The mantra of Islamic Finance has been “Islamic Finance prefers partnership over debt.” Hammering this idea into the minds of the masses has resulted in many people using less than optimal structures for their business needs. At times its better to finance through debt, at times through partnership, and at times through revenue sharing. In this short article, I discuss a few of the pros and cons of each and when to use them.
DEBT BASED TRANSACTIONS
Loans at interest are synonymous with Riba, the pre-Islamic practice of charging a premium on a debt, whether that premium is stipulated at contract or on default. Given this prohibition, Muslim jurists encouraged the sale of assets, allowing for long term deferred debts to be created by these sales and the time value of money to be embedded in the value created by the sale. So while debt-based sales are feasible, they are not optimal for all business situations. Almost sole reliance on these contracts by nearly every segment of the Islamic finance industry has resulted in growing debt, greater default, and legal artifice that uses these structures to synthesize a guaranteed interest rate. When are debt-based sales optimal? When you are short on cash for a large purchase that ownership of will boost your business’ ability to grow and profit. Example: equipment for a construction company.
With partnerships, there’s several ways they can be structured. I wrote a bit about this for Oxford that you can read here. With partnerships, there are certainly upsides. By pooling financial resources, partners talent, and sharing time to improve the business, partnerships can prove lucrative. Where they falter is when the mission and vision of the partners is misaligned. When this happens, there will naturally be a misalignment in the human capital contributed. So regardless if both of you committed funds, when someone intentionally (or negligently) doesn’t pull their weight, the partnership will experience a downturn and all partners suffer.
There are several other downsides to partnerships, the greatest one being dilution of ownership. In order to bring in capital, owners must valuate their company and solicit investors to purchase shares of that company. Problem is, the capital contributed in exchange for the shares may not be worth the perpetual return that a partnership of any form offers. Why give up 5% of your business FOREVER just for a cash injection? Why invest significantly in a business that won’t give you more than 1% of the business? This is obviously where negotiation comes in, and finding that sweet-spot means creating the market for your offer, beating the best alternative to what you are offering. When are partnerships optimal? When all partners are aligned and your efforts now have a greater net future value than doing anything else.
Lastly, there are revenue sharing agreements. While there were very common in the pre-modern period, due to it being almost wholly agrarian, they are not as widely used today. Any deal in which an individual receives distributions based on the revenue (i.e. the amount of money the business makes) rather than on the amount of work that was done is a form of revenue sharing. So let’s say you own a car but can’t operate it for profit, so you give it to someone to operate and share 1/3 of the revenue generated. Another example is you inject $1000 into your friend’s business for inventory, and take a little off the top of every sale until you’ve recuperated your capital and a profit.
WHICH ONE DO I CHOOSE
Each of these structures has their pros and cons. Deciding which one to use can make of break your business before it ever turns a profit. Want to discuss which one is best? Let’s talk.
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