Crowd Funding and its Application in Islamic Finance. Issues and Challenges

PERMISSION FOR ACADEMIC USE OF WORK BY INCEIF

1. I hereby allow INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE (INCEIF) to upload it in the INCEIF’s KMC database and make it available to INCEIF students for educational purposes

2. I, hereby allow INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE (INCEIF) to upload it in INCEIF’s website and make it available to the public.

Name of Student: Syed Salman Date: 30th July, 2015

Abstract

The Islamic crowdfunding concept despite of no history as such in the past are still much demanded and appraised in the Islamic as well as conventional economies. Also, in the backdrop of a rising global Muslim population, attractiveness of the much necessitated halal products and services and increasingly conscious investors, the Islamic CF platform will serve to narrow the financing/funding gap which is currently posing a threat to striving entrepreneurships and subsequent economic growth and social benefit, especially in low-income and developing economies. Islamic value driven approach fits well within the growing fascination towards socially responsible and ethical investing. This paper has discussed the Islamic CF portals available in the Muslim world and how their mechanism is being applied. These platforms are not limited to Muslim communities rather they are general public focused and economic growth driven engines which if used with efficacy can result in astounding results.. We believe that if Islamic CF is made available to the financially inclusive economies, it will be beneficial for them for their development. Furthermore, to overcome religious and social barriers in order to vitalize economic progress resulting from innovative and creative entrepreneurship, Islamic CF platform will follow a more proactive approach regarding those projects which create positive value, over and above financial gain, such as those supporting the growth of green economies, conservation of resources, sustainable development, job creation and specifically, etc.

Keywords:

Crowd funding, Islamic Finance, Entrepreneurship, SME and Economic growth

Introduction, problem statement and research objectives

The promise of crowdfunding (CF) in the news for entrepreneurs has been recognized by Media and public both. However, not many scholarly articles are present that address the implications of CF (Lehner, 2013) and its inner workings in context related to Islamic Finance. We therefore by reviewing extant literature, try to thematically analyze accessible emerging enquiries and draws up a plan of how to indulge the theme of CF into Islamic finance realm which may assist in coping up with the existing financial inclusion issues in the society at large.

Islamic finance(IF) has created its success history for more than four decades now and its growth and achievement is indeed to be well cherished for, but out of many issues which were expected to be resolved through it, one major issue was the financial inclusion to the small and medium sector enterprises and poverty alleviation of the Muslim world. Despite of various efforts and research, still there are various excuses for the Islamic financial institutions to remain reluctant in assisting the entrepreneurs and small or medium size enterprises, be it the risk of default, collateral shortage, difference in regulatory framework, shariah harmonization etc. To address and resolve this critical issue of providing finance to the SMEs & entrepreneurs and to fuel fast development, the new concept of public private partnership a.k.a. crowd funding (CF) was introduced. Although the concept was not taken from Islamic finance literature per say but this new mechanism of modern day crowd funding was not alien to the arena of Islamic finance, as the model is much relevant to the concept of Mudharabah ¹ . The current crowd-funding movement is rooted from the concept of microfinance, which is essentially aimed at poverty alleviation, equitable distribution of wealth and sustainability; this is, in effect, the theme of Islamic Finance. Crowd-funding, in comparison to other microfinance schemes, provides an essential link between donors or investors and the entrepreneurs wherein providers of funds are much aware of the financial solutions they are providing for, especially through the use of internet portals.

Usually in conventional crowd-funding platforms, the effort is usually for specific communities, serving usual under financed projects through their targeted audiences and its funding. This may involve various diverse platforms including religion based community for social entrepreneurship to gather the attention or other gender based alliances to attract certain cause which requires investing in certain industries. However, the purpose of Islamic Crowdfunding is not limited to such aforementioned ideas but it is to combine religious and ethical values and mottled entrepreneurships within the confines of Shariah.

This paper is inscribed to demonstrate the relevance of the CF with IF and will later enlighten the readers, the possible means of incorporating this innovative source of funding in IF and its advantages. The focus of this paper is to outline those economic sectors which can be catered by the Islamic crowd funding (ICF); a platform that will be precisely intended to support in establishing those businesses and industries which are Shariah compliant/Shariah based and will strengthen Islamic communities through empowering the entrepreneurs, whether social and for-profit through innovation and advancement of halal products and its related categories. The appeal of this form of investment and funding is that it need not be limited to Muslim communities but extended to those investors who regard Shariah based projects and risk sharing techniques as ethically correct. This will ultimately result in risk diversification through expansion of investor base. In auxiliary, we will also discuss the present practices and challenges that may be faced by the Islamic Banks in implementing such solution to their core businesses.

What is Crowd Funding?

Crowdfunding is an innovative process for funding diverse and multiple new ventures, allowing entrepreneurially skilled individuals to request funding from the public/crowd, which in return will get the product or equity (Mollick, 2013). These founders of for-profit, social or cultural projects are the seedbeds of innovation and form the backbone of economies. The diversity of goals and funding in CF projects can range from small artistic venture, to entrepreneurs seeking hundreds of thousands of dollars in seed capital as their primary resource and the substitute to traditional venture capital firms (Larralde, 2010). Furthermore, CF is also said as tapping the large dispersed audience, labelled as ‘the crowd’ for trivial sum of money to fund in a project or a venture. It is also called creative industry in some literature which is empowered by the internet or social media communication channel for more user interaction and tapping the large population through one gate. The notion of crowd funding has its history rooting from 17th century. Even the concept of modern crowd funding is of 2 decades now. It incepted in 1997 when a UK rock band raised funds for their reunion tour through online podium. Further this idea was elaborated and implemented by ArtistShare, which became the first modern day crowd funding platform in 2000 (Fundable, n.d.), and till date, various enhancement and innovations in the CF mechanism has been made to further boost the reach of this source of fund to the needy and viable projects.

For either for-profit or social entrepreneurship (SE), crowd funding knowledge is the key to avail financing and funding from an alternate source as traditional means of finance is even inadequate or sometimes at subpar in starting as well as sustaining such forms of entrepreneurships. The for-profit entrepreneurs and the SE have cognitive and cultural distance- related barriers which build communication gap among them. Hence many startups face difficulty in financing situations especially the SE. In auxiliary, the global financial crisis also contributed in worsening the situation and increased the pressure for financial intermediaries to be more stringent in their policies and exposures, as public sector tends to reduce spending to cope-up with the governmental debts. This created sheer need of alternate access to funding and to finance new social ventures/projects (Lehner, 2013). Hence by innovatively merging existing factors, such as social media platforms, everyday people’s values and opinions, and alternative reward systems, entrepreneurs found alternative, custom-made methods of funding and financing their projects that seems a consistent way and fits well to the new deliverance of the public (Drury and Stott 2011; Reyes and Finken 2012; Valenzuela et al. 2012).

The one especially suited answer which CF may offer to the financing needs of social and for-profit ventures is the ease of access to the funds, as crowd investors typically do not look much at business plans or collaterals rather, they look at the ideas and core values of the firm and thus at its acceptability (Ekedahl and Wengstro¨m 2010).

The Founder’s Objective for Crowdfunding

In crowdfunding (CF), the tangled projects have ample diversification of objectives. Many CF projects pursue to raise small amounts of capital, to pledge a particular one-time project, often under $1000 (e.g. an event). Capital is often provided by family and friends in such cases. However, it appears to be a viable source for entrepreneurial seed capital. For example, at Kickstarter² in 2012, 95% of the 50 highest funded projects have turned into ongoing entrepreneurial firms. Since the rules around investment crowdfunding are developing, it is indistinct to what degree to which, crowdfunding will ultimately substitute for other forms of formal venture funding (see, for example, the JOBS Act, 112th Congress), as these new investors typically propose more than funding to these new ventures which may comprise of governance, advice, and prestige (Ferrary and Granovetter, 2009; Gompers and Lerner, 2004; Gorman and Sahlman, 1989; Hsu, 2004). To generate funding from more traditional sources, founders have also used crowdfunding to demonstrate demand for a proposed product, if the demand by the funders does not suffice what founder is looking for, makes it easy for founders to “fail quickly” without investing additional capital or effort. For example, the Pebble “smart watch” which was able to secure huge amount of VC funding after creating its demand through crowdfunding portal, although the project was initially rejected for VC funding.

The Funder’s Objective for Crowdfunding

Since all forms of crowdfunding are based on identical principles, funders are rightly to be labeled as investors. Their core objective is to support social/economic cause for satisfaction, either being a philanthropist, lender or investor. Funders expect a successful outcome of the project, they are investing their funds/capital in, and thus, expectation may differ based on the motto of the project and the interest of the funder. They make decisions about which projects to support based on the underlying appeal of the project and their expectations for its success (Ajay K. Agrawal, 2011). Regardless of their expectations for financial return, funders always respond to signals about the quality of the project(s) (Mollick, 2013).

Crowd Funding Models

Crowdfunding (CF) can be categorized into four segments, i.e; donation-based, rewards- based, lending based and investment based. The primary differentiation among each category is dependent on what the funders are promised to receive, for the capital they have invested. The Donation-based campaigns/projects are for support causes and funders gain internal satisfaction instead of any tangible return for their capital commitments. Typically, these CF campaigns are led by public groups like religious institutions, schools, museums etc. Rewards-based CF campaigns promise its funders to receive some kind of “reward” in exchange for their capital. These rewards include public recognition (e.g. one can be enlisted as “producer” for a crowdfunded movie), access to special events and limited-edition goods etc. Like the best example of reward based CF is Pebble watch that committed its investors ranging between USD 50 and USD 100 in exchange for an early edition of the Pebble watch. However, the Lending- based CF campaigns differ from the two former categories. In such type of CF, funders receive their contribution back with some interest after a specified period of time (Jason W. Best, 2013). However, in the case of micro-financed loans, the funder/lender might be much interested in the social good supported by the venture rather than any yield, thus encompassing patronage model elements as well (Mollick, 2013). The Investment-based CF is the one closely related to Islamic finance where funders receive equity in the business. Neither the capital is guaranteed nor the success of the venture, but if the business get success, there in massive potential of realizing significant financial rewards to the funders. Because these equity-based CF campaigns involve the issuance of securities, such CF investment category is both the most complex form and the one that has the greatest potential for capital formation (Jason W. Best, 2013).

Below mentioned Table 1³ will help the readers to clearly understand the pros and cons of each of the crowdfunding categories as well as what the funders, expect and get upon completion of the venture they put their capital into. In auxiliary it also elaborates few existing CF portals which are operative and are providing their services in respective CF categories.

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Table 1 Crowd Funding Models

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¹ Mudharabah is a Islamic finance equity based contract where one party (Financier) invest capital and the entrepreneur invest through his effort, further complemented by a mutually agreed profit sharing ratio, distributed between the parties at the successful completion of the contract and in case of loss, the financier bears the loss of capital while the entrepreneur suffers the loss of efforts.

² Kickstarter is a premier crowdfunding website that creates a bridge between founders and funders. Further details of the website can be visited at https://www.kickstarter.com/

³ The Table is taken from the Report titled “ Crowdfunding in Muslim Markets” published in 2013 and can be accessed at http://www.islamicbanker.com/publications/crowdfund-investing-muslim-markets-action-plan-governments