«JKAU: Islamic Econ., Vol. 10, pp. 3-20 (1418 A.H / 1998 A.D) Venture Capital: A Potential Model of Musharakah SAMI AL-SUWAILEM Al Rajhi Banking and ...»
JKAU: Islamic Econ., Vol. 10, pp. 3-20 (1418 A.H / 1998 A.D)
A Potential Model of Musharakah
Al Rajhi Banking and Investment Corp.
Research Center, Riyadh
ABSTRACT. Venture capital is a form of active investment through equity-based
instruments. Venture capital financing is praised for its role in promoting growth while
maintaining financial stability. From an Islamic point of view, such arrangements appear
very close to the model of musharakah which Islamic banks are seeking, but many in reality failed to adopt. Venture capital is also well suited to Islamic countries because of its positive impact on growth and development.
1. Introduction Venture capital is a form of equity financing in which the investor actively participates in the venture being financed. The objective is to add value to the recipient company during the financing period, so that the venture capitalist can sell his share later on with positive returns. Although the concept as such is not new, a formal market for venture capital in the U.S. started only after World War II. Venture capital institutions currently manage over $30 billion in the U.S. and another $30 billion in Western Europe (Bygrave and Timmons, 1992, p. 23). On average, about 60% of hightechnology companies going public in the U.S. are financed through venture capital (Al-Suwailem, 1995). The concept of venture capital is increasingly attracting researchers, and academic studies of venture capital now appear regularly in professional journals.
A venture capital firm manages funds provided by investors and directs it to the most promising ventures, mainly in the form of equity. The venture capitalist, who is responsible for managing investors’ funds, provides financial and strategic assistance to the recipient company and actively participates in its management. The support continues until the venture materializes, at which stage an outside investor might be interested in owning the company, or it might be able to go public. Returns then are distributed back to the investors.
4 Sami Al-Suwailem From an Islamic point of view, venture capital is based on equity financing (sharikat′inan), and thus falls within the framework of Islamic finance. It therefore combines economic viability and Islamic preferability, which makes it a promising option for Islamic financial institutions. Although the details of practices of existing venture capital institutions may not be totally consistent with Islamic rules, these details can be easily modified without compromising the positive aspects of its principles.
The objective of this paper is to give Islamic economists and financiers an overview of the structure of venture capital financing, with emphasis on the economic role it could potentially play. The relevance of venture capital to developing countries has been emphasized by many researchers, and the World Bank has taken a lead in this regard, as will be explained later.
Section II starts with a description of the venture capital contract, then provides analysis of its economic significance. Sections III and IV review the performance of venture capital institutions and venture-backed companies, respectively. The conclusion is given in section VI(1).
2. The Structure of Venture Capital
2.1 Definition General partners are responsible for managing the funds and directing them to the most promising ventures. They are typically experienced in particular industries ( e.g., pharmaceuticals, semiconductors, etc.). Usually, they contribute a small percentage (1%) of committed capital. Their compensation is based on the total committed capital as well as on realized gains on the fund.
Once a venture capital fund has been established, the venture capitalist must identify investment opportunities, arrange deals with entrepreneurs, monitor the investments, and ultimately achieve some return on his capital. The venture capitalist usually invests in recipient companies in the form of convertible preferred stock; that is, preferred stock that can be converted into common stock. The financing process is done in stages, and the amount of capital given at each stage is sufficient only to reach the next stage. Venture capitalists take an active role in the recipient companies through membership on boards of directors. To avoid losses, venture capitalists form a portfolio by investing in several companies at one time.
The venture capitalist continues his financial, managerial and marketing support until the venture materializes. At this stage, an outside investor ( e.g., a large company) might be interested in owning the recipient company, or the recipient company might prepare to go public. Returns from selling the company are then distributed to the limited partners, and the venture capitalist starts raising a new venture capital fund.
For further details, consult Sagari (1992) and Sahlman (1990).
(1) This paper is based on Chapter 3 of my Washington dissertation. I thank my committee chairman, Professor Steve and Bruce Petersen for valuable guidance. I also thank Professor Anas Zarqa for useful discussions and comments. I am solely responsible for any errors.
Venture Capital: A Potential Model of Musharakah
2.2 Analysis of Venture Capital Arrangements In an environment of uncertainty and informational asymmetry, the venture capitalist faces the problem of identifying the most promising venture, where adverse selection is common at this stage. Even after a contract between the venture capitalist and the entrepreneur is signed, possible conflicts of interest between the two parties present serious difficulties for the venture to develop and mature; such problems are usually referred to as moral hazard problems. The following discussion will analyze how the venture capital industry developed its practices and arrangements to minimize these problems.
2.2.1 Sharing Venture capital is structured around a basic theme - sharing. Investors are limited partners, the venture capitalist is a general partner, and the venture capital fund finances entrepreneurs through equity. All parties, therefore, have in essence the same objective. This structure dramatically reduces possible conflicts of interest and
associated moral hazard (Milgrom and Roberts, 1992). In Sahlmans words:
Because venture capitalists are compensated based on the performance of the fund they manage, they have every incentive to increase value. This is precisely why their interests and those of the companies they back are aligned. Each side of the transaction benefits if and only if value is created (1994b, p. 36).
Sharing extends even to the employees of venture-backed companies. ″Successful investors found that venture capital works best when all the companys employees are granted stock in the company, thereby giving them a stake in its success″ (Kunze, 1990, p. 2).
Another form of sharing is syndicating investments by more than one venture capitalist. In addition to pooling more resources and capital, syndication helps spread the risk among the venture capitalists. It also brings together more expertise and support (Lerner, 1994b). Bygrave and Timmons (1992) note that syndication also helps to share information and thus reduce uncertainty. The authors examine a data set of firms receiving venture capital during 1967-1982, and found that there was more coinvesting in high-tech than in low-tech companies. This is also true for early-stage compared to late-stage companies.
Debt contracts, in contrast, suffer from inherent conflicts of interests between the borrower and the lender. Since the entrepreneur has to pay fixed payments regardless of the performance of the project, he will be better off choosing risky actions, exposing the lender to the risk of default, as Stiglitz and Weiss (1981) show. This leads to serious moral hazard problems and agency costs.
2.2.2 Monitoring and Assistance Sharing has important consequences. One is that it creates incentives for the capital provider to monitor and assist his partner (Davis, 1992, p. 265). Given the 6 Sami Al-Suwailem venture capitalist’s stake in the venture, the better the quality of assistance he provides to the entrepreneur, the better the likelihood that the venture will succeed, and therefore, the higher the expected value of his stake. It is often remarked that the financial contribution that the venture capitalists make may be less valuable than the business expertise and contacts they contribute to small ventures (Sagari, 1992). One venture capitalist writes, “A venture capitalist is not merely a money manager for investors funds but also a full partner with the entrepreneur, sharing a mutual goal of creating a valuable company” (Kunze, 1990, p. 3).
Based on a survey obtained from a sample of venture capitalists, Gorman and Sahlman (1989) found that venture capitalists spend about half their time monitoring and assisting their portfolio investments. They also found that venture capitalists provide three critical services in addition to providing money: (1) building the investor group, (2) reviewing and helping to formulate business strategy, and (3) filling in the management team.
Sapienza (1992) analyzes 51 questionnaire responses from a sample of entrepreneurs/CEOs of venture-backed companies, matched by those of lead venture capitalists in these companies. The study found that the average value-added by venture capitalists, as perceived by both venture capitalists and entrepreneurs, is significantly positively related to the level of innovation pursued by these companies, but negatively related to their size. This shows that the assistance venture capitalists provide is particularly useful for small, highly innovative ventures. Sapienza concludes that ″the provision of money alone appears to play a necessary but far-from-sufficient condition to promote economic growth and resilience; evidence is mounting that venture capitalists do add value″ (p. 22).
Such a degree of involvement by venture capitalists would be inconceivable from traditional financiers. Combining harmony of interests with monitoring and assistance, we see how venture capital structure helps to overcome the high risk and informational asymmetries associated with typical ventures.
2.2.3 Selection Criteria Sharing also affects the selection criteria of ventures. The type of information and criteria that venture capitalists look after when selecting a company reflects their preferences as active investors and shareholders. As equity holders, venture capitalists would profit most from fast-growing companies, as this would translate into higher value of their equity. The bias of venture capitalists towards small and innovative companies, therefore, is not accidental. For example, venture capital funds directed an average of 60% of total annual disbursements to high-tech ventures during the period 1985-1993 (Venture Capital Journal). This preference can be compared to that of commercial bankers (Sagari, 1992, and Rosman and O′Neill, 1993). Since bankers invest mainly through lending, they usually target mature, well-established companies whose financial histories reflect their viability as good borrowers. This sharp difference
in preferences between venture capitalists and commercial bankers has a significant impact on market growth and development (see section II.3 below).
2.2.4 Staging Capital Commitment Another essential feature of venture capital is staging the commitment of capital to portfolio ventures (Sahlman, 1988, 1990, 1994b). This feature is closely related to equity financing. In a sharing contract with asymmetric information ( i.e. without monitoring), the entrepreneur always has an incentive to under-report profits (see Bolton and Scharfstein, 1990, for a formal model). This entails the investor receiving a smaller share of the profits, thus increasing his own. By staging capital, such incentive is inhibited, since the entrepreneur has to return to the venture capitalist to obtain capital for the next stage of the project. This mechanism, furthermore, encourages the entrepreneur to optimize his efforts to convince the venture capitalist to continue his support.
Staging the commitment of capital also helps reduce the uncertainty typically surrounding small ventures. As time passes, the venture capitalist is able to gather more information about the team, the market and the product, thus reducing major risks and uncertainties considerably (Sahlman, 1988). Moreover, by staging the commitment of capital the venture capitalist gains the option to abandon and to revalue the project as new information arrives (ibid., p. 29). As Sahlman shows, this option in fact raises the value of the investment. This is the corner stone of the recent theory of investment under uncertainty, in which the irreversibility of investment creates value for the option of waiting for better information (Dixit and Pindyack, 1994). Gompers (1995) provides an empirical evidence on the importance of staging venture capital in gathering information on financed projects, where he found that high-tech companies, with less tangible assets and higher risks, are subject to more frequent monitoring by venture capitalists.
2.2.5 Adverse Selection Several writers, e.g. Sahlman (1990), Amit et al. (1990a, 1990b) and Petersen (1992), expressed concerns about adverse selection in the venture capital market. The reason behind these concerns is the relatively high costs of obtaining venture capital.
Such costs would greatly affect the type of entrepreneurs seeking venture capital. For the venture capital market to operate with minimum efficiency, benefits of venture capital must outweigh its costs. These are discussed in turn below.