whatever his share is worth proportionate to the net Zakatable assets in the startup.

Finally, every person in such a predicament should consult a Mufti and a Zakat expert to ensure they are calculating correctly. You can do that at the IFG fatwa forum.

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