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Mudarabah contracts – an Islamic contract whereby a financier (Ras Al Mal) enters into a profit-sharing agreement with the recipient (Mudreb) with the former assuming all financial risk – can be extremely beneficial to business owners and founders who are receiving funding.
But they can be very risky for the party that enter into it as a Ras Al Mal. While they do offer them some advantages to those who will provide funding (as noted in a previous entry), mudarbah contracts generally favor the recipient of that funding in terms of financial liability and control.
That said, however, there are strategies that can be employed by Ras Al Mal to mitigate these factors and retain some form of control on the business or project that is being funded through a mudarabah contract.
Read more about: The basic guide to mudarabah
Before we dive into the strategies, it is important to go through how and why mudarabah contracts benefit the Mudreb over the Ras Al Mal.
The big one is that the latter bears all financial responsibility and the losses for a project or business failing.
It is incumbent on them to provide the entire funding for the business, with the Mudreb having none. And barring any incidents of misconduct or negligence, the Mudreb bears no financial responsibility should a project fail.
And despite bearing all the financial responsibility and risk for the project, the Ras Al Mal retains very little control over a project or business.
While there are controls that can be put in place (which we will get into them later on), the day-to-day management of the business must go to the Mudreb.
The top two complaints that funders in this arrangement complain about is transparency and moral hazard. Without the adequate corporate governance structures in place,
it is very easy for a Mudreb to mislead or hide crucial aspects of the business to their funders. And without the proper accountability procedures, it is very easy for a Mudreb to mismanage the funding obtained.
Even in cases where there isn’t any misconduct or negligence, there is the issue of moral hazard – as in the recipient of the funding does not feel the financial pressure to succeed because they have not staked much into the business and will likely not receive as large a share in the profits as Ras Al Mal.
These downsides from funding a mudarabah contract can be mitigated primarily through two means:
- Structuring the right contract
- Deal and setting up proper corporate governance structures.
From these two we can extrapolate several strategies that will work to manage the risks associated with mudarbah contract and create a more secure investing environment.
These include the following:
It is crucial before entering into any financial relationship that the funding party do the proper research to ensure that the Mudreb has the prerequisite expertise and know-how to manage the business.
These include running background checks and studying the past performance of the Mudreb in other similar businesses. It is also vital that Ras Al Mal does the prerequisite research on the sector that the business is in, in order to better understand the market dynamics and not simply take the word of the Mudreb on everything.
In a restricted mudarabah (mudarabah Muqayadah), the financier can limit the activities, operations and the type of sectors that the Mudreb can engage in. This places an initial layer of control a Ras Al Mal can have on the operations of the business.
This also helps to ensure that the capital being invested is used in a manner that is conducive to the investor’s risk appetite. This is in stark contrast to a Mudaraba Mutlaqah (or unrestricted Mudarabah) where a Mudreb has unrestricted control over where to invest the capital and could engage in activities that are beyond the investor’s risk appetite.
Establishing regular monitoring and reporting requirements can help the Rab Al Mal stay informed about the business’s performance. This transparency can reduce the risk of mismanagement.
This could involve setting up several independent committees that monitor the performance of the business at regular intervals – such as an audit committee to monitor the finances of the company.
This may also require regular management and board meetings to assess where the company currently stands on key metrics and performance indicators.
While mudarabah contracts do require that the Mudreb receive a portion of the profits, sometimes these aren’t enough to incentivize them to work harder for the business to succeed.
These may include giving them an added share in the profits, or better yet making that additional share contingent on meeting certain performance metrics.
Having clear terms and conditions setting the monitoring and control procedures, profit-sharing ratios, and other incentive structures set about in the mudarabah contract will be vital in enshrining the aforementioned requirements and mitigating any disputes that may arise.
Whether it is monitoring the accounting, business practices, and even the Shariah-compliance involved in the management of the business, having a team of advisers will be essential in ensuring that that the invested capital is being used up to the standard of Ras Al Mal.
They could either advise the funding party personally or they can be part of the monitoring procedures set about for the business.
7-Diversification
Diversification is the best guard against one single point of weakness in a portfolio. That is why it is important to have multiple investments running as insurance against a single business failing.
Read more about: How can SMEs can benefit from mudarbah?
Disclamer:
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.
