Is Sharia Finance Bogus?
Debt versus equity financing and sharia implications
Some seem skeptical. Others seem to scowl. Hands shoot up around the room with questions when I end my talk about my conversion to Islam by mentioning that I’m the founder of a company called Blossom that helps improve access to sharia financing. The first question:
“Brother, we all know financing is haram [impermissible].
So how can financing be ‘Islamic’?”
His question is not surprising. It reflects the general lack of knowledge amongst many Muslims about the fiqh (Islamic rules) of business and the general misunderstanding of what financing means amongst many people.
Not all financing is created equal.
Financing means providing money for some purpose. Collecting money to build a new masjid (mosque) is financing. Borrowing money from your family is financing. Taking out a mortgage to buy a house is financing. So what does Islam say?
“O you who believe! Do not devour usury, making it double and redouble and be careful of (your duty to) Allah, that you may be successful. And guard yourself against the fire that has been prepared for the unbelievers.”
— Surah Al-Imran [3:130–131]
Debt Financing (Loans)
A loan is something borrowed. Usually, it’s an amount of money. When you take a loan, you take on debt. Debt is an obligation to repay something. And in Islam, you must repay debts. Your hajj (pilgrimage) is not valid unless you pay off your debts beforehand.
Loans and debts are not inherently haram (impermissible). What makes a loan impermissible is a specified increase over the original amount. That’s called interest, or usury, and it’s strictly prohibited in Islam.
Equity Financing
Having equity means you own a piece of a business. Usually, it’s an amount of stocks or a percentage ownership of a business partnership.
Equity financing is inherently halal (permissible). Islam encourages equity financing because profits and losses are shared. The main principle of equity financing in Islam is that the ratio of profit and loss sharing must be fixed during the creation of the contract.
Examples in Practice
Consider Mr. Haji, the entrepreneur. He’s opening a pizza shop; let’s call it Haji Pizza. He has $50,000 saved up, but he calculates the total cost to open his pizza shop is $100,00.
How can Mr. Haji raise the remaining $50,000 to open his pizza shop?
Debt Financing: Taking a Loan
Mr. Haji goes to a conventional bank called Piggy Bank, Inc. The loan officer at Piggy Bank checks Mr. Haji’s credit report and background; he recognizes that new businesses are very risky (especially restaurants), but Mr. Haji has good credit and no debt. The loan officer approves a loan for the $50,000 with a repayment period of 10 years. In exchange, Mr. Haji agrees to pay interest of 20% APR. The interest is compounding. This means that not only will Mr. Haji pay 20% on the principle (original loan amount), but also on any accrued interest.
Mr. Haji’s loan specifies a monthly minimum payment of $966. No matter what happens with the business, Mr. Haji must make this payment every month or he faces penalties. If all goes as planned, over the course of 10 years, Mr. Haji will end up paying $115,953 to Piggy Bank. But this loan also comes with a personal guarantee. If Haji Pizza fails, Mr. Haji is personally responsible for paying backthe loan to Piggy Bank.
Equity Financing: Business Partnership
Mr. Haji goes to his friend Musa’ed and proposes his idea for Haji Pizza. Musa’ed thinks it’s a great idea because Mr. Haji’s pizza is delicious and there’s no pizza shop near the proposed site. Mr. Haji and Musa’ed become business partners.
The business contract between them specifies that since they both contribute $50,000, they will split the profits 50:50. If all goes as planned, after 6 months the business the will generate profit and the profits will be payed monthly. There is no mimum or maximum payment to Musae’d — he’ll only make money if Haji Pizza succeeds. If Haji Pizza fails, both Mr. Haji and Musae’d may lose their entire investment, but their loss is limited to the original $50,000 they invested.
What’s the difference?
With Equity Financing, profits and losses are shared.
In debt financing, the loan amount must be repaid regardless of how well the business performs. But in equity financing, the risks are shared by the investor and entrepreneur. This is why debt financing is not allowed in the sharia and equity financing is encouraged.
Profit and loss sharing is a key principle of sharia finance, and equity financing fits the bill. In a future article, I’ll provide an overview of the five basic principles of sharia finance.
