Islamic Finance 

Shariah issues relating to preference shares in conventional VC deals

| 08 December, 2016 | General
 Dr. Elsayed Elsiefy, Professor, Qatar Faculty of Islamic Studies
Shariah issues relating to preference shares in conventional VC deals
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As part of the Bahrain Economic Development Board and Thomson Reuters' Bahrain Islamic Venture Capital Report that focuses on the regulatory and market infrastructure needed for building a venture capital ecosystem in Bahrain, Dr. Elsayed Elsiefy, Professor, Qatar Faculty of Islamic Studies, who also serves as an investment advisor in the investment committee in Qatar's Ezdan Holding Group writes about Shariah issues related to preference shares in venture capital investments.

The report can be downloaded from HERE.

We cannot use conventional venture capital without modification and claim it to be Shariah-compliant. Conventional VC investment can take different legal forms. The way in which funding is provided to the enterprise will determine many of the rights for the parties involved and will impact the method and timing of their return on the investments.

In addition, different VC investment structures can have different legal rights and different tax treatments. All of this, of course, depends largely on the law of the country in which VC investments operate. The most common forms of VC investments are equity (shares), convertible debt (a loan that can be converted into shares) and preferred shares. Whereas the concept of common equity shares in general is compatible with Shariah principles, preference shares and loans with interest are not accepted in Islamic finance.

Issue of preference shares

A key issue of difference between conventional VC and Islamic finance is preference shares. Regular shares are compatible with the Shariah and scholars accept the concept  of limited liabilities; they consider shares a modified form of Islamic partnership contracts (musharakah and mudarabah). On the other hand, preference shares are not Shariahcompliant and rejected by most scholars. According to Islamic scholars, the main issue with preference shares is that they give rights to the owners of these shares without justifiable liabilities.

As a simple definition, preference shares have preference over common shares in the event of liquidation of the company. Preference stock has a face value which is paid out before looking at common shares.

VC investors typically require preference shares as a precondition to their investment that they receive certain protections and rights that are superior to those of the founders or early angel investors. Preference shares may give exceptional rights regarding the allocation of proceeds upon a sale, protection against future dilution, guaranteed board representation and certain negative controls.

Preference shares violate Shariah principles

If we look at the issues from the VC investor’s point of view, they are investing in risky businesses that are still under development. The control of business is the entrepreneur’s responsibility and it is usually the case that it would be the entrepreneur’s first project. Investors would seek protection, which a normal partnership (using ordinary shares) would not offer, so they turn to a mixture of a partnership contract along with the security of a debt contract using preferred shares. A lot of money will be pumped in and there is a high probability of the VC investors losing that investment. So from their point of view, it is justifiable to place conditions on the entrepreneur and be given preferred treatment over him. VC investors believe that the entrepreneur is the main party responsible for the failure or success of the project because it is his or her idea and he or she is the main person managing the business.

From a Shariah point of view, there can be no mixing of debt and partnership contracts. It is either equity finance contracts or debt finance contracts, each with their own sets of rights and obligations. It is unfair, from a Shariah point of view, for one partner to have more benefits than others, without justification.

In my opinion, VC investment is a special kind of investment that we cannot consider fully as normal partnership that partners agree to set up. It is usually investment in intangible assets and in ideas that are still under development. It is very difficult for VC investors to prove neglect or misconduct on the part of the entrepreneur. That is why VC investors ask for more than just being partners, and they seek more protection using different methods, one of them being preference shares.

The issue needs serious consideration by Shariah scholars and perhaps they can come up with an alternative Shariah compliant structure/solution that addresses VC investors’ legitimate concerns without being unfair to the entrepreneur.

DOWNLOAD THE REPORT

BahrainEDB-TR Bahrain Islamic Venture Capital Report 2016

Copyright Thomson Reuters 2016

Dr. Elsayed Elsiefy received his BA and MA degrees in Business and Financial Management from University of Alexandria, Faulty of Commerce Business and Administration, Egypt and earned his Ph.D. degree in portfolio performance evaluation and selection in 2001 from University of Birmingham, United Kingdom. Dr. Elsiefy is currently Professor in the Islamic Finance Program at Qatar Faculty of Islamic Studies (QFIS) and an Executive Director of the Executive & Consulting Department at the faculty. He also serves as an investment advisor in the investment committee in Ezdan Holding Group, Qatar.

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