Despite holding core values of social and economic development, questions remain about how beneficial Islamic finance has been for the majority of the Arab world. Could the emergence of crowd-funding platforms help to generate a more equitable distribution of wealth?

While Islamic finance has experienced unprecedented success in terms of growth and expansion of late, its limitations have often been criticised, with some claiming that the industry is little more than an investment vehicle for high-net-worth individuals rather than a tool to significantly contribute to social and economic development for the vast majority of Muslims.

Today, a high number of Muslims are seeking access to capital to enable them to capitalise on the investment opportunities that are available to big industry players. 

Islamic finance was conceived as a value-oriented proposal, constructed through concepts such as ‘equity’, ‘justice’, ‘human dignity’, ‘freedom of enterprise’ and ‘moderation’, with the ultimate aim of utilising economic and financial resources to satisfy the material and social needs of all members of the community. The emphasis on asset-backed transactions together with the central tenets of risk- and profit-sharing was intended at delivering such objectives.

Real contributions?

In its essence, Islamic finance is constructed to have a real impact on an economy through job creation and entrepreneurial development, but its practice in recent years has been increasingly criticised for not doing enough to contribute to a ‘real economy’.

In light of the fact that sharia-compliant financing has so far not fulfilled its expectations, the introduction and refinement of new financial instruments accessible to a wider range of investors is crucial to highlight the core values of Islamic finance – principally the promotion of real economic activities, social development and the enhancement of human welfare.

Among such instruments and strategies, Islamic microfinance and 'zakat' funds (the obligation that a person should donate a proportion of wealth to charitable causes) have been considered. However, crowd-funding, which has grown tremendously in western Europe and the US with successful fund-raising campaigns over the past three years, stands as an increasingly attractive alternative that can help establish an optimality between social development and capacity-building, but also profitability.

The term ‘crowd-funding’ refers to a collective co-operation of a network of people gathering resources to support the initiatives of others looking to establish, build or develop a specific business or project. In this way, it enables entrepreneurs and small investors to jointly contribute to the development of small and medium-sized enterprises (SMEs) or projects. 

Donations shift

Over the past few years, the vast majority of crowd-funding platforms have been donation based, but a notable shift has been seen this year. The growth in the equity-based form of this style of funding has grown a phenomenal 300% in the first nine months of 2012 compared with just 50% based on donations, according to data provided by Crowdsourcing.org, a US-based unique research and advisory firm specialising in the crowd-sourcing and crowd-funding industries.

It should also be noted that 79% of these equity-based crowd-funding platforms have a fund size smaller than $250,000 – a size considered too small for most venture capital and private equity firms. Donation-based crowd-funding can be closely related to donation-based microfinancing since 90% of the projects funded with donations have a fund size of less than $10,000, according to Crowdsourcing.org.

Within the framework of Islamic finance, zakat can be directed to contribute to such projects, for instance, and similar attempts exist in Muslim countries through non-profit organisations that collect donations to support micro-entrepreneurs, such as the successful operation of zakat funds in Malaysia.

The main difference between such organisations and typical crowd-funding is that, in the latter’s case, the donor can determine specific projects or entrepreneurs to invest in. As a result, the growth in donation-based crowd-funding services can notably increase the access to capital for micro-entrepreneurs through engaging a wider spectrum of contributors.

Muslim countries and entrepreneurship

Despite the fact that entrepreneurship is part of the Islamic culture, current data and experience does not show strong evidence for entrepreneurship in Muslim countries. Therefore, it must be promoted to meet the challenges faced in boosting economies and creating jobs for the huge young population residing in these countries.

According to a survey conducted in 2010 by research company Gallup across the Arab countries, 15% of young Arabs wished to start their own business within the next 12 months compared with only 4% of young people in North America and Europe. In terms of business entry, most of the entrepreneurial Arab youth identified financing as the main barrier to starting their venture. Such data indicates the appetite for entrepreneurship provided that the needed capital is available.

According to Gallup’s 2010 survey, 30% of young people surveyed in the Arab League countries aspired to migrate permanently but would stay in their home country if either they found a job or a better job than their current one. Also significant is the median age in the Muslim countries, with a range in the mid-20s, compared with a much older US population that has a median age of 37.1 years. Therefore, one of the main resources Muslim countries have to capitalise on is their young population.

In acknowledgement of the demographic structure of Muslim countries and the potential opportunities in the Middle East and north Africa (MENA) region, a number of initiatives have been established to try to help promote an entrepreneurial ecosystem.

Filling the gap

To date, equity-based funding for MENA start-ups and SMEs with growth potential has essentially been provided by venture capital firms and large ‘angel’ investors. This has led to extreme difficulties for entrepreneurs trying to raise seed or early-stage capital, specifically those whose capital requirements are lower than the $1m to $2m usually invested by venture capital firms in a start-up.

Therefore, equity-based crowd-funding can be considered as an alternative financing method, filling the observed ‘funding gap’ through reaching out to a much larger base of small investors. Furthermore, equity-based crowd-funding represents a significant opportunity for Islamic finance to deliver on its initial goal of providing the combined benefits of social development and investment opportunities to a wide range of both entrepreneurs and investors.

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, as characterised in the original form of Islamic finance.
  • Providing access to capital to a wide range of entrepreneurs.
  • Opening up a new asset class for small and medium-sized investors.
  • Minimising risk through splitting limited capital across multiple start-ups.
  • Promoting innovation and preserving local talent.
  • Creation of jobs through the established start-ups.
  • Supporting the growth of ventures to enterprises and possible future initial public offerings in new sectors such as technology and health that are almost non-existent in the public equity markets in Muslim countries, and thus increasing diversification for fund managers.

Risk reduction

Of course, one of the main disadvantages of funding start-ups is the potential risk of failure. Additional measures need to be put in place to help reduce this risk. Such measures can include entrepreneurial training, milestone financing based on success and legal protection for investors, among others.

To ensure sharia compliance, Islamic equity-based crowd-funding has to meet the following criteria:

  • Investments have to be socially responsible.
  • Start-ups have to operate sharia-compliant businesses.
  • 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 modified to adhere to sharia principles.

MENA hopes

The Arab Spring in north Africa has brought about considerable political and economic change, which means many now have high hopes of Islamic finance acting as a vehicle to deliver the economic development and job creation in the affected countries that was stifled by the former regimes. To meet these expectations, Islamic finance needs to move quickly. It should be noted that several initiatives to offer crowd-funding in the region are currently being launched with the aim of closing the funding gap for local entrepreneurs.

In introducing this alternative source of financing to the region, investors’ risk must be reduced as much as possible and entrepreneurs should be equipped, not only with capital, but also with the skills needed to increase their chances of success. Consequently, the conventional crowd-funding process needs to be restructured to meet not only sharia requirements, but also the circumstances and special requirements of entrepreneurs and investors in Muslim countries.

The crowd-funding of start-ups based on either donations or equity represents a positive opportunity for Islamic finance to embrace its core values in terms of social and economic development. It also represents an exciting opportunity to promote innovation across various sectors of the MENA economies, especially technology, agriculture, health services and education.

Dr Mehmet Asutay is director of the Durham Doctoral Training Centre for Islamic Economics and Finance at Durham University Business School, and Shehab Marzban is co-founder and managing partner of Shekra, a specialised crowd-funding platform in Egypt.

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