Recently we did a video on the halal high-paying careers in the city, and one of the options was working in venture capital (“VC”). We said VC is generally halal, but there are a few wrinkles.
But even if you don’t work/want to work in VC, investing in startups is an important plank of halal investments in the UK (and globally), so its important to understand the Islamic finance issues that are in play here.
(If you’re wondering what on earth venture capital is, check out our recent podcast on this topic here.)
The two big wrinkles to VC investing are:
a) VCs use preference shares/debt instruments (“PS”) to invest in their portfolio companies and these are standardly viewed as haram by the majority of scholars; and
b) preferred return (“PR”) – more on what this is later.
In the start-up deals IFG invest in, we don’t take PS’s but it is nevertheless still important to address, as the Muslim, Middle East, Pakistani, and Far East VC spaces are growing, and being able to structure in a sharia-compliant way is crucial for investors to attract the best deals, and for entrepreneurs to be able to secure investment from sharia-compliant investors.
In this article we outline:
- what PS and PR is;
- are preference shares halal? Is preferred return halal?
- why VCs use PS and PR; and
- some potential alternatives/solutions to this issue.
What are Preference Shares?
When you are a shareholder in a company, you get shares. Shares come with standard rights – usually, rights to receive a dividend, vote, and in the event of the company being liquidated, to get paid back on a pro-rata basis with the other shareholders.
But what if you want to give different shareholders different rights? Think of a family company. You might have a father than wants to give shares to his children, but doesn’t want them to have any voting rights attached to those shares whilst he is alive.
In the case of VC, a VC fund will want certain advantages over other shareholders if it is investing into a company. Hence, “preference” shares. We’ll explore exactly what VCs aim to achieve through PS later.
Now let’s turn to the separate concept of preferred return.
What is a Preferred Return?
This whole concept centres around an investor into the VC fund (whereas preference shares is relevant to when the VC fund itself is investing into companies).
Under a standard private equity or VC fund, the money is distributed according to a particular order, with the ultimate aim of splitting profits 80/20 in favour of investors. So what happens if an investor puts in £100? (This is going to get slightly complicated
First, investors will receive back their invested capital (£100). Next, investors will receive all profits up to, say, 8% (£8) (this is usually known as a “hurdle”). After that, the fund manager receives all the capital until it has caught up with the investors (who have been taking all the profits up to this point)(so it will take the next £2, as then the profit split will be 80/20). Finally, once the fund manager has caught up with the investors, all profits will be split 80/20, in favour of the investors.
The preferred return is the name given to the “8%” in the above example. This amount is a guarantee for the investor that they will get at least all the profit up to this amount, and will only have to start sharing the profits with the fund manager after they exceed that amount. In other words, the fund manager makes nothing if they don’t make a profit above 8%.
What is the Islamic issue with Preference Shares and Preferred Return?
The first thing to say when discussing preference shares and preferred return is that these constructs are modern constructs that are tied up with the invention of the modern limited liability company and as such classical Islamic law doesn’t directly address these instruments. However there is enough broader analysis and scholarship to be able to constructively address these issues – and scholars have done so.
The basic issue is that under the classic models of an equity contract in Islamic law (musharakah/mudarabah) there is an ethos of risk-reward sharing, whereas under the PS or PR set-up, a certain class of shareholders are getting, well, preferential treatment.
Similarity with debt
The other reason why Islamic scholars don’t like PS and PR is that they look like debt in many ways. Under a PS you may be due a fixed return every year, regardless of the company’s performance, and these returns may even be cumulative and compounded so that, if in a particular year the dividend is not issued, in a subsequent year the dividend due to a PS shareholder will make up for the missed dividend. Preference shares can also be drafted in relation to the interest rate (as opposed to the performance of the company), which further strengthens the debt-like characteristics of this instrument.
Similarly a PR too can look like debt in some ways. One can have a compounded PR, for example, and whenever there is a profit, the investor gets the first bite at the cherry. Admittedly though, PR is much less debt-like than PS.
Unequal power dynamics
Ultimately, when you boil it all down, Islamic finance wants to create a system where there is less uncertainty and injustice (as explained in a video we did). So, stripping it all back, the real issue with PR and PS is that some people end up with greater rights and protections than their partners in the business. They get preferential treatment in the core ways a stock can be valuable: (a) in obtaining dividends; (b) in liquidation scenarios; and (c) even in selling a stock they get an advantage – they can assess whether or not they should convert their preference share to a common share if that is now worth more (now that the business has grown, proven its model, and become much more valuable).
Why do they get that power and why do companies agree to give such PSs? Because the investors are bringing the money.
But Islamic law does not like financiers taking excessive advantage of their economically stronger position and has these and other rules to balance the risk-reward spread more equally.
Why do VCs use Preference Shares and Preferred Return?
So we know Islamic scholars and Islamic law doesn’t like the look of PS and PR. But why do VCs use PSs and PR in the first place? Answering that might give us a clue about how we can come up with a sharia-compliant alternative.
Typically, VC investors use PSs for one of 5 reasons:
- To get dividends paid first to them before they get paid out to any other shareholder (and so if there’s only enough for them, they’re the only ones who get dividends that year).
- Get priority before other shareholders when it comes to liquidating the stock – so if there’s not enough money for others to get paid, a PS shareholder will be the only one that gets paid.
- To get the ability to convert the PS into common stock if the investment’s value rises so much that the VC ownership % would be more profitable if PSs were converted to common stock.
- Potential board representation/veto rights.
- Potential anti-dilution protection (to protect preference shares from falling in ownership %).
Let’s exclude (4) and (5) from the analysis, as these rights can easily be built into the standard shareholders’ agreement of the company directly, and thus the PS analysis does not ride on it.
Of the remaining, reasons, these are technical reasons that translate roughly into the following two actual real-life motivations of a VC investor.
- To stop founders of a company selling/liquidating their company immediately after raising the capital from the VC. If a company has £0 in cash terms before investment, and a post-investment bank balance of £1.5m, then, assuming the founders hold onto 80% of the equity, if they were to liquidate/sell at this point, they’d make £1.2m and the VC would get back £0.3m. Not a great outcome for the VC you’d agree!
- To try to maximize returns, by protecting downside risk. Most companies a VC will invest in will tank. That’s the nature of the business. So VCs want to try to minimize as much as they can, the losses that accrue from such tanked companies. Let’s use the example of £1.5m investment (for 20% equity) into a company and assume that at the point the company has failed and is being liquidated, there is only £500k in the bank account. In such a situation, as the PS has priority over other shareholders, it will take all of that £500k. Yes, it’ll still be a £700k loss, but at least the VC has gained an extra £100k that it wouldn’t otherwise get if the £500k had been split pro rata to its shareholding.
I have some sympathy for (1), but again, in my view, this does not require a PS structure to achieve. A well-drafted shareholders’ agreement (and other ancillary documents) should achieve the same effect. But lets turn now to understand why people use PR, before we explore how Islamic law has some alternatives.
VC funds offer PR on their funds overwhelmingly because investors demand it and it is now established market practice. Part of the reason is risk-mitigation of course: an investor knows it is easier to make less than 8% than it is to make above 8% returns. Therefore, they ask for the first 8% (which is more likely to be achieved) to be given to them. But another part of the reason is that investors like to compare against other investment options they may have, and they might reasonably consider that 8% is a return they could quite easily achieve in other investments that are more liquid and less risky (e.g. a leveraged return on property).
Let’s address a solution to PR first, because it is the easier of the two to address.
The AAOIFI Standard states at provision (3/1/5/5) : “It is permissible for the partners to agree on any method of allocation of profit, either permanent or variable, for example, by agreeing that the percentages of profit it shares in the first period are one set of percentages and in the second period are another set of percentages, depending on the disparity of the two periods or the magnitude of the realised profit. This is allowed provided that using such a method does not lead to the likelihood of a partner being precluded from participation in profit.”
So fundamentally, a difference in the split is allowed between two different portions of the profit. What the AAOIFI Standard rightly doesn’t like though is that the fund manager is entirely cut out of profit in a particular portion of the profit. So applying to the PR context of a VC fund, the Standard requires that at least a small fraction of the first 8% of profits accrues to the fund manager – say 5-10%.
I think that gets us to sharia-compliance (and also achieves the commercial purpose of the PR). Fundamentally, a PR is part of a wider economic set-up where the profit is split 80-20 – which is perfectly sharia-compliant and pretty fair. So there isn’t much tweaking to do here in our view. (But let us know if you disagree in the comments section!).
The International Islamic Fiqh Academy states : It is not permissible to issue preference shares with financial characteristics that involve guaranteed payment of the capital or of a certain amount of profit or ensure precedence over other shares at the time of liquidation or distribution of dividends.
So the Fiqh Academy is saying that preferential treatment with respect to dividends and upon liquidation is the issue. In a VC context, an investor is not typically that bothered about a preferential treatment for dividends. The reason being, most start-ups won’t issue dividends, and the profits will come out upon a sale or IPO, rather than dividends. So a VC investor should be able to get comfortable dropping preference on dividends.
That leaves us with the preference on liquidation issue, and, though the Fiqh Academy doesn’t mention it, the convertibility issue (i.e. the ability to switch from PS to common stock).
The Tanazul Solution
The literature on PS treatment in Islam consistently does not allow preference in a liquidation scenario. Even some recent attempts by Al-Suhaibani, M. & Naifar  to come up with an Islamic PS, do not allow preference on liquidation. However the Malaysians do allow such preference on the basis of tanazul. This is the concept of the other shareholders in the company willingly foregoing their automatic right to equal standing with the PS shareholder, and saying “we give up our right in your favour – you go ahead and take preference in a liquidation scenario”.
The Wa’d Solution
Another approach you can take, which is inspired by the AAOIFI Standard (3/1/5/4 of the Musharakah Standard (12)), is a wa’d structure. 3/1/5/4 states that it is valid for a partner to bear the responsibility for the loss at the time of the loss, without any prior condition that he would accept such responsibility. In Islam a wa’d (promise) is a unilateral promise from one party to another and is not seen as a binding contract (which is bilateral). However under English law one can make unilateral and binding commitments. Thus one could get the founder to enter a wa’d to take on the loss at the time of the loss, should one arise.
The Negligence Solution
Islamic law also permits the founder to compensate the investor in case of loss that arises out of the founder’s negligence. Thus one could set up some paperwork that either (a) made the definition of negligence pretty broad (to be triggered in a liquidation scenario only) – thus triggering a negligence payout for the investor on liquidation; or (b) give the investor sole discretion to decide, in a liquidation scenario, whether the founder has been negligence.
The Best Solution
Of course, the most sharia-compliant option to deal with the preference on liquidation issue is to reject it and share in the risk just as one shares in the reward.
The next-best solution
The best solution is unfortunately not often commercially palatable/workable so is there any other option?
Revenue-share VC models have recently been gaining popularity. These models are particularly effective for those companies that are successfully selling a product for a profit (e.g. if a company makes £3 on every £8 jumper it sells), and just need more money to produce, market, and sell their product. In essence for these companies, the more money they put in, the more money they make. So the more jumpers they can produce and market, the more jumpers they sell.
Revenue-share models are in principle halal, so, with some careful structuring, an interesting solution can be reached where:
- the VC Fund ends up with a quicker return of its principal (so substantially derisks its investment – which is the whole point of PS in the first place);
- the VC Fund takes a traditional equity stake in the company.
Without loading this article with unnecessary legal structuring, a version of this model could be achieve in a product-based company by combining (A) a joint-venture agreement to establish a revenue share for a specific product line; and (B) a traditional equity investment.
Similarly, if a company is asset-rich, then a mixture of (X) a sale and leaseback arrangement on a high-value asset; and (B) a traditional equity investment could also get us to the same position.
Convertible shares are shares that act like a debt instrument yielding a fixed return, unless they’re converted into equity – at which point they become like other shares. This is an instrument used by investors to have the best of both worlds.
There are certainly ways that one can synthetically create the same economic effect of a convertible option using sharia-compliant products (along the lines of the solutions listed above for liquidation preference), but in my view the best approach from an Islamic perspective would be to get such investors to put in a portion of their investment as sharia-compliant debt and a portion as normal equity. That way they get the safety of not being too overexposed on the equity, but at the same time it allows the business to get the necessary capital it needs to grow.
With these solutions, we would be comfortable a VC is a halal employment option/business to go into and such preference shares are halal.
Without these solutions, we’d ultimately still get comfortable with someone working at such a firm given that the overwhelming ethos of VC is in line with sharia, and, in contrast to PE, it doesn’t deploy actual debt. We reach this conclusion based on a degree of pragmatism: if we were to be so strict on the sharia-compliance of quite technical structures of a potential employer, then many, if not most, jobs would be rendered impermissible (e.g. Shell with its derivatives business, or the NHS with its various financing structures) – which is not a viable conclusion.
However if one ever were to set up a VC business oneself, then of course there is no excuse for structuring their own company in an impermissible manner and using haram preference shares.
If you would like to explore investing in startups or are a startup looking for funding, find out how we can help here. We have helped 6 businesses secure an aggregate of £1.4m in funding this year.
 Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) Shariah Standards
 International Islamic Fiqh Academy Resolution No. 63 (1/7) – https://uaelaws.files.wordpress.com/2012/05/resolutions-and-recommendations-of-the-council-of-the-islamic-fiqh-academy.pdf
 Al-Suhaibani, M. & Naifar, N. J Bus Ethics (2014) 124: 623. https://doi.org/10.1007/s10551-013-1897-6