Harvard Islamic Finance Forum 2014 Shariah- compliant Crowd Funding: An Efficient Framework for Entrepreneurship Development in Islamic Countries Shehab Marzban Co- founder and Managing Partner, Shekra Crowd Funding Mehmet Asutay, Reader in Political Economy, Director of Durham Centre for Islamic Economics and Finance, Durham University Adel Boseli Co- founder and Managing Partner, Shekra Crowd Funding Abstract: Based on Islamic moral economic values, Islamic finance should develop capacities and empower individuals and societies, as the majority of Muslim countries are in their development phase. Thus Islamic finance, through acting as an alternative and ethical financing method, should finance impact- oriented real economic activities. However, in its current form in terms of adopting the role of conventional commercial banks, Islamic banks are not there to provide such financing. Accordingly, there is an urgent need to develop non- banking Islamic financial institutions and instruments to respond to the developmentalist needs of the societies including development of entrepreneurship. Crowd Funding in the form of either donations, rewards, debt and/or equity represent a new mode of financing for entrepreneurial activities and small enterprises overcoming the funding gap and risk implications faced by financial institutions. Shariah- compliant Crowd Funding provides an opportunity for investors, donors and entrepreneurs for the socioeconomic development of the micro and small enterprises sector in Islamic countries. Even though crowd funding has witnessed tremendous growth after the financial crisis in 2008, customized models tackling the current status of the entrepreneurial ecosystem and players, cultural and religious factors as well as the economic statuses of Islamic countries need to be developed and emphasized. Within this paper a Shariah- compliant Crowd Funding framework tackling these issues is formulated and discussed including the appropriate Shariah financing mechanisms to employ.
Introduction Based on Islamic moral economic values, Islamic finance should develop capacities and empower individuals and societies, as the majority of the Muslim countries are in their development phase. Thus Islamic finance, through acting as an alternative and ethical financing method, should finance impact- oriented real economic activities (Asutay, 2007; 2012). However, in its current form in terms of adopting the role of conventional commercial banks, Islamic banks are not there to provide such financing. Hence, there is an urgent need to develop non- banking Islamic financial institutions and instruments to respond to the developmentalist needs of the societies including development of entrepreneurship. Crowd Funding in the form of donations, rewards, debt and equity represent a new mode of financing for entrepreneurial activities and small enterprises overcoming the funding gap and risk implications faced by financial institutions. Thus, Shariah- compliant Crowd Funding provides an opportunity for investors, donors and entrepreneurs for the socioeconomic development of the micro and small enterprises sector in Islamic countries. Even though crowd funding has witnessed tremendous growth after the financial crisis in 2008, customized models tackling the current status of the entrepreneurial ecosystem and players, cultural and religious factors as well as the economic statuses of Islamic countries need to be developed and emphasized. Entrepreneurship in Islamic Countries The definition of the term entrepreneurship is not a trivial task since its meaning might vary across time, geography, culture and the local socioeconomic conditions of the respective entrepreneur. In Silicon Valley, for instance, the term entrepreneurship is directly linked to innovation, technology and growth whereas entrepreneurial activities in less- developed countries such as in Yemen might refer to micro- entrepreneurs struggling to survive. Therefore a clear distinguishing factor in defining entrepreneurship is the motivation of being entrepreneurial, which has been differentiated by the Global Entrepreneurship Monitor (2013) as entrepreneurship by necessity versus entrepreneurship by opportunity. Entrepreneurship by necessity refers to entrepreneurs driven by a need to generate income for a living due to the lack of job opportunities, for instance. Entrepreneurship driven by opportunity on the other hand can be defined as a mindset and process to create and develop economic activity by blending risk- taking, creativity and/or innovation with sound management, within a new or existing organization (Commission of the European Communities, 2003).
Even though entrepreneurship is part of the Islamic and Arab culture and research indicates that a substantial portion of Arab youth is seeking to be entrepreneurial (according to the World Economic Forum and Booz & Company (2011), on average 15% of Arab youth seek to be entrepreneurial compared to 4-8% in Western countries), the majority of entrepreneurial activities in the Islamic world excluding the GCC are mainly driven by necessity (such as in Yemen and Morocco) whereas there is no strong evidence or the quantity and quality of success stories for entrepreneurship driven by opportunity in the Arab world as compared to Western countries. Therefore, the entrepreneurial spirit and eagerness in Islamic countries irrespective of the reason has to be utilized efficiently to meet the core challenges in terms of boosting the economies and creating jobs for the increasing and young population residing in these countries (see Table 1). Country Population Internet Users % Internet Penetration Median Age Bahrain 1,248,348 961,228 77.00% 31.4 Bangladesh 161,083,804 8,054,190 5.00% 23.9 Egypt 83,688,164 29,809,724 35.60% 24.8 Indonesia 248,645,008 55,000,000 22.10% 28.9 Jordan 6,508,887 2,481,940 38.10% 22.6 Kuwait 2646314 1963565 0.742 28.8 Malaysia 29,179,952 17,723,000 60.70% 27.4 Morroco 32,309,239 16,477,712 51.00% 27.7 Oman 3,090,150 2,101,302 68.80% 24.7 Pakistan 190,291,129 29,128,970 15.30% 22.2 Qatar 1,951,591 1,682,271 86.20% 32.4 Saudi Arabia 26,534,504 13,000,000 49.00% 26.0 Turkey 79,749,461 36,455,000 45.70% 29.2 UAE 8,264,070 5,859,118 70.90% 30.3 Total 875,190,621 220,698,020 Table 1: Population, Internet Users and Median Age in Sample OIC Countries 1 1 Source: Internet Stats, World Bank - 2013
According to Silatech and Gallup (2010), most entrepreneurial Arab youth identified financing as the main barrier for their ventures. The financing problem is also supported by the figures reflecting the proportion of SME loans to total loans in MENA as shown in Figure 1. Figure 1: Percentage of SME Loans to Total Loans in MENA Countries 2 The reluctance of banks to support young entrepreneurs and their startups or small enterprises due to their perceived risk profile and non- existence of collaterals triggered the evolvement of new financial actors and innovative products to address the funding gap for Micro and Small and Medium Enterprises (MSMEs) in MENA. In the microfinance space, non- profit institutions and associations have taken a strong role in providing microloans for necessity- driven entrepreneurs such as it is the case for instance in Egypt, Yemen, and Palestine. With respect to opportunity driven entrepreneurship focusing on innovation and technology, a wide spectrum of entrepreneurial ecosystem support actors has entered the MENA markets to address the funding gap of young entrepreneurs across the different stages of their ventures including incubators, accelerators, angel networks and venture capital funds. Still, market efficiency is not achieved due to the limited quantity and funding size provided by these actors who are not able to address the overall demand and market potential resulting in lost opportunities and significant brain drain of Arab talent migrating to innovation- driven markets providing them with job opportunities and the appropriate environment to excel. 2 The World Bank and The Union of Arab Banks. R. Rocha: The Status of Bank Lending to SMEs in the MENA Region. 2011
Thus, to increase the access to capital and instead of relying on institutional capital only via venture capital funds or on high net worth individuals via angel investors, a much larger capital pool can be provided through engaging a much larger base of small investors such as the increasing middle class in MENA and the global diaspora originating from MENA to fund MSMEs and startups. This process is referred to as financial inclusion via investment inclusion (Marzban, 2013), which can be most efficiently achieved via innovative financial products such as crowd funding. Crowd Funding Since financial inclusion is crucial to ensure socioeconomic development and the support for young entrepreneurs driven either by necessity or by opportunity to develop innovative startups or small enterprises with growth potential, innovative financial products have to be utilized to serve these needs adequately. One of these innovative financial intermediates growing globally is crowd funding. The term crowd funding refers to a collective cooperation of a network of people to gather mainly financial resources in the form of donations or investments to support the initiatives of others willing to establish, build or develop a specific business or project. Based on the power of the internet and social media specifically to link potential initiatives or projects with a wide spectrum of potential investors or backers, crowd funding overcomes the main challenges faced by entrepreneurs not able to receive funding from financial institutions, which consider them either too risky, too small or not bankable. There are four main types of crowd funding models: 1. Donations- based crowd funding Typically backers support an initiative through donations from a purely philanthropic perspective without any expected future compensation. 2. Reward- based crowd funding Within reward- based crowd funding, backers receive an appreciation for supporting an initiative such as receiving a gift, acknowledgement for support or being provided with the products or services developed. 3. Lending- based crowd funding While the first two types are more philanthropic in nature, lending- based crowd funding is an investment vehicle through which crowd investors provide loans to startups or small enterprises to support their ventures in exchange for receiving returns in the form of interest payments. 4. Equity- based crowd funding Similar to lending- based crowd investing, crowd investors are supporting startups or small enterprises for a financial gain. Within an equity- based investment, the investors receive shares in the venture financed and are thus part of a profit- and- loss sharing agreement with the funded startup. This type of
crowd investing has to a large extent parallels with the venture capital industry, which is also equity- based. According to Massolution (2013), the world wide crowd funding volume in 2012 reached $2.7 billion, where donations- and reward based crowd funding represents 51.4%, lending- based crowd funding 44.2%, and equity- based crowd funding represents only 4.2% of the total volume. These figures might be justified through the complexity and uncertainty of the different crowd funding business models as reflected in Figure 2, where equity- based crowd investing is most complex from a regulatory and legal perspective and with respect to information asymmetries between entrepreneurs and investors (Ahlers et al., 2012). Figure 2: The Complexity and Uncertainty Profile of Crowd Funding Business Models The regulatory, legal, and information asymmetry challenges faced by equity- based crowd funding are currently being addressed through regulatory frameworks being developed by capital market authorities to govern equity- based crowd funding as it is the case, for instance, in the United States, the United Kingdom, and in Malaysia. Crowd funding represents a clear opportunity for MENA MSMEs since based on infodev (2012), the potential of capital to be raised in the region via crowd funding is estimated to be $5.6 billion. Nevertheless, to tap into this opportunity pool, a customized crowd funding framework for MENA and Islamic countries has to be developed taking into consideration the nature of these markets and most significantly the compliance and
adherence of the financial instruments with Shariah from the perspective of the different stakeholders involved in the crowd funding process. Crowd Funding and Islamic Finance The growth witnessed in Islamic finance assets, which are estimated to have reached $1,354 Billion in 2012, with a potential to reach $4,095 billion according to Thomson Reuters (2013), is criticized for being limited to a high extent to offer services for high- net worth individuals rather than significantly contributing to social and economic development of Muslim markets faced with a growing population living under poverty. Based on Grewal (2013), less than one percent of the Islamic finance industry is devoted towards microfinance. Considering that Islamic finance at the origin is a value oriented proposal, it is constructed through concepts such as equity, justice, human dignity, freedom of enterprise and moderation, with the aim of utilizing economic and financial resources to satisfy material and social needs of all members of the community. The Asset- backed transaction nature together with the risk- and- profit sharing nature aims to deliver such objectives in an aspirational sense. Based on these moral values, crowd funding represents a significant opportunity to utilize the different crowd funding models in a Shariah- compliant manner underpinning the core ethical and social dimensions of Islamic finance. Survey by Surveyed Country Respondents preference (%) CGAP 2008 Jordan, Algeria and Syria 20% - 40% Planet Finance 2007 West Bank and Gaza 35% - 60% IFC/FINCA 2006 Jordan 32% The Ministry of Planning and Jordan 20.4% International Cooperation 2012 Frankfurt School of Finance Algeria 20.7% and Management 2006 SFD 2008 Egypt 13% USAID 2011 Iraq 79.6% IFC Sponsored Study Yemen 40% IFC 2007 Syria 43-46% Table 2: Demand for Shariah- compliant Microfinance in MENA Additionally, different surveys and researches conducted reflect that Muslims are sensitive both as entrepreneurs and investors in regards to Shariah- compliance. With respect to micro entrepreneurs, entrepreneurs by necessity, according to Nimrah et al (2008), a substantial figure across different MENA countries would prefer Shariah- compliant micro financing (see Table 2).
From an investor perspective, according to Booz & Co (2011) a third of GCC clients prefer Islamic products over conventional products, depending on ethnicity and investment style. Thus, donation- based crowd funding represents an optimal channel for Islamic charity to be utilized efficiently for poverty alleviation due to its global outreach via social media enabling access to a wider spectrum of individual donors willing to support Shariah- compliant initiatives via Zakat or Sadaqa. A major initiative to provide Shariah- compliant donation- based crowd funding has been initiated by Silatech in Qatar through Narwi, which will provide MENA micro- entrepreneurs through financial intermediates microloans in a Shariah- compliant manner. With respect to reward- based crowd funding, one platform started providing products based on Shariah- compliant crowd funding called Yomken, which is based in Egypt. Crowd lending which is mainly based on interest payments is not compliant with Shariah. To provide Shariah- compliant crowd lending, the platform has to rely on Islamic financial contracts and processes to provide interest- free alternatives such as the use of Murabaha for instance, which is currently being offered by the Jordanian- based Liwwa platform. From the perspective of Islamic finance, equity- based crowd funding represents a significant opportunity to deliver the essential expectations from Islamic finance by combining the benefits of social development and investment opportunities for a wide range of entrepreneurs and investors. Based on Asutay and Marzban (2012) the advantages of equity- based crowd funding from an Islamic finance perspective include: Equity- based crowd funding is based on a profit and loss sharing basis (Musharakah), as characterized in the original form of Islamic finance; Providing access to capital to a wide range of entrepreneurs thus reducing the funding gap; Opening up a new asset class for small and medium investors; Minimizing risk through splitting limited capital across multiple start- ups; Promoting innovation and keeping the talent local; Creation of jobs through the established start- ups; Supporting the growth of ventures to enterprises and possible future IPOs in new sectors such as the technology and health sector which are almost non- existing in the pubic equity markets in Muslim countries and thus increasing diversification for fund managers.
To ensure Shariah- compliance, Islamic equity- based crowd funding has to ensure the following criteria: The platform has to be governed by a Shariah board or Shariah advisory Investments have to be socially responsible; Start- ups have to operate in Shariah- compliant businesses and thus not to be generating income from none Shariah- compliant sources; Due to the fact that the crowd funding service provider and the backed investors collectively represent a significant equity ownership in the start- up, clear legal restrictions have to be defined to ensure that the start- up does not raise interest- based debt, deposit cash, invests in non- compliant instruments, or extends the product and service portfolio to include non- compliant activities in the future; The typical shareholder structure enforced legally by venture capital firms in terms of granting preferential rights for the investors are deemed non- compliant. Therefore the shareholder structure and investor protection requirements have to be designed to adhere to Shariah principles. In Table 3 a number of proposed Shariah- compliant crowd funding models are provided. So for example if financing is provided to the platform for Islamic charity (Zakat or Sadaqa) only donation- based crowd funding can be used and the beneficiary should be micro- entrepreneurs to support poverty alleviation. Three possible instruments to use would be Hiba, Qard- Hasan and finally Murabaha if the platform were collecting the proceedings provided through charity to be revolved among micro- entrepreneurs for sustainable effect. Financing For Crowd Model Potential Beneficiary Instrument With End Client Islamic Charity Donation Microfinance Hiba Qard- Hasan Murabaha Product Reward Microfinance Sale Small Enterprises Startups Investment Debt Microfinance Murabaha Small Enterprises Ijarah Equity Small Enterprises Diminishing Musharakah Musharakah Startups Musharakah Table 3: Shariah- compliant Crowd Funding Models and Instruments In the case of equity- based crowd funding, potential beneficiaries include small enterprises and startups. While startups are generally financed through pure equity, small enterprises and especially family businesses typically prefer to buy- back the shares of their enterprise rather than being acquired from third parties and thus a diminishing musharakah is more appropriate to be employed.
Case Study: Equity- based Crowd Investing Shekra Based on the fact that crowd investing is a new financial instrument introduced to MENA markets, Shekra developed a framework through which it tackled the core characteristics, opportunities existing in MENA market resulting in redefining the crowd contributors and crowd investing processes (see Figure 3). Figure 3: The Shekra Shariah- compliant Crowd Funding Framework Due to regulatory restrictions in MENA, crowd investing has to rely on a closed network of investors instead of relying on public contributors. Even though this might be perceived as limiting the capital pool available, the cultural and socioeconomic nature of MENA provides a much broader meaning for the crowd. Individual contributors residing in the respective country as well as the diaspora investing back in their countries of origin provide a significant contribution pool to be provided mainly in the form of equity but in some cases also in the form of interest- free loans to support entrepreneurs from a social responsibility perspective. Another pool of capital can flow in from the institutional crowd contributors in the form of matching capital either as interest- free loans (such as provided by government organization and international development organizations), matched equity investments, grants such as provided through international donors as well as via the private sector providing Corporate Entrepreneurship Responsibility (CER) contributions to entrepreneurs.
Since financing is only one side of the equation, crowd investing within this framework is based on a multi- stage process including elements of incubators, angel investors and venture capital funds to reduce information asymmetries between investors and entrepreneurs as well as to screen and select high quality entrepreneurs to be crowd funded. To address the needs of different classes of entrepreneurs, a clear distinction between startups and small enterprises is crucial providing financing mechanisms reflecting their long- term purposes and vision for the respective venture. Small enterprise owners such as restaurants, agricultural products or family business in general seek financing to grow their business rather than targeting a possible acquisition. For such kind of financing purposes, the exit scenario is in the form of a share buy back by the respective entrepreneur through using a diminishing musharakah agreement between the entrepreneur and the crowd. In the case of startups with growth potential the typical venture capital equity nature is more appropriate to employ due to the increased risk nature of seed / early stage startups, which is compensated through expected multiples returns from a prospective exit scenario. The framework employs for startups structured contracts based on both Musharakah and interest- free loans to ensure fair distribution among capital providers in the case of liquidation and thus to overcome the Shariah concerns regarding preference shares. Conclusion Entrepreneurship varies across time, geography, culture and the local socioeconomic conditions of the respective entrepreneur. Similarly, while considering crowd funding and investing as a potential solution to enhance the entrepreneurial ecosystem in Islamic countries a customized approach tackling the direct need of the respective entrepreneurs and investors or contributors. Crowd funding of micro entrepreneurs, small enterprises and start- ups represents a clear opportunity for Islamic finance to maximize the promotion of its core values in terms of social and economic development. The ability of redefining the crowd as a pool including small and medium size investors with limited capital as well as different types of development institutions and corporations will enrich the access to capital to meet the growing entrepreneurial supply, which cannot be met by the current market practitioners. Combining the core values of Shariah, crowd funding, the advancements in technology, and globalization represent an opportunity to significantly contribute to the enhancement of the entrepreneurial ecosystem in Islamic countries.
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