A number of venture products are being marketed to Islamic retail investors with the advent of tech under peer to peer funding.
Special Piece by Dr Mushtaq Shah
Prime facia direct investment into non listed companies should be unconditionally Shariah compliant. Over the years we at RI-Islamicly have advised a number of conventional funds in this space and all but one ended up not launching.
The problems arose from the majority of target companies being conventional and the fiduciary responsibility of the Private Equity fund managers. We have noted with interest that a number of venture products are being marketed to Islamic retail investors with the advent of tech under peer to peer funding.
So what has changed?
Almost all conventional venture funds will only invest in preferred shares, not common equity. In general pre-seed (friends and family) rounds are done in common equity. Preferred shares have all sorts of liquidity preference and anti-dilution rights.
This thing creates 2 problems. First, preferred shares are not Shariah compliant. So an Islamic fund cannot co-invest on the same terms as most other conventional VC funds (they will all insist on preferred shares). Second, all track records of VC funds are based around preferred investments. It is clear that performance would have been materially worse if they had done common equity at the same valuation.
If you co-invest with another fund which is getting preferred equity and you (the Islamic Investor) are getting common equity at the same valuation, it’s a great deal for both the other investors and the company, but a pretty lousy deal for you!
If you co-invest with another fund which is getting preferred equity and you (the Islamic Investor) are getting common equity at the same valuation, it’s a great deal for both the other.
The funds we advised felt this was a breach of their fiduciary duty. Getting a lower valuation would be difficult as it complicates matters for the company and it’s not clear what this valuation should be. You are essentially comparing apples with oranges. It’s hard to measure how much these provisions are actually worth but the VC experts are adamant it’s a lot and not having them would have a meaningful impact on their performance track record since so many companies they invest in, do fail.
An example can perhaps illustrate the importance of preferred shares for a professional VC but it also illustrates how unfair they can be to other investors and why our Shariah scholars will not approve such structures.
Assume an angel investor invests $20,000 in a company pre-product and revenue. Let’s say the investment is done at a post money valuation of $1 million, so he owns 2% of the company. The company does very well and IPO’s at $1 billion. So the investor should make $20 million or 1,000X right?
Not necessarily!
Let’s assume an institutional investor comes in at a subsequent round and puts in $250 million at a $2 billion valuation but is given a 4X liquidity preference. The market gets tough so the IPO is done at a $1 billion valuation, then the institutional investor gets 4X his investment or $1 billion and the angel investor gets nothing! This can and has happened.
This means that the Islamic investor has the choice of either investing directly via Seedrs say or to find a 100% Islamic venture business with the same pedigree and track record as some of the established names. The problem with both is the target companies by a whole are not Islamic so they will prefer to go to established names so you won’t see the high quality deal flow.
Even if a direct common equity investment could be done on sensible terms, by and large the companies are not Shariah compliant. Subsequent funding rounds will be preferred equity and most likely eventually be conventional debt. The companies will need constant audit/monitoring from a Shariah perspective. Whilst it is unlikely that at the time of debt issuance the 33% rule of debt/market cap will be breached, what if we had another scenario like this year? A number of unlisted companies now have ridiculously high debt ratios as their valuation has collapsed. For example:
Then the Islamic investor would be in a non-compliant investment and be forced to exit (that is if he could find a buyer, in a tough market).
So the question remains….
How are these new funds promising the same sort of returns as conventional venture fund?
We believe that they are invoking a Shariah principle whereby something that is essentially Haram is permitted because of special circumstances. For example most Islamic Takaful insurance companies are permitted to reinsure with a conventional player simply because there is no commensurate size Islamic alternative and to not reinsure will subject the Islamic insurer with potentially disastrous losses and it will be unable to pay out to its policy holders at their time of need, which would have devastating consequences for the community. This clearly isn’t the case for preferred shares – it is simply unfair and a wealth transfer from ordinary investors to the more powerful institutional VCs.!
Direct investments in early stage private companies is intuitively Shariah compliant.
Direct investments in early stage private companies is intuitively Shariah compliant and looking at the track records of the big industry names such as Accel, Kleiner etc show what a lucrative asset class this can be. However, the devil is in the details. There are a number of Shariah compliant funds that have been launched especially ones that invest in the Gulf and MENA region in pure equity investments. However, it is not clear how these same funds can access the same deal flow in the Western markets for the reasons outlined above. Islamic venture funds should not use the track records of conventional funds to promote their products or asset class as it is akin to comparing “apples with oranges”.
We would advise you to be very wary of funds being marketed as Islamic Venture funds but are investing in preferred shares using a ‘Shariah side letter’.
