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International Journal of Management (IJM)

Volume 9, Issue 4, July–August 2018, pp. 40–59, Article ID: IJM_09_04_006

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COMPARATIVE ANALYSIS BETWEEN

ISLAMIC FINANCE AND VENTURE CAPITAL:

DO IFIS AND VENTURE CAPITALISTS ADOPT

THE SAME INVESTMENT DECISION

PROCESS?

A. Sakouili and M. EL Azhari

PhD student at the University Hassan the 1st, 26000 Settat, Morocco

R. Chroqui and S. Hattab

Professor at the University Hassan the 1st, 26000 Settat, Morocco

ABSTRACT

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.

Keywords: Venture Capital, Musharakah, Mudarabah, Project Selection, Limited

Rationality, Reliability Models

Cite this Article: A. Sakouili, M. EL Azhari, R. Chroqui and S. Hattab, Comparative

Analysis between Islamic Finance and Venture Capital: do IFIS and Venture

Capitalists Adopt the Same Investment Decision Process?, International Journal of

Management, 9 (4), 2018, pp. 40–59.

http://www.iaeme.com/IJM/issues.asp?JType=IJM&VType=9&IType=4

Comparative Analysis between Islamic Finance and Venture Capital: do IFIS and Venture Capitalists

Adopt the Same Investment Decision Process?


1. INTRODUCTION

In contrast to conventional finance, which links economic agents with a need for financing

and those with the capacity to meet that need for an interest-based compensation, Islamic

finance admits a different definition of this compensation, including moral criteria inherent in

Islamic ethics. Accordingly, one of the fundamental principles of this practice is the

prohibition of interest in all transactions (Benammara, 2015), for the purpose of creating

instruments constituting an alternative based on the principle of Risk sharing.

Indeed, the Islamic economic system believes that any agent providing capital in the form

of money to a commercial enterprise assumes the risk of loss. This does not necessarily mean

that he cannot make profit (Siddiqui 1987) as he is entitled to a proportionate share of the real

benefits (Siddiqui, 1994). In this way, the system protects the entrepreneur who, in a

conventional economy, should pay fixed interest even when the business loses money

(Usmani, M.I. 2002,).

This principle of 'sharing' is manifested in the practice of the Musharakah and Mudarabah

contracts. Despite their undeniable advantages, these instruments remain seldomly used by

Islamic financial institutions (IFIs), because of the complexity of their forms and rules of use.

Khan & Mirakhor (1987) argue that “Even though in practice the role of profit-sharing and

partnership is very small at present, they continue to dominate the theory of' Islamic banking.

They are regarded as the norms towards which practice should and would, eventually

gravitate.” (p.185-199).

These contracts are often likened to the practice of Venture Capital (VC), which also

enable the realization of projects with a level of risk that does not enable the access to a

traditional financing through conventional banks. In fact, this method of financing has proven

itself in developed countries, particularly the US model which is an undeniable success. It is a

profession, structured and organized in all developed economies, playing a major role in

funding and supporting high-risk projects (De Fontaine Vive, 2008; Frémiot, 2007).

Hence, although the concept of VC is often linked to that of innovation, several studies

comparing this financing mode to certain practices of Islamic finance (notably Musharakah

and Mudarabah) have been carried out in recent years. However, we have noticed on one

hand, that these studies have attempted to bring elements of comparison in a general way

through the decortication of the terms‟ simple definitions. On the other hand, we have noticed

that few studies have treated this issue deeply from the point of view of the project selection

process.

In this sense, our contribution aims to enrich the existing literature in this subject by

comparing the Mudarabah and Musharakah contracts with private equity (of which VC is a

component) and try eventually to study the applicability of the decision-making analytical

tools, used in the field of VC, particularly those provided by the theory of bounded rationality

in the field of Islamic finance.

In order to achieve this goal, in the first part of this paper, we will try to present the

history of the two modes of financing, before proceeding to define them in depth, in order to

explain their functioning. Thereupon, we will conduct in a second part, a comparative analysis

of these two modes according to five criteria namely:

Investment Type;

Partner Type;

Management;

Profit and Loss Sharing;

Partnership Duration;

A. Sakouili, M. EL Azhari, R. Chroqui and S. Hattab


Finally, in the third part, we will discuss the analytical tools provided by the theory of

bounded rationality, particularly the reliability model, in order to study its applicability in the

field of Islamic finance.

2. HISTORY AND DEFINITIONS

2.1. History

Financing instruments such as Musharakah and Mudarabah are one of the first forms of trade

that were used by the people of the Arabian Peninsula, even before Islam emerged and started

to expend. In fact, these methods were already beginning to gain space compared to other

commercial procedures. Ref

The Holy Prophet (PBUH) authorized the practice of these instruments by using them

himself; it is reported in the Sunnah manuscripts that the Prophet (PBUH) was a Mudarib

with the money of Khadija (his wife) before even his advent as a prophet (Sabiq, 1983). Once

the Hijra took place, the Prophet announced that the Muhajireen [1] and Ansar [2] are

brothers. Because of this, they have partnered in business through Musharakah and

Mudarabah and other forms of commerce. Subsequently Fiqh scholars adapted and created

new forms from what was practiced at the time of the Prophet and this with the

implementation of the IFIs in 1970.

The purpose of these instruments (especially the Mudarabah) is to find opportunities for

cooperation between the financing funds provided by the owners, on one hand, and the

experiences, physical, intellectual and creative efforts provided by the people who work on

the other hand. In fact, in any society, many people owning money do not know how to

invest, do not know the right means or may not have the time to invest and directly supervise

their project. Similarly, there are a number of project developers with the expertise, the

investment methods and enough time to develop and support investment projects but they do

not have access to the appropriate funds.

In a like manner VC financing fits in this perspective. The venture capital industry

emerged and expanded in the United States in the mid-1940s. It‟s in 1946 that the first

American Research & Development (ARD) VC fund was created by a group of private

individuals 'Business Angels', to take off ten years later under the name 'Venture Capital',

together with the development of the electronics industry (manufacturing of semiconductors,

computers, instrumentation ...) (Cerveaux, 2014; Duboucage, 2003; Paulré, 2007). Thirteen

years later (in 1958) the 'Small Business Investment Act' was born; the purpose of this act was

to codify the practices of VC firms and establish what the professionals called 'Small

Business-Investment Companies' (SBIC) (Emmanuelle and Galindo, 2008; Poncet, 2013). As

a result, the tax measures undertaken by the financial authorities and the explosion of the

High-Tech sector favoured the VC‟s expansion.

Unlike the United States, VC in France begin to emerge in the 1970s, thanks to the action

of public authorities, this resulted in the creation of the first legal framework for this kind of

practice (Cerveaux, 2014). Today, the VC market is characterized by the multiplicity of

stakeholders and the diversity of status (Ekeland and al., 2016a). As a result, the venture

capitalists‟ profession is evolving and has gradually moved towards financial specialization in

development operations (Ekeland and. al., 2016b).

In Morocco, the VC industry is relatively new and dates from the 1990s, with the creation

of the first VC firm named 'Moussahama', the latter has dominated the Moroccan VC market

for a considerable time. Starting from 1999, VC companies have multiplied. This has created

a favourable climate for the creation of AMIC (Moroccan Association of Capital Investors) by




VC professionals (AMIC Report, 2016; Belalia. A and al, 2015; Ndour. A. D, 1998; Diamane

and Koubaa, n.d.).

The reading of the recent annual reports, provided by AMIC, makes it possible to note

numerous remarks, two of which are important, namely:

A dominance of development capital funds, unlike those of venture capital that are

significantly marginalized, leads us to conclude that Moroccan venture capitalists

are more risk-averse

The absence of specialized venture capital funds and the existence of a limited

number of specialist funds oriented to particular sectors (Ed-dafali .S, Bouzahir .B,

Chakir .A, n.d.)

2.2. Definitions

2.2.1. Musharakah and Mudarabah

2.2.1.1. Musharakah (Partnership)

Musharakah meaning in Arabic Sharing, derives from the word „Shirkah‟ which signify

partnership (Abu Al-Fadl. M.J, n.d.; Al-Hamiri. N.B, 1999; Al-Qorafi. A.C, 1994). It is a

word recently introduced by scholars in the field of Islamic finance, it does not exist in Fiqh

manuscripts, the term recurrently used is Shirkah. It has a broader meaning and include two

type of partnership, Shirkat-al-„Aqd (contract partnership) and Shirkat al-Milk (partnership of

ownership).(Usmani, 2004)

a. Shirkat-al-Milk (partnership of ownership): it‟s a partnership where the ownership

of a particular property is shared between two persons for one of the following

reasons: they purchased it, they inherited it, it was gifted to them or was given to them

as part of a testament. (Hammad, 2008), the losses or profits generated by this

partnership are distributed according to their ownership shares.(Nassar, 2010). This

kind of Shirkah comes to existence in two different ways (Nassar, 2010):

Shirkah Ikhtiyarya (Optional partnership): when two people decide by choice to

enter a partnership, with or without a contract (Hammad, 2008), the scholars

explain that it‟s when, willingly, two partners create or enter in a joint ownership

of a property, if they purchased it, was gifted to them or was given to them in a

Will (Al-Zohaili. W., 1985; Journal of the Judicial Verdicts, n.d.; )

Shirkah Jabriyah (Automatic or forced partnership): when the shared ownership is

created without the partner‟s free will, as in the case of inheritance(Al-Zohaili,

1985; Hammad, 2008; Journal of the Judicial Verdicts, n.d.).

b. Sharikat al-‘Aqd (joint commercial enterprise): it‟s a contract between two persons

or more, by which they enter a partnership where each brings a share of the capital and

in return have a part of the profits (Al-Zohaili, 1985; Hammad, 2008; Nassar, 2010;

Usmani, 2004). It is divided into four types:

Sharikat al-Amwal (capital partnership): it‟s a partnership where two persons or

more invest their money in a commercial enterprise, in which the profits are

distributed according to their capital shares or according to predefined percentages

agreed upon. This type is subdivided into two kinds:

Shirkat Al-Mofawada: it‟s when the partners are equal, in the investment shares, in

the right to manage the business and in the profit distribution provided that the

contractors specify at the beginning that it is a Mofawada partnership otherwise

it‟s a „Anaan partnership.



Shirkat Al-‘Anaan: it‟s when the evenness between the partners‟ investment shares

is not a requirement, the partners contributions and the profit distribution shall be

as agreed between them. (Al-Barkati, 2003; Al-Jurjani, n.d.; Al-Qadiri, 2005; Al-

Zohaili, 1985; Nassar, 2010; Usmani, 2004)

Shirkat al-A’mal (partnership in service): it‟s an agreement between two persons

or more, through which they jointly undertake to carry out a service to their

customers sharing the earnings according to predefined percentages. It is called

also Shirkat al-Abdan, Shirkat al-Taqabbul or Shirkat al-Sanai‟. (Al-Zohaili, 1985;

Hammad, 2008; Nassar, 2010; Usmani, 2004)

Shirkat al-Wojouh ( Liability partnership): in this kind of partnership, the partners

have no investment, they use their relations and connexions to purchase

commodities on credit (delayed payment) and sell them for cash, the profits are

distributed between them equally or according to the ratio they‟ve agreed

upon.(Hammad, 2008; Nassar, 2010; Usmani, 2004)

Mudarabah: we‟re going to discuss this type of Shirkah in dept in the next part

because it‟s one of the two major equity financing instruments used by Islamic

financial institution.

The diagram presented below sums up the different types of Shirkah [3]:

Source: Nassar. A.M. 2010, Investment using Musharakah in Islamic banks, P 33

The term Musharakah is a bit limited in comparison with the term Shirkah, Usmani (2004)

explains that Musharakah, the term used nowadays, is narrowed to Shirkat al-Amwal.

According to Usmani (2002) “Under Islamic jurisprudence, Musharakah means a joint

enterprise formed for conducting some business in which all partners share the profit

according to a specific ratio while the loss is shared according to the ratio of the

contribution.”. Through a Musharakah contract, two partners jointly invest in a capital-profit

sharing project, whereas the losses are borne by both parties in proportion to the capital

invested (Daly and Frikha, 2015; Supreme Sharia Supervisory Authority of the banking

system and financial institutions, 2006).




Figure 1 Musharakah contract

Another type of Musharakah contract has been developed by the IFIs with the aim of

achieving various objectives, tolerating the possibility of its implementation in the current

banking and commercial environment. It is Musharakah Motanaqissa (Diminishing

Musharakah). It is a type of partnership where one of the partners accepts and commits to

gradually give up his share in the business to the other partner until there is only one owner.

Both operations must be independent because it is not allowed to require the progressive sell

option in the main contract, there must be a contract for each transaction (Accounting and

Auditing Organization for Islamic Financial Institutions (AAOIFI, 2014; Usmani, 2004).

The transfer takes place in three forms, namely (AAOIFI, 2014) :

The partners agree that the transfer is made after the completion of the

participation contract, so that the partners have complete freedom to sell their

shares to the other partner or to others.

The partners agree that in addition to the part of the income obtained under the

partnership agreement, the transferring partner will obtain a relative share of the

other partner's net income as a payment for the sale of his share and thus there will

be only one owner of the project after a period of time.

Each partner will have a specific proportion in the form of shares representing the

total value of the project. One of the partners may periodically acquire a certain

number of these shares, so that the shares of one diminish by increasing the

other‟s, until one owns all the shares and becomes the sole owner.

2.2.1.2. Mudarabah (financial tutelage)

There is some difference in the naming of this type of contract among the four Madahib [4]. It

is called Mudarabah by the Hanbali School and Hanafi school (Al-Kassani. A, 2003), and

Qirad by the Maliki school and Chafi‟i school (Al-Qorafi. A.C, 1994b). It refers to the

situation where one person gives a sum of money to another, through a Mudarabah contract,

to invest in a business enterprise. The money for the investment is provided by the fund-raiser

named Rab-al-Mal, while the work and management of the company is the exclusive

responsibility of the other person named Mudarib. The profits generated are allocated

according to predefined ratios, whereas any loss is only suffered by Rab-al-Mal, unless there

is negligence, fraud or breach of contract conditions on the part of the Mudarib (Abu Al-Fadl.

M.J, n.d.; AAOIFI, 2014; Al-Jurjani, n.d.; Al-Qadiri, 2005; Hammad, 2008; “Journal of the

Judicial Verdicts,” 1877; Qorchi, 2005; Usmani, 2002).



Figure 2 Mudarabah contract

The scholars distinguish two types of Mudarabah videlicet (Al-Tahnaoui, 1996; Al-

Zohaili, 1985; Hammad, 2008; “Journal of the Judicial Verdicts,” 1877; Nassar, 2010;

Usmani, 2002):

Mudarabah Motlaqah (Unrestricted Mudarabah): in this type of Mudarabah the

Mudarib has full freedom to choose and manage the business the way he deems

right, rabu-al-mal cannot impose any condition on the Mudarib, such as the place

where, the time when, the persons with whom or the way the business is

conducted, he is a sleeping partner.

Mudarabah Moqayadah (Restricted Mudarabah): conversely, it‟s when Rab-al-

Mal imposes one of the conditions specified above in order to invest in the

enterprise.

The validation of these contracts from a Sharia point of view requires a number of terms

to be respected (AAOIFI, 2014; Al-Kassani. A, 2003; Al-Khafif, 2008; Al-Sarkhassi, 1989;

Al-Zohaili, 1985; Nassar, 2010; Sabiq, 1983). We chose to present only a few terms, the

others we presented and used in the comparative analysis. The table below sums up these

terms:

Musharakah Mudarabah

Validation

The contract is concluded on the

expression of the offer and the

acceptance, otherwise it is not

valid.

The contract is concluded on the

expression of the offer and the

acceptance.

Rab-al-mal must specify in his

offer that it is a Mudarabah or

Qirad contract.

Contractors

Partners must be eligible and sane

to make the commitment that a

Mudarabah contract requires.

Like Musharakah, the eligibility

of Rab-al-Mal and Mudarib is a

necessary condition for the

validation of the contract.

Equity capital

The contribution of each partner

must be specified at the time of

signing the contract, to know its

amount and its nature.

Rab-al-Mal must be the owner of

the invested capital.

This capital cannot be considered

as a loan to the Mudarib.

The capital invested must be

specified at the time of signing the

contract.

The capital must be invested

exclusively in the project

concerned, except with the

consent of the rab-al-mal.




2.2.2. Venture Capital

Venture capital is a capital injection intended to finance nascent, or very young, companies

with high growth potential, which are rapidly developing and operate in activities requiring

significant capital during their first years of existence (start-up) (Duboucage 2003,Ekeland et

al., 2016a; Paulré, 2007; Savignac, 2006; Garnier 2009). This financing takes the form of a

minority and temporary participation in the capital of these companies, not listed on the stock

market, so that the majority stays with the project holder (Diamane and Koubaa, n.d.). It is a

medium-term "partnership" contract between a young entrepreneur and a financier who acts

as an intermediary facilitating access to financing for high-risk projects(Chatti, 2010; Cherif,

1999; Garnier, 2009).

Financing through VC proves crucial when traditional solutions do not allow the financing

of the project. Schier (2006) discern two main reasons for using VC financing, namely:

Access to a private equity market without going through the financial market,

since in the latter the constraints in terms of communication such as information

asymmetry and adverse selection constitute obstacles to the financing of the

project;

Access to significant amounts of capital in the absence of tangible personal

guarantees, since venture capitalists bear the risk inherent in the funded project

At the beginning of its emergence, venture capital has often been used to finance the early

stages of start-up‟s development. Afterwards, his role was widened by the professionals so

that it touches all development phases of a project. Thus, its terminology varies depending on

the funded phase (Kharis .M, 1997).

The following table illustrates the appropriate funding for each phase of a project's life

cycle:

Project phase Funding concerned

Research and development Seed capital [5]

Creating Venture Capital

Growth Development Capital

Project Survival Capital transmission

Adjustment (in case of difficulty) Rollover capital

Source: AMIC,2016

However, the term VC is often used to refer to these different phases of the investment

cycle. There are generally three types of capital, namely: seed capital, creation capital and

post-creation capital (the financing required for the stages following start-up) (Chatti, 2010).



Figure 3 Company life cycle

Source: Dylan Tylor, The Next Wave of Space Investors,2016

Figure 4 company funding life cycle

Source: Dylan Tylor, The Next Wave of Space Investors,2016

Seed Capital: This is the riskiest (and most unsuccessful) investment among all

the different types of VC. It concerns the earliest stage of a company's life where

the product is not yet developed. Generally, this kind of fund is dedicated to the

study of the feasibility of the project (Stanislas De Zutter, 2010).

Creation capital (Start-up): This type of financing represents the main part of

VC. It concerns companies (with less than one year of existence) that have already

validated their business plans and are looking for financing to start their activities;

It is used for the purchase of materials or equipment and the acquisition of the

business premises, etc…. This type of capital is also very risky (but less risky

compared to seed capital) due to the sensitivity of the creation phase and to the




risks that it generates namely : technical, commercial and managerial (Chatti,

2010; Diamane and Koubaa n.d.; Stanislas De Zutter, 2010).

Post-creation capital: it is a financing intended for companies that have already

started for some time their activities and whose development requires external and

additional financing, this type of financing is less risky than the previous ones

(AMIC, 2017; Chatti, 2010; Ed-dafali.S, Bouzahir.B, Chakir.A, n.d.)

Other researchers including Douchane and Rocchi (1997) classify the field of intervention

of VC into two sub-categories only: seed capital and capital-creation.

In the following table, they summarize the differences between seed capital and creation

capital:

Seed Capital Creation Capital

Turnover 0 >0

Net profit Loss by absence of cashed

products

Loss (inability to reach the dead

point)

Amount invested Low, due to high risks Higher, due to lower risk

Nature of needs covered

- Feasibility study

- Prototypes tests

- Preproduction

-R & D

- Industrialization

-Marketing

-Research and investment

Potential added value Very high High

Risk taking intensity Probability close to hitting

the jackpot Very high

Risk nature Product, technological,

concept

- Industrial

- Market

Organizational model Absence (creator working in

his garage) Informal

Maturation From one to five years From one to three years

Source: Douchane Amar & Rocchi Jean Michel (1997), Technique of Financial Engineering: Practical

and Technical Financial Arrangements, Ed. SEFI. Paris, P23

3. COMPARATIVE ANALYSIS: VENTURE CAPITAL VS

MUSHARAKAH / MUDARABAH

After having studied each of these financing modes separately. We will try in this part, which

will be dedicated to the search for points of similarity as well as the points of dissimilarity

between the Musharakah and Mudarabah contracts on one hand and the risk capital on the

other hand, to draw up tables facilitating this comparison. These tables consist of three lines

representing Standard Musharakah, Diminishing Musharakah and Mudarabah contracts.

Three columns representing the three phases of private equity (venture capital, development

capital and capital transmission).

To illustrate our analysis, suppose a young entrepreneur with a project 'P'. The latter,

lacking the financial means necessary to implement his ideas, is in a situation of choice

between three sources of financing [6] existing on a given economy, namely:

Conventional banks: the destination traditionally solicited by young entrepreneurs.

Financing funds offered by VC.

IFIs, through the Mudarabah and Musharakah contracts.



Due to the absence of tangible guarantees, the lack of experience of the young

entrepreneur, the lack of traceability of the project and the strong presence of information

asymmetry and moral hazard, the chances of rejection of the project by a conventional bank

are very high. Thus, we will not consider the possibility of obtaining funding from these

institutions. In that case, access to finance is limited to the two remaining sources of funding.

The question that arises at this point is as follows: How these two organizations proceed to

fund the project P?

In order to answer this question, we have chosen five main elements for the financing of a

project that allows a comparison between the two financing methods namely:

Investment Type;

Partner type;

Management;

Profit and loss Sharing;

Partnership Duration;

These criteria will help to facilitate the comparison in terms of the investment decision

making process.

3.1. Investment Type

Private

equity

Musharakah

Mudarabah

Venture Capital Development

Capital

Transmission

Capital

Standard Musharakah

Diminishing Musharakah

Mudarabah

Key: Similarity Dissimilarity

„Investment Type‟ refers to the nature of the capital invested in the 'P' project. For

Mudarabah contracts, the capital invested in a project must be in the form of the popular

currency used in the country where the agreement is made. While for Musharakah it is

permissible for one of the partners to provide the capital in kind (in the form of goods or

materials), provided that its value must be determined by an expert and approved by the

partners when signing the contract (Al-Kassani. A, 2003; Al-Sarkhassi, 1989; Al-Zohaili,

1985).

In the same way, venture capitalists provide an investment in the form of equity intended

to finance the project (Ekeland et al., 2016a; Emmanuelle and Galindo, 2008; Schier, 2006).




3.2. Partner Type

Private

equity

Musharakah

Mudarabah


Capital

Transmission

Capital

Standard Musharakah


Mudarabah


As it was explained in the definitions, for the Musharakah contract, the invested capital is

brought by all the partners, each brings a proportion. So, we have only one type of partner.

Whereas, in a Mudarabah contract, we have two types: Rab-al-Mal who brings all the

invested capital, and the Mudarib who come up with the project idea and takes care of the

management (AAOFI, 2014; Al-Zohaili, 1985; Nassar, 2010).

As far as VC is concerned, when it comes to financing the preliminary stages (where the

product is not yet commercialized) it can be said that there is a resemblance to the Mudarabah

contract. Indeed, it is the venture capitalist who brings all (or almost) the amount invested in

the project, while the idea is properly brought by the young entrepreneur (Paulré, 2007).

Beyond these phases, VC is approaching the Musharakah contract as the company now has its

own resources and therefore any fund provider will act as a partner.

3.3. Management

Private

equity

Musharakah

Mudarabah

Venture capital Development

Capital

Transmission

Capital

Standard Musharakah


Mudarabah (restricted)


Regarding the Mudarabah contract, with the exception of Mudarabah Moqayadah, where

Rab-al-mal outlines the project (Hammad, 2008), the Mudarib is authorized to perform the

various tasks and make all the decisions to guarantee the survival, growth and success of the

project. He has the exclusive right to manage the project ( AAOIFI, 2014). While Rab-al-Mal

cannot participate in managing the affair or impose conditions that limit the ability of

Mudarib to act and make decisions (Nassar, 2010).

In cons, in a Musharakah contract, the partners share the right of management and

decision-making. In fact, there are three scenarios (AAOIFI, 2014):

All the partners participate in a complementary way to the management and

decision-making process that concerns the various project departments.



They can choose one of them, granting him the exclusive ability to manage the

project and make all the necessary decisions.

They can appoint a stranger to manage the project, for a fee that will be recorded

as an expense in the project activity report.

As for VC, among the clauses that can be established in the shareholders' pact, there is

often that of management which gives a large margin to the venture capitalist and thus plays

the role of a veto right on certain strategic decisions (Schier, 2006). Therefore, we can

understand that the entrepreneur does not have all the freedom of management. We also note

that the role of the venture capitalist is not only limited in the contribution of funds but also in

consulting (Duboucage, 2003, Emmanuelle and Galindo, 2008; Vololona Rabeharisoa, 1998).

Thus, the young entrepreneur can benefit from the experience of the latter and also from his

wide network of professionals.

We can therefore conclude that VC converges in this respect with the Mudarabah

Moqayadah contract.

3.4. Profit and loss Sharing

Venture

Capital

Musharakah

Mudarabah

Venture capital Development

Capital

Transmission

Capital

Standard Musharakah


Mudarabah


The main purpose of the Musharakah and Mudarabah contracts is the realization of

profits, some rules of profit sharing have been specified by the Sharia:

It can be shared only after deduction of the invested capital (Nassar, 2010)

It must be known and declared accurately (Al-Kassani, A, 2003)

To avoid any conflict, profit distribution ratios between Rab-al-Mal and Mudarib

must be specified at the time of conclusion of the contract, otherwise the contract

is not valid (Usmani, 2002).

It is not allowed to distinguish one of the partners with a specific amount of the

profit, it must be distributed according to the predefined ratios (AAOFI, 2014).

The only distinction between the two contracts is the way in which the profits are

shared. In fact, in the Mudarabah contract the profit sharing is done according to

predefined ratios, while in a Musharakah contract the profit is shared either

according to the ratios as in the Mudarabah or depending on the contribution of

each partner.

With regard to the losses sharing, in the Mudarabah contract only Rab-al-Mal can suffer

tangible losses, the Mudarib only loses the time and effort he has put into the project.

However, if it turns out that the losses were caused by negligence, a fraudulent activity or

breach of the contract terms by the Mudarib, he also bears some of the losses (AAOIFI, 2014;

Nassar, 2010). On the other hand, the losses are shared in the Musharakah contract according




to the amount of capital that each partner has brought to the company (AAOIFI, 2014; Al-

Zohaili, 1985; “Journal of the Judicial Verdicts,” 1877).

About VC, among the practices used in this financing method, is the step-by-step funding;

in fact, venture capitalists undertake funding one stage of the life cycle of the start-up at a

time. The main purpose of this practice is to reduce the risks inherent in financing high-risk

projects, it is called 'Stage Financing'; it consists of allocating the investment according to

each phase of the project's life cycle and intervening according to the evolution of the

environment and the achievement of the different objectives set by both partners (Nasica and

Dufour, 2011). This leads us to conclude that during the initial phase of the business life

cycle, we cannot talk of profit as the product it is not yet commercialized. It is for this reason

that venture capitalists use a medium-term investment, and therefore aim for a sale of their

shares within a horizon of five to ten years, with a surplus value. They cannot in any case

withdraw from the investment or request a return of investment before the completion of the

phase concerned by the financing. Their profit is realized therefore, either by selling their part

at the end of this phase to another investment fund for a capital gain, or on an IPO in the event

of success (through the sale of their stock shares). Both partners negotiate the profit

distribution rate at the beginning of their partnership (Schier, 2006; Soulignac, 1991). It can

thus be deduced that VC financing in the development and transmission phases is resembling

to an extent the Musharakah contract.

On the other hand, the loss of invested capital is a very likely event because of the high

risk during the early stages of the nascent enterprise's life cycle, and it is up to the venture

capitalist to bear the loss alone. The entrepreneur, in case of failure, loses his innovative

project (Cerveaux, 2014; Pommet and Rainelli, 2012). On this point, VC financing is similar

to the loss sharing mechanism of the Mudarabah contract. Beyond the completion of these

phases, and when the company begins to commercialize its products, the losses will

eventually be shared among the unitholders according to the ratios on which they have agreed

upon in advance (Financial Markets Authority, 2015; Cerveaux, 2014; Pommet and Rainelli,

2012), The principle of this sharing converges with the Musharakah contract.

3.5. Partnership Duration

Private

equity

Musharakah

Mudarabah


Capital

Transmission

Capital

Standard Musharakah


Mudarabah


With the exception of the last two forms of the Diminishing Musharakah contract, where

the transfer of shares from one partner to another takes place during the execution of the

contract (see definition), none of the partners has the right to withdraw before the completion

of the agreed duration.

Likewise, as mentioned above, VC financing is executed per phase (stage financing) and

therefore the investor cannot recover his investment at any time, he has to wait for the



completion of the phase (which may take several years) (Chatti, 2010) for the fund to be

"closed" in order to sell his shares to another investor (Emmanuelle and Galindo, 2008).

We can conclude from these analyses that in theory these financing methods are similar,

but it seems that VC fits perfectly with the first form of Diminishing Musharakah.

4. BOUNDED RATIONALITY AND APPLICATION

Given the specificities of the decision-making environment of the two modes of financing in

terms of the risk inherent in an investment project, information asymmetry, moral hazard and

the limited cognitive abilities of the investors (Cherif .M, 1999). We have been led to propose

a projection of the analytical tools provided by the theory of bounded rationality used by VC

companies, notably the reliability models.

From what has been said in the previous sections, it can be easily seen that the decision-

making environment of venture capitalists and IFIs is not just risky but uncertain. This

observation has important implications for the choice of analytical tools appropriate to the

study of the relationship between IFI / young enterprise on the one hand and VC / young

enterprise on the other hand. Unlike the first relationship where the literature allowing its

analysis is rare or absent, the literature on the second relationship is very rich. So, a multitude

of ways have been explored in recent years using several tools including those provided by

the theory of real options (Nasica and Dufour, 2007). However, these tools have shown some

limits to the particularities of the decision-making environment of venture capitalists by

ignoring the reality and the complexity they‟ve faced. This has led other researchers to

analyze this relationship with the analytical tools provided by the approaches in terms of

"bounded" rationality (specifically the work of Nasica & Dufour, 2011; Laville, 1998 and

others).

The concept of bounded rationality was developed by Herbert Simon in 1947, in his book

'Administrative Behavior'. According to the author, the rationality of the decision-maker is

necessarily limited; the decision integrates into a complex environment that restricts the

perception of choices and imposes many constraints on the decision maker. The latter is

limited in the amount of information that he can integrate in the process of decision making in

a given period of time. It is therefore a question of seeking a satisfactory solution rather than

an optimal one. Thus, we are in the presence of a decision maker always rational but within

limits set by his environment (Diemer .A, n.d.).

Among the models of bounded rationality widely used in the analysis of the venture

capitalists / young companies relationship, we find the model of reliability. This model come

from the decision theory, which, unlike other models of the same theory (satisfaction models

and cost models), describe the behavior of economic agents as resulting from a tacit evolution

attributing to agents only weak cognitive abilities (Laville, 1998). This is perfectly applicable

to the decision-making environment of venture capitalists. In 1983, Heiner developed a model

defending the following thesis: because their cognitive abilities are limited, agents are pushed

to restrict their range of choices which makes their behaviors regular and predictable. This

creates a gap between the cognitive abilities of an agent and the complexity of the

environment he‟s confronted with: Competence-Difficulties (C-D)

It is characterized by two types of variables:

p: perception variables, it summarizes the cognitive limits of the agent and determine his

competence;

e : environment variables; it summarizes the complexity of the environment and

determine the difficulty of the decision problem.

Internal uncertainty




The C-D difference introduces an uncertainty in the determination of the optimal action:

due to this uncertainty, the agent cannot always choose the optimal action. Its structure is

represented by the following function:

Let‟s take back the case of the 'P' project illustrated in the previous section, to better

understand the model. The model parameters are the following:

Action A: the decision to finance the „P‟ project;

: the set of circumstances in which choosing the action A is appropriate;

: the set of circumstances in which choosing the action A is inappropriate;

: the probability that the circumstances will be favorable to finance the „P‟ project;

: the probability that the circumstances are unfavorable to finance the „P‟ project;

: the anticipated gain from financing the „P‟ project when this choice is optimal;

: the anticipated loss from financing the „P‟ project when this choice is not optimal;

⁄ : probability of financing the 'P' project when this choice is

optimal;

⁄ : the probability of financing the 'P' project when this choice is

not optimal;

Therefor a venture capital firm will agree to invest in the „P‟ project if:

The model is written as follows:

Consequently:

Or, in condensed form:

with:

: the reliability ratio associated with the investment decision, in other words the

confidence given to the choice of financing the project „P‟.

: the minimum threshold of tolerance that the reliability ratio must reach so that funding

is granted.

Therefore, the more the ratio is higher than the threshold, the more the venture

capitalist will adopt a more or less flexible behaviour vis-à-vis the financing of the 'P‟ project

Otherwise, (if is lower than ) the venture capitalist will not grant funding to the 'P'

project and will probably move to another project that achieves the condition of reliability.

As above mentioned, the decision-making environment of venture capitalists and IFIs is

similar and after having broken down the components of this model, it is appropriate to

conclude that this model will constitute an analytical tool for decision making that can be used

by IFIs in the future.

However, it should be noted that the area of investment in Islamic finance, in addition to

financial constraints, is governed by "extra-financial" rules (Hernalsteen .M, 2012).



Indeed, Islamic finance is supported by five basic pillars; no interest, no uncertain

speculation, no financing of socially harmful "illegal" activities (companies involved with

goods or services deemed haram, such as weapons, pork or gambling), profit and loss sharing

and the need for all financial transactions to be backed by tangible assets. This will limit the

diversity of projects to be funded and will influence the likelihood of acceptance or rejection

of a given project, accordingly, this will create a certain rigidity in the behavior of IFIs

compared to a VC firm.

In addition, instruments used by an IFI to finance a project must be Sharia compliant.

However, the lack of harmonization in banks 'and jurisdictions' interpretations of what is

acceptable under Sharia law leads to less standardization in the products available

(Chittilapally.J, 2016).

5. CONCLUSION

In this paper, we tried to compare the concept of VC with the participatory techniques of

Islamic finance, especially Musharakah and Mudarabah. We can conclude that these two

concepts have a lot in common, and in particular their approach to investment and their

conception of partnership in business.

Thus, the venture capitalists and IFIs (via their practices: Mudarabah and Musharakah)

generally adopt the same investment behavior. In fact, these techniques are specific modes of

financing since they agree to share the risk with the entrepreneurs they finance, which is

different from the design of the most of conventional financing products.

However, studies conducted on the practices of Mudarabah and Musharakah have shown

that, even in developed countries in the field of Islamic finance, they are rarely used by the

IFIs despite their undeniable advantages because of the difficulties encountered by financial

operators during the application of the procedures of funds granting.

On the other hand, despite the development of VC in some Arab countries such as Tunisia

and Morocco, start-ups still find it difficult to access financing. Indeed, we can estimate that

the introduction of the Mudarabah & Musharakah contracts in the Moroccan financial market

can be another source of funding to facilitate access for them.

Finally, it should be noted that this contribution opens avenues for research in the

modelling of decision-making processes in participatory finance that will be the subject of our

next contributions.

NOTES

1. Muhajirun (The Emigrants): were the first converts to Islam and the Islamic Prophet

Muhammad's advisors and relatives, who emigrated with him from Mecca to Medina,

the event known in Islam as The Hijra. See https://en.wikipedia.org/wiki/Muhajirun,

visited the 01/15/2018

2. Ansar (The Helpers): is an Islamic term for the local inhabitants of Medina who took

the Islamic Prophet Muhammad and his followers (the Muhajirun) into their homes

when they emigrated from Mecca (hijra). See

https://en.wikipedia.org/wiki/Ansar_(Islam), visited the 01/15/2018

3. We did not take into account a third type of Shirkah called Shirkat Al-Ibaha, since it

will not be used in the rest of our analysis and we have added Mudarabah as a form of

Shirkat Al-'Aqd ( see (Al-Zohaili, 1985))

4. Madahib: Al Madahib are scientific schools that try to understand and explain

religious texts to develop jurisprudential rules that Muslims need in their lives to know

the appropriate decision to take in a given situation




5. Several authors consider Seed Capital as a component of venture capital as: Stanislas

De Zutter, 2010

6. We suppose in our study case that there are only these three sources of funding,

ignoring any other source of funding.

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