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Application of
The application of venture capital venture capital
strategies to musharakah strategies

financing
Aisyah Abdul Rahman and Shifa Mohd Nor 827
Faculty of Economics and Management and Institute of Islam Hadhari,
Universiti Kebangsaan Malaysia (UKM), Bangi, Malaysia, and Received 24 May 2016
Revised 14 February 2017
29 October 2017
Mohd Fadzli Salmat 24 May 2018
Ministry of Maritime, Melaka, Malaysia 16 August 2018
30 October 2018
Accepted 12 November 2018

Abstract
Purpose – This paper aims to explore the strategies used by venture capital (VC) firms in assisting
entrepreneurs who have business potential but lack capital. The study also aims to investigate whether the
VC strategy can be adopted by Islamic banks through musharakah financing.
Design/methodology/approach – Apart from content analysis, primary data were gathered from
several interview sessions with the management of three VC firms and two Islamic banks.
Findings – Islamic banks in Malaysia have great potential to offer musharakah financing and mitigate risk
by adopting the following five VC strategies: method of selection, channelling of funds, monitoring, non-
capital assistance and period of investment. We propose the channelling of corporate social responsibility
funds for musharakah financing as an initial step in applying VC strategy.
Research limitations/implications – Given the limited number of willing and eligible respondents in
Malaysia, the scope of this study can be widened to a cross-country analysis where musharakah financing is
widely adopted.
Practical implications – This study motivates regulatory bodies and Islamic banks to consider
musharakah financing using the risk monitoring strategy adopted from the VC industry.
Originality/value – This study is the first to empirically explore the strategy adopted by VC companies
and evaluate whether such a strategy is suitable for the concept of musharakah financing.
Keywords Risk, Venture capital, Islamic banks, Musharakah financing
Paper type Research paper

1. Introduction
Islamic banking is an important financial service in Malaysia. This could be attributed to
the increase of Muslims in the country who are aware of the need to comply with riba’-free
banking as prescribed by Islam (Al-Jarhi, 2007; Dusuki, 2008; Alam and Rizvi, 2017; Rashid
et al., 2018). Moreover, Islamic banking provides a competitive alternative financing to
conventional products. Muslims have realised that Islamic banking offers another form of
financing with a viable investment method that is particularly inclined toward equity-based
financing and is consistent with the spirit of shariah.
However, equity-based financing contracts, such as musharakah and mudharabah[1], are
deemed less favourable in the Islamic banking industry (Abdul-Rahman et al., 2014; Hassan
Journal of Islamic Accounting and
Business Research
Vol. 11 No. 4, 2020
pp. 827-844
The authors gratefully acknowledge the financial support from the Faculty of Economics and © Emerald Publishing Limited
1759-0817
Management, UKM (EP-2015-011) and the Universiti Kebangsaan Malaysia (EP-2018-001). DOI 10.1108/JIABR-05-2016-0061
JIABR and Aliyu, 2018; Abdul-Rahman et al., 2019), because they involve higher risk than other
11,4 shariah contracts[2] (Anwar et al., 2010). In Malaysia, debt-based financing, such as bai
bithaman ajil (deferred payment sale), ijarah (lease) and murabahah (cost plus profit), are
financing concepts that are widely used in most products offered by Islamic financial
institutions. This is because institutions are extremely profit-driven and less inclined to offer
risky schemes such as musharakah (Farooq, 2007; Hassan et al., 2013). Debt-based financing
828 contracts, which are based on sales transactions, are usually adopted in financing schemes
offered by Islamic banking.
Islamic banks may offer musharakah and mudharabah financing because it increases
value for the banks, with proper and discrete monitoring, relative to debt-based financing
(Muda and Ismail, 2010; Shaikh, 2017). Given the existence of musharakah and mudharabah
financing products in Islamic banking, the objective of maqasid shariah[3] can be met,
especially in terms of asset acquisition, which fulfils the shariah requirements. Moreover,
risk-sharing will lessen the burden between parties and prevent potential abuse of the
weaker party by the stronger one (Abdul-Rahman et al., 2014). Musharakah and
mudharabah financing will also prevent businessmen or entrepreneurs from engaging in
riba’, or usury, which is strictly prohibited by Islam. This mode of financing realises the
aspiration of Islamic economy that upholds socioeconomic development.
The concept of musharakah is fairly similar to the concept of venture capital (VC). Thus,
the present study focuses on musharakah financing rather than mudharabah financing. VC
financing, which practices the business concept of profit and loss sharing, is widely
implemented in Malaysia. However, the two concepts are differentiated by the basic
principles and contracts of financing. VC ownership can be liquidated through an initial
public offering (IPO) (Al-Suwailem, 1998), but this option is not applicable in musharakah.
In principle, the financing of business capital represents equity-based financing, which
emphasises risk and profit sharing between investors and entrepreneurs (Abdul-Rahman
and Mohd Nor, 2016; Othman et al., 2017). This partnership brings advantages to both
parties. Entrepreneurs do not have to bear the burden of debt that requires scheduled
repayments, whereas investors will gain the advantages of technology know-how as a result
of the partnership. Investors may also serve as a mentor to their partner such as help to
formulate the company’s corporate strategy and enhance its performance with new network
financing and markets (Nordin et al., 2005).
A VC investor is a specialised financial intermediary that pools funds to finance new or
existing projects (Da Rin and María Fabiana Penas, 2017). VC financing has been practised
in Malaysia since the 1990s and has become a contributor to the economic growth of the
country. According to the 11th Malaysia Plan (2011), the government remains a major
source of funds of VC because of the importance of VC in the early stages of financing.
According to the Malaysian Budget (2016), the VC industry has continued to grow as a new
source of economic financing; in particular, Khazanah Nasional allocated RM500m to VC
funds. The industry continues to demonstrate sizeable development in terms of the number
of funds, total amount of investment from domestic and foreign sources, number of VC
companies and number of venture companies.
The criteria and incentives provided by the government and the strategy to minimise the
risk of loss by the VC industry are based on the success of VC in Malaysia. The general
research question is as follows: How can the strategy of successful VC investment be applied
to Islamic banks to encourage them to offer musharakah products? The specific research
questions that guide this study are as follows:
 RQ1. What are the challenges that hinder musharakah financing from being offered by Application of
Islamic banking institutions? venture capital
RQ2. What are the strategies adopted by VC companies to manage investment risk? strategies
Given the two aforementioned research questions, this study aims to comprehend the
possibility of adopting VC strategies towards musharakah financing by providing empirical
evidence on the possibility of applying VC in musharakah financing in Malaysian Islamic
banks. 829

2. Literature review
The structure of the literature review is based on previous studies on musharakah financing
and VC. Existing studies have shown that musharakah financing can be potentially developed
because of its many advantages, but the implementation of VC financing, including investment
risk, moral hazard and asymmetric information, also presents challenges (Rifai and Khan,
2000). These challenges arise from agency theory, which involves two types of individuals or
groups, namely the principal and the agent (Jensen and Meckling, 1976). In the present study,
agency theory refers to the basic relationship between partners (entrepreneur and capital
provider) in financing a project. This study also emphasises the self-interest of the
entrepreneur, which could jeopardise the objective of maximising the profit of the project that
will be shared between partners according to a pre-agreed ratio.

2.1 Musharakah
The concept of musharakah, or “partnership”, is closely related to agency theory and is
defined as a contract between two or more parties who contribute capital towards financing
a project (Dusuki and Abdullah, 2014; Zaher and Kabir Hassan, 2001; Usmani, 1999). All
parties share profits according to a pre-agreed ratio, whereas losses are shared according to
equity participation. All parties (the financier and entrepreneur) or only one of them may be
involved in managing the project A musharakah contract is usually offered for funding of
entrepreneurs’ working capital, fixed assets and project financing.
Che Arshad and Ismail (2010) reviewed the parameters set by the Central Bank of
Malaysia by focusing on a specific definition in identifying the important criteria to
understand the needs of a shariah contract. Musharakah parameters include capital,
management, profit-and-loss sharing (PLS) and joint ventures. All criteria identified in the
parameters could help the Islamic financial services industry determine, understand, apply
and differentiate the PLS contract from other contracts that are widely available in the
industry, especially the small and medium-sized enterprises (SMEs). This assertion was
supported by Al-Suwailem (1998), who stated that VC has a huge potential through
musharakah contracts because VC could increase the economic growth of the country.
Although a musharakah contract may be subject to failure, it provides an exciting
alternative method of investment financing, particularly in Islamic countries.
The musharakah contract differs from VC (Kamaruzaman and Fadillah, 2005) only in its
principles, implementation and operational aspects. A musharakah contract has a good
likelihood of development along with the advancement of the Islamic financial system in
Malaysia. A musharakah model considers sharing of profit for a fair and equitable
investment and cooperation between the capital provider and entrepreneur (Mohd Jaffar,
2010), which indirectly encourages entrepreneurs to invest and provide the initial capital to
prove their commitment. Therefore, this model can reduce risk, inefficiency and
mismanagement because the capital belongs to the entrepreneur. Risks will be shared
accordingly because the profit-sharing ratio is agreed by both parties (Mehri et al., 2017).
JIABR A gap was observed between the theory and practice of Islamic finance, wherein the
11,4 systems used in Islamic banks do not function optimally. There are a few reasons why
Islamic banks cannot offer musharakah. Islamic banks prefer to invest in less risky short-
term assets, such as debt-based financing (Dar and Presley, 2000; Ascarya and Rokhimah,
2008); thus, musharakah is not the best financing mode for Islamic banks at the current time.
This is attributed to the lack of liquidity of banks when offering medium- to long-term
830 investments. Thus, Islamic banks cannot offer attractive investment opportunities to parties
interested in medium- or long-term investments. Musharakah is exposed to operational risks
given the risky nature of the partnership, the need for additional monitoring cost, the lack of
transparency in markets and the reluctance of depositors to incur risks. Moreover, the
financier may lack appropriate technical expertise for monitoring the project (Iqbal and
Molyneux, 2005; Mirakhor and Zaidi, 2007; Febianto, 2012; Kayed, 2012;). In addition, the
musharakah mode of financing lacks the following aspects: clarity between shareholders
and investors or depositors (Greuning and Iqbal, 2007), detailed records (Iqbal and
Molyneux, 2005) and information on entrepreneurial abilities (Sadr and Iqbal, 2002; Iqbal
and Molyneux, 2005). Information asymmetry occurs in musharakah financing. Haron and
Lee (2007) asserted that musharakah financing may lead to credit risk related to capital
impairment risk, which means that the capital provided by the financier may not be
recovered. Thus, the challenges faced by musharakah financing are undoubtedly similar to
those in VC financing.

2.2 Venture capital

Numerous studies have examined the risks in VC investment. Chemmanur and Loutskina
(2014) confirmed that corporate VC firms are more advanced, even though they are newer,
riskier and less profitable than independent VC firms. Hochberg and Ljungqvist (2014)
estimated that approximately two-thirds of VC firms lack skill; thus, they speculate on risky
investments. According to Wong (2002), investment in a VC firm entails high risks, but such
a feature is not an obstacle for investors in the VC industry. Wong believed that investment
at the infancy stage is the right choice in increasing long-term return as well as avoiding
short-term risks when faced with economic downturn and recessions.
Petty and Martin (1983) and Buchner et al. (2017) revealed that VC is a high-risk and
high-return investment. Therefore, investments should be diversified into different
portfolios to ensure that investment risks can be minimised. This assertion was proven by
Petty and Martin (1983) in relation to the characteristics of profit risk in VC investments and
investment in trust funds. Their study revealed that investors who prefer high-risk
investments would choose to invest in venture companies rather than in trust funds. In
another study, Bottazzi et al. (2016) demonstrated that the element of trust plays a
significant role in the selection of VC investments.
Apart from investment risk, the VC industry must also deal with moral hazard problems
and asymmetric information. Gompers and Lerner (2001) stated that VC faces difficulties
from uncertainty and information asymmetry, particularly for new firms in high-technology
businesses. A VC investment is considered high risk, and the investor faces difficulties in
monitoring the firm’s operations. Bergermann and Hege (1998) and Mehri et al. (2017)
believed that problems such as asymmetric information will be encountered by the investor
and entrepreneur in relation to the prospect of investment; moral hazard could emerge at the
entrepreneur’s side in such cases. This problem could be prevented if the investor monitors
the operations of the firm by periodically supervising and analysing financial records. They
suggested that VC firms should rigorously examine a potential enterprise before providing
capital and proceeding with the monitoring process. Among the monitoring steps
highlighted are distributing financing in stages, collaborating in investments with other VC Application of
firms, meeting with the board of directors and associating performance with compensation. venture capital
Mat Nor et al. (2012) concluded that asymmetric information affects business
performance. Studies conducted on capital providers and venture companies revealed that
strategies
high asymmetric information contributes to the failure of business ventures, whereas low
asymmetric information facilitates success. Asymmetric information between the
entrepreneur and the venture company should be minimised to ensure the success of any VC
project. 831
Besides examining the investment risk and asymmetric information in the VC
investment, investigations were conducted with regard to the implementation of VC
financing to determine the financing stage that provides the highest return on investment.
Gompers (1998) concluded that efficient management in the early stages of firm
establishment is extremely important because the first stage of the business life cycle is
crucial.
Berger and Udell (1998) claimed that VC financing is appropriate at the introductory
stage after completion of the first stage of the business life cycle. This argument was
supported by Gompers and Lerner (1997), who believed that the firm will generate a high
return at the initial growth stage. In addition, they discovered that the degree of
transparency of information is an important characteristic influenced by the size of the firm.
Small firms are usually financed by an internal investor, such as individual entrepreneurs,
family and acquaintances. This situation is due to the difficulties faced by small firms in
raising capital from external investors.
In addition to the requirement of using efficient VC fund managers, high returns also
depend on the mechanism applied during the exit of the investment. Black and Gibson
(1998) revealed the benefits of capital exit through IPOs. An investor could return the shares
of the firm to the entrepreneur if the investment could be liquidated through an IPO
(Al-Suwailem, 1998; Black and Gilson, 1998). In this way, both parties would benefit, as the
investors get the returns from their investment and the entrepreneurs obtain ownership of
the firms that they managed. According to Boocock (1995), most entrepreneurs are not keen
on VC financing because they could lose control over their firm, especially family-inherited
firms.
A conclusion based on previous studies indicates that VC financing involves high risk,
but has high potential to be developed further because it could generate lucrative income.
However, researchers acknowledged a few obstacles that must be addressed in the VC
industry. The problems faced by both investors and entrepreneurs include issues of moral
hazard, business management and asymmetric information.

2.3 Similarities between musharakah and venture capital

The similarities between musharakah and VC can be classified into four categories:
definition, high risk, information asymmetry and monitoring and assistance.
By definition, both musharakah and VC must operate through a specialised partnership
contract (Da Rin and María Fabiana Penas, 2017) in a medium- to long-term investment. In
this contract, partners involve the capital provider and the entrepreneurs, who pool their
financial capital and efforts towards meeting the objective of the business. The nature of
return for the musharakah and VC occurs according to the PLS ratio (Choudhury, 2001; Kia,
2001; Hasan et al., 2011).
In a musharakah and VC contract, partners are exposed to high risk, which is consistent
with the financial concept of “high risk, high return” (Wong, 2002; Anwar et al., 2010) and
the Islamic legal maxim in business of “no pain, no gain” (Hasan et al., 2011).
JIABR In terms of information asymmetry, both contracts face similar challenges in selecting the
11,4 most credible business (Choudhury, 2001). Given this uncertainty of information, adverse
selection usually emerges throughout the business process. In addition, musharakah and VC
are exposed to the moral hazard problem, such as conflict of interest between two parties
after the contract becomes binding (Al-Suwailem, 1998). Nevertheless, Kia (2001) suggested
that the moral hazard problem in both contracts may be minimised as the firm’s equity is not
832 marketable to the public, except for the VC and musharakah partners’ own knowledge. In
other words, a public investor has no opportunity for capital gain. Hence, there is high
incentive for the VC and musharakah partners to reduce moral hazard.
Finally, both partnership contracts require discrete monitoring to avoid losses. Besides
monitoring, musharakah and VC investors must also provide assistance to entrepreneurs to
increase the probability of success (Muda and Ismail, 2010; Shaikh, 2017).

3. Methodology
To achieve the objective of this study, a qualitative research design is adopted to obtain a
comprehensive understanding of the specific situation (Merriam, 2009). Qualitative research is
normally an exploratory study that answers the “why” question indulging deeper reasoning
(Vandestoep and Johnston, 2009). An inductive strategy is used to collect data to build a
concept on venture capital strategies to be applied to musharakah financing. The inductive
strategy is appropriate as small pieces of data interviews are gathered to build a larger theme to
generalise the concept (Merriam, 2009). Interpretive orientation is used in this study since the
respondents are from top- and middle-level management, and are knowledgeable with vast
experience in the industry. These individuals, who are involved in a complex and sophisticated
decision-making process, may have similar experience and understand the same “objective
reality”, but may react in different ways for their own reasons (Bryman, 2016; Merriam, 2009).
As this study involves a specific industry (i.e. Islamic banking and venture capital), the case
study approach is deemed suitable as it provides descriptive and intensive information that
allows for in-depth exploration of the topic (Bryman, 2016).
This study gathers the primary data from a semi-structured interview process. The
process begins by interviewing the venture capitalists to gain information on the strategy
used. Next, interviews are conducted with Islamic bankers to explore the understanding of
musharakah financing in these institutions. The interview is guided by the following
interview protocol, which is divided into two categories:

(1) For the venture capitalists:

 What is the selection process of your VC firms like?
 How do you assess the financial position of the firms?
 How do you disburse the funds to the firms?
 What kind of support do you offer besides monetary assistance?
 What is the monitoring mechanism used to mitigate risk?
 For how long are you involved in the venture capital investment?
(2) For the Islamic bankers:
 Does your institution offer musharakah financing?
 If yes, what is the financial status? Is it profitable?
 If no, what are the main reasons for not having musharakah in your
institutions?
  Is the VC strategy suitable to be adopted in musharakah financing? Application of
(3) Selection of the interview panel was made according to the following venture capital
considerations:
strategies
Respondents must be involved directly in the financing activity and product

development.
 Panel members must have wide experience and knowledge of Islamic banking
833
equity-based financing.
 Panel members must be qualified and possess relevant educational background
for the study.
The study was conducted on three active VC firms and two Islamic banking institutions that
are directly involved in offering musharakah financing. All data and information gathered
were obtained from interviews with a few individuals personally engaged in the activity,
management and administration of their respective institutions. Table I shows the profile of
the five respondents and their pseudonyms for this study.
Appointments were made to conduct interviews with each selected panel member. The
interviews were conducted at the respondents’ workplace. A voice recorder was used in all
interview sessions to store the information obtained. Interview sessions lasted between 40
and 60 min. After transcription of all the interviews, thematic analysis was used to gather
data according to selected themes. Content analysis was then performed to support the
information obtained.
Data were obtained from the five interviewees, which were then analysed using thematic
analysis (Braun and Clark, 2006). This method involves coding data from each interview
transcript based on themes or patterns. A theme is a trend found in information that, at the
minimum, elaborates on possible remarks and, at the maximum, infers features of the
phenomenon (Boyatzis, 1998).

4. Findings and discussion

This section discusses the findings on the musharakah financing challenges and the
strategies to be implemented. The study identified four challenges: high risk and collateral,
selection of entrepreneur, market demand and guarantee of capital security. In addition, five
themes on successful strategies were ascertained: selection, funds disbursement, monitoring,
non-capital assistance and period of investment.

4.1 Challenges of musharakah financing

According to the interview analysis, the four challenges that prevent musharakah financing
being offered are as follows:

No. Company’s name/bank Respondent position Total fund

1 Joint Venture 1 (JV1) Chief of Investment RM750m*

2 Joint Venture 1 (JV2) Chief Executive Officer RM200m* Table I.
3 Joint Venture 2 (JV3) Senior Vice President Not disclosed
4 Islamic Bank 1 (IB1) Assistant General Manager and Head of Shariah Division RM 37,451m**
General information:
5 Islamic Bank 2 (IB2) Shariah Advisor RM 81,757m** venture capital
company and Islamic
Notes: *Information received from respondent; **annual report 2012 banking
JIABR 4.1.1 High risk and collateral. The high risk in musharakah financing is mostly due to the
11,4 entrepreneur’s lack of expertise and experience in running the business:
We failed in our attempt to offer products in musharakah. I cannot remember the exact figure.
Thus, musharakah is considered a high-risk asset in banking from the capital perspective when
computing the risk–investment ratio. The bank has to sign a higher capital charge. (IB1)
Potential customers usually include SMEs and entrepreneurs who do not have a good
834 financial track record compared with multinational companies and locally established
companies:
Normally, the big boys, which are blue-chip companies such as energy or telecommunications
companies, do not aim for musharakah financing. These companies, instead, bargain for the
lowest financing cost that the bank can offer because they have high creditworthiness. (IB1)
Banks require collateral because of the high risk. Banks need to ensure security of the
capital invested since most of the capital comes from depositors.
4.1.2 Selection of entrepreneur. Sourcing a business partner with experience and with
business potential that could be developed is difficult. A company with a good track record
and good financial performance is necessary:
[. . .] we will choose a business partner based on a three-year good track record with possible
business potential that is disclosed in public [. . .] however, most fund seekers have a problem
with creditworthiness [. . .]’. (IB2)
4.1.3 Market demand. Requests for musharakah usually come from SMEs that are new
to the business. This situation increases the risk of failure:
[. . .] the minimum investment that we provide is RM1 million [. . .] if the size of the company is too
small, we become the majority investor instead of the normal practice of only owning 10 to 20%
of total equity [.. . .] the problem is that most project owners are considered small and medium-
sized [. . .]. (JV1)
4.1.4 Guarantee of capital security. Not all partners can afford to provide a guarantee on
capital, because those who choose musharakah are clients who lack capital:
[. . .] we need to look at the amount of capital that the fund seekers are willing to contribute,
because it represents their commitment. If there is no capital guarantee, we will at least see how
they plan to get the cash flow. However, most potential partners lack capital without a convincing
business plan. (JV2)

4.2 Strategies for musharakah financing

According to the interviewees, there are five strategies to ensure the success of the
investment. However, the interviewees from Islamic banks highlighted the investment risk,
which needs to be closely monitored. The following strategies are suggested:
4.2.1 Selection. Selecting the company to enter into a partnership contract with is a
difficult task. The right selection is extremely important in guaranteeing the triumph of an
investment for a determined period. In general, two criteria must be considered in the
selection of a company, namely, the company’s background and its capability to do the
project.
If an unfamiliar customer (company) approaches us, we will investigate their background. We
will try to create trust in them by asking for their purpose in obtaining financing. If the company
started a government project to repair a school worth RM10,000, we would review the gross profit
and cash flow of the company. (IB1)
 We are still looking for the right partner in the right industry. If we find a suitable partner, we will Application of
offer musharakah financing (IB1)
venture capital
These two criteria should be seriously observed and evaluated to make sure that the venture strategies
is profitable and sustainable. In the selection of a business enterprise, VC companies usually
choose a company that has been in operation for at least three years. This condition
guarantees that an assessment of the company’s track record and financial performance for
the past three years can be done. Evaluating the potential growth of a company that has 835
been in operation for less than three years will be difficult and the risk of business failure is
high:
The selection is mostly focused on emerging companies at the growth stage, where the company’s
profit record is at least three years. Companies like this should be supported because of their great
potential and often the size of the company is not too small. (JV2)
A business with a track record reduces the probability that the entrepreneur will abscond
after receiving the funds from the VC company. In addition, VC companies prefer to invest
their funds in a business that has a clean track record, such as those without legal action
against them and no unpaid banking debts. Track record is extremely important for the
company that receives the VC to ensure that the funds received are not misused for settling
outstanding summons and business debts. Another important criterion is the selection of an
experienced entrepreneur in the business. An entrepreneur who is actively running a
company besides holding company shares is a good sign that guarantees the company’s
viability. Therefore, an entrepreneur who has always demonstrated good commitment in
every task can attract investors to provide funding to the company.
4.2.2 Funds disbursement. A few precautionary measures must be undertaken for the
disbursement of funds to the venture company to prevent mishandling of funds. A
disbursement schedule will be introduced. In other words, funds will be disbursed in series
and not in a single lump sum disbursement. This method will mitigate the risk of losses and
ultimately protect the capital provider from being in a high-risk position:
Disbursement of funds to companies or entrepreneurs is implemented according to the need to
pay at once or to pay periodically in order to control the risks. (JV1)

The purpose of implementing the payment periodically is to see the commitment of the company
or entrepreneur in carrying out its business and achieving the agreed objectives. Profit from this
business will be shared by the agreed percentage or percentage of shareholding. (JV3)
Disbursement of funds must be made according to the written proposal that has been agreed
upon. During the presentation of the proposal paper and before reaching an agreement, the
entrepreneur will state the utilisation period of the funds for business activities, such as to
purchase merchandise and specific assets. Generally, the purchase will be done in stages. In
this manner, the funds will only be disbursed when necessary and as planned earlier.
However, some VC companies disburse funds in lump sums to finance businesses.
Disbursement also depends on assessment during the presentation of the proposal by the
entrepreneur and the discretion of the VC companies. However, disbursement made in
stages is less risky in that it prevents the entrepreneur or the venture company from
absconding or committing fraud.
4.2.3 Monitoring. Monitoring of the venture company after the disbursement of funds
should be done periodically. Continuous monitoring is important to prevent
mismanagement and mishandling of the disbursed funds and to guarantee that the venture
company is running the business as stated in the written proposal.
JIABR To ensure that business activities are conducted as per the agreed terms, VC companies
11,4 will appoint a representative from the company to be a member of the board of directors of
the venture company to perform the said monitoring. The representative is also responsible
for providing views and advice to the venture company during difficult times. The
representative must constantly observe and provide reports to the VC company on whether
the business is run smoothly or otherwise. In addition, the monitoring process must also
836 include visits to the project site as well as using technology:
We are in the process of creating a regulatory system where the invested company will report
online performance and activities. This is a facility that enhances the company’s performance
with the use of blockchain technology. The aim is to share information on funds and investments
with its stakeholders that will have a better impact, especially on the transparency of corporate
governance. (JV1)
A monitoring strategy through site visits could provide motivation to the entrepreneur as an
indication that the VC company is always ready to offer continuous cooperation and
commitment towards the joint venture.
Close monitoring by requesting the venture company to submit monthly financial
reports and business progress updates should also be conducted. These reports will keep the
VC company abreast of the business activities and provide evaluations on such activities.
Monitoring through financial reports will identify and deter any misuse of funds and other
untoward actions that could increase the risk of losses and failure of the venture company.
Monitoring must be regularly performed to achieve the ultimate objective of making the
business profitable and to develop and grow the business to greater heights.
4.2.4 Non-capital assistance. Apart from the selection process, monitoring and the
method of disbursement, other assistance could also be emphasised as a strategy to ensure
the success of the investment and to reduce the risk of failure of VC companies. One type of
assistance that could be provided by the VC company to the venture company is skill
training. VC companies could provide training on managing the company to establish a
structured entity and prepare the company for a stock exchange listing with a strategic
management approach. This management approach is not only confined to the managers of
the venture company, but should also involve the owner.
The training to be given is the basics of business management because the partner company is
new [. . .] but if it is private equity, training is highly focused on the company’s operations
because it is a mature company’. (JV1)
In terms of technology utilisation, venture companies are new entrants in the market, with a
low level of technology. Therefore, capital assistance should not be in the form of cash only
but could be through machines or other technological equipment. New technology
introduced to the venture company will enable it to progress along with other companies.
To add value to the venture company, publicity aspects should be emphasised to ensure
that the company is widely known both locally and in a wider forum. VC companies will
assist in marketing the company’s products to establish a new market for the business. In
addition, the VC companies will create a business network by introducing the venture
company to government agencies to strengthen their business relationship.
4.2.5 Period of investment. According to the interviews conducted, a VC investment is
acknowledged to have a stipulated investment period. This investment could be categorised
as a long-term investment that lasts between three to five years before the investment term
ends. This duration is the most appropriate term to allow for exit from the investment or
disposal of the shares before it becomes difficult due to certain factors:
 [. . .] the maturity of the investment is normally within three to five years before being released. Application of
We do not allow a longer period of investment horizon as it becomes hard to release’. (JV1)
venture capital
VC companies commonly employ a few methods to exit from holding the shares or the strategies
investments made. The first method is sale of the shareholding to the entrepreneur if the
entrepreneur agrees to buy the shares owned by the VC company. The second method is sale
of the shares to other investors if the entrepreneur refuses to purchase the shares owned by
the VC company. The third approach is disposal of the shares through an IPO on the stock 837
market.
Table II provides a summary of the challenges faced by Islamic banking in offering
musharakah financing and the VC strategy in minimising the risk of losses and failure on
the basis of the interviews conducted. On the basis of a comprehensive overview (Table II)
with regard to the issues faced in musharakah financing and the strategy towards VC, this

Issues in Musharakah Venture capital strategy

High risk High risk due to Selection of Selection aspects that involved
entrepreneur’s lack of project selection of company and selection
expertise and experience in of entrepreneur.
running the business. Choose company that has been in
Depositors own most of the operation for at least three years
money invested Has clean business record
entrepreneur who is experienced in
the business and active in
managing the company
assessment on the entrepreneur’s
character such as his attitudes and
moral values especially his
integrity
Selection of Difficult to select business Disbursement Disbursement of fund by stages or
entrepreneur partner with experience and of Funds in schedule as per the proposal
business potential that could paper.
be developed. Lump sum cash disbursement is
Need to choose company that not allowed
has good track record and
good financial performance.
Market demand Request for Musharakah are Monitoring Regular monitoring
from small and medium Appoint representative in the
industry that is new to the board of directors of the venture
business. This increases the company.
risk of failure Visit to project sites
Guarantee for Not all partners can afford to Non-capital Skills Training.
capital security provide guarantee on capital assistance Company’s management training.
as those who choose Marketing assistance.
Musharakah are clients who Technology assistance
lack capital
Period of Long-term investment between 3
investment and 5 years.
To dispose shares to the Table II.
entrepreneur or other investor or
through IPO upon expiry of the
Issues in
term musharakah and the
strategy of venture
Source: Interview result with Islamic banks and VC companies capital
JIABR study concluded that the strategy of VC in reducing the risk of failure could be applied in
11,4 musharakah contracts in Islamic banking. If musharakah is widely implemented, the same
obstacle faced by the VC firms will also be encountered by Islamic banking institutions,
especially on the risk aspects, such as moral hazard, asymmetric information and the aspect
of business management, as mentioned earlier. Therefore, if Islamic banking offers
musharakah financing, the same business strategy adopted by the VC firm can be applied in
838 mitigating the risk of failure. This approach includes adopting the strategy through the
selection process, disbursement of funds, monitoring, period of investment and non-capital
assistance. These strategies can transform a musharakah contract in Islamic banking to
become viable and competitive while managing risk effectively.
Just as the VC firm invests in SMEs with growth potential, Islamic banking should also
play the same role by providing assistance in channelling funds to small and medium
entrepreneurs who lack capital to expand their business.
The concept of VC is similar to the musharakah concept, in that it entails a joint venture
between two parties who agree to provide capital, run the business and share profit and loss.
However, the difference is that musharakah financing is based on shariah parameters (free
of riba’, maisir (gambling), gharar (uncertainty) and not conducting activities that are
prohibited in Islam). By contrast, VC is an investment in any form of business as long as it is
legal and does not breach the laws of the country.
An equity-based financing contract such as musharakah is more favourable than a sale
and purchase financing contract because the element of risk sharing is fundamentally
important in the sharing of profit in Islamic banks. Therefore, the recipe for success in a VC
institution could be emulated as a model in formulating a risk management strategy for
musharakah financing.
Our finding offers practical implications. We propose that Islamic banking
institutions adopt the VC strategy in offering musharakah financing. Islamic banking
frequently argues that its obligation to depositors has prevented it from offering
musharakah financing. Thus, the initial step is to recommend Islamic banks to offer
musharakah financing to small and medium-sized businesses by using the funds for
corporate social responsibility (CSR) for micro financing. The CSR model is realistic
because the funds are meant for community welfare without expecting a return on or
repayment of the initial capital invested. If the CSR model proves successful in the long
term, Islamic banking could move one step further by offering musharakah financing
from the deposits received. The CSR model could provide a training platform for
officers of Islamic banking on how to manage musharakah financing in an effective and
efficient manner.

4.3 Utilisation of corporate social responsibility funds in micro financing through the
musharakah contract
A CSR fund is available in an Islamic banking institution through contribution from equity
holders, charities and alms from certain parties for social and welfare activities.
The musharakah VC is high risk because it is sourced from customers’ deposits. Thus,
the CSR fund should be channelled to entrepreneurs by adopting the musharakah contract.
This method is initially suitable as an experimental channel to fund small businesses in
small amounts. The modus operandi in Figure 1 shows the proposed process for
musharakah financing[4].
One example will be used for this purpose to understand the modus operandi in detail.
We assume that RM1m is taken from the CSR fund and then placed in the Musharakah
Special Fund (MSF). From the fund, the bank will contribute RM20,000 to the business while
 Application of
venture capital
strategies

839

Figure 1.
Modus operandi of
Musharakah

the entrepreneur contributes RM10,000. With the capital of RM30,000, both the entrepreneur
and bank will commence business as agreed. The sharing of profit and loss was agreed
previously. Losses, if any, will be shared by both parties according to the agreed ratio. If the
business is profitable, the bank’s portion of the profit will be returned to the MSF, while the
entrepreneur will receive his or her share of the profit. If the business incurs losses due to
negligence or other reasons as specified by shariah, all assets, such as vehicles, machines
and equipment, will be liquidated and returned to the MSF.
Most of the bank’s funds are sourced from depositors, which poses a burden to the bank
in the event of losses. The bank’s risk could be reduced with the establishment of the MSF
for micro financing to small businesses. The utilisation of CSR funds to assist the
entrepreneur is also a form of CSR as the bank’s main objective is not solely profit-oriented
but rather to help small entrepreneurs. However, the rate of profit sharing should be pre-
determined to prevent the parties from being indifferent in ensuring the success of the
business.
With the RM1m in MSF as a start, financing on a micro scale to entrepreneurs instead of
offering large financing will help new entrepreneurs. Given that financing is offered on
a micro scale, the probability of success will be high because more entrepreneurs are
involved, in contrast to a large financing in which fewer entrepreneurs are being
assisted. The bank does not need to recruit new staff to monitor each business because
it can sufficiently leverage existing manpower, given that the businesses are small
scale and easy to monitor.
The MSF should be increased each year from the allocated CSR fund. The source of
funds for the MSF must not be confined to the profit generated by the CSR fund. Funds may
come from others who wish to contribute. To ensure the sustainability of musharakah
financing, none of the profit generated from the musharakah contract must be used by the
bank, but must be returned to the MSF as a source of capital for future musharakah
financing projects. Musharakah financing could be continuously offered because the bank
will not be under pressure to raise new capital.
JIABR 5. Conclusion
11,4 Musharakah is an appropriate and fair profit-sharing model in Islamic banking, which considers
two rates of the joint venture profit between the capital provider and the entrepreneur. Profit and
loss risks are also shared by the two parties. Consistent with agency theory, the findings of this
study identify four challenges faced by Islamic banks in providing musharakah financing.
These challenges, namely, high risk, entrepreneur selection, market demand and capital
840 guarantee, must be managed wisely to minimise the risk of loss and failure.
The VC industry, which is largely successful in joint venture businesses, should be
considered a close example for Islamic banking to offer musharakah financing products on a
wider scale. The approach used in the VC concept must be fully understood to ensure that
the VC elements compliant with the shariah requirements could be applied to musharakah
financing.
The strategies in reducing the risk of losses and business failures by the VC industry
could be learned and applied by Islamic banking institutions in providing musharakah
financing. The VC strategies that could be used include the selection criteria, disbursement
of funds, monitoring, non-capital assistance and period of investment, as discussed earlier.
Application of the VC strategies could facilitate the widespread provision of musharakah
and mudharabah financing by Islamic banking in future.
The application of VC strategy in musharakah financing in Islamic banking will offer
tremendous benefit to all parties, especially to consumers and the Islamic community, once
Islamic banking overcomes its phobia of offering musharakah financing. This study could
facilitate an improvement in the community standard of living and simultaneously upgrade
both the Muslim and non-Muslim economies. The increase in income and standard of living
of Muslims will lead to a more respectable Muslim community worldwide. This study is also
crucial to Islamic banking because it will help Islamic financial institutions in providing
equity-based financing that could assist small and medium entrepreneurs and large
entrepreneurs who lack capital for their business. Hopefully, this study will also add value
to Islamic banking and fulfil the maqasid shariah by not solely focusing on profit.
The proposed MSF model also shares the possibilities of dynamic activities in
implementing the musharakah concept in Islamic investment, especially in Islamic banking.
This MSF model plays an important role in the economic development of Malaysia. The
model also acts as another innovative instrument in the Islamic financial system, especially
in Malaysia. Musharakah financing based on the MSF model can become a source of
financing that adds value to financing instruments in Islamic banking institutions. The
Malaysian Government fully supports and acknowledges the importance of the banking
industry for its economy. Thus, the MSF musharakah financing model has great potential to
become an alternative investment and source of financing for investors and other dynamic
Islamic entrepreneurs, particularly in Malaysia.
Islamic banking and finance should step outside their comfort zones by offering
financing based on musharakah to customers and become involved in the business as active
partners. The implementation of the MSF model will increase equity-based financing
compared with financing on the basis of sales transactions, which is practised widely by
Islamic banking institutions in Malaysia.
The result of this study is limited to the application of VC in Islamic banking institutions.
However, interviews could be conducted with non-banking Islamic establishments that offer
Islamic financing (such as zakat and waqf centres), because these organisations have the
potential to offer micro financing using the musharakah VC concept[5]. The scope of the
study could relate to their readiness in applying the VC strategy within their legal scope and
the objective of the institution.
Notes Application of
1. In mudharabah financing, the bank (with no interference in the customers’ business operations) venture capital
provides capital to customers for business purposes with the agreement that the profit will be strategies
shared between the two parties while losses will be borne by the capital provider (bank) alone.
The effort by the mudharib without any compensation is considered as his or her own loss, even
though there is no loss in monetary terms. Musharakah financing is a joint venture between the
bank and the customer for a specific purpose. Both parties contribute in the form of capital and
expertise, with the agreement that both profit and loss will be mutually shared upon a pre-agreed 841
ratio.
2. Given the high risk exposure of mudharabah, Anwar et al. (2010) developed a new formula that
can capture comprehensive and realistic market movements using an artificial neural network
for calculating mudharabah time deposit as an investment instrument.
3. Maqasid shariah contains five pillars of Islam, such as maintenance of religion (Din),
maintenance of human life (Nafs), maintenance of children (Nasl), maintenance of wealth (Mal)
and maintenance of intellect (‘Aql).
4. We adapted the waqf-CSR model from Lukman et al. (2014) to match our proposed CSR-
musharakah model.
5. A zakat centre is an institution for the collection of charity by Muslims who are eligible to pay
zakat, while a waqf centre is an institution for Islamic endowment. Lukman et al. (2014) suggest a
“faith-based model”, which is a combination of the use of CSR with waqf, infaq and donation, to
help micro financing.

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Corresponding author
Shifa Mohd Nor can be contacted at: [email protected]

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