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Contract texts

We choose the right type of contract based on the economic risks of each project and on the investor’s appetite for risk. Below are the three types of contract we use, and the risks of each.

1. Cash purchase and instalment sale of goods (murabaha)

Under this contract, instead of paying cash directly, the investor buys the asset or raw material that is needed — such as steel or machinery — and sells it to the applicant in instalments at an agreed rate. The rate of return is close to fixed and predictable, because the business transaction is completed within a short period, say one week, and the profit is then known.

For the investor’s convenience, the project works in practice like this: the investor first appoints the business as its agent to buy the goods for cash, out of the investor’s contribution, within a set period such as one week. Once the goods have been obtained, the agent sells them to itself on the instalment terms agreed in advance. In this way the business is financed and obtains the goods it needs, and the investor earns the expected profit.

Risks of this contract

1. Withdrawal risk: Under this contract, the agent cannot be compelled from the outset — before the goods are bought — to purchase them once they have been obtained. The agent might therefore buy the goods for the investor and then not sell them to itself. In that case the goods belong to the investor.
2. Loss-of-goods risk: Between the agent buying the goods and selling them to itself, the goods could be destroyed. In that case, provided the agent has not been negligent, the loss falls on the owner of the goods — the investor.

2. Forward purchase of goods and sale after delivery (salaf, with agency to sell)

Under this contract, the investor pays cash today in order to receive goods in the future — say, six months later. The business gains access to the cash and can use it as it sees fit. The investor, meanwhile, has bought the goods at a discount: below today’s price, and possibly worth more in the months ahead. In this model the business, as the seller of the goods, usually also takes on selling them at maturity, and must try to sell them at a price that at least delivers the investor’s target profit.

An important advantage of this contract is that the investor can benefit from future price rises. Under murabaha the profit rate is fixed from the outset and cannot change once the purchase and sale are complete; under a forward purchase, the investor can structure the contract so that a rise in the price of the goods brings a larger profit.

Risks of this contract

1. Price-fall risk: The investor owns the goods. If their price has fallen by the due date, the loss falls on the investor.
2. Risk of not selling at maturity: The other risk of this contract is that the goods may not sell on the due date.

3. Partnership contract (musharakah)

Under this contract, both the investor and the operator contribute capital and share in the profit and the loss.

Types of partnership

Full partnership: Profit and loss are shared according to actual performance — for example, by capping the investor’s profit and allocating any surplus to the operator. Because the necessary infrastructure is still lacking, this contract is used less often at present; we are, however, working to make room for full partnership too.
Preferred partnership: When profit is distributed, the investor has priority. If there is a loss, however, it is first borne by the investor’s principal and only then by the operator.

A worked example

Suppose the investor contributes 1 billion Toman and expects a profit of about 40% over seven months — that is, for their 1 billion Toman to grow to 1.4 billion Toman by the end of the seventh month.
Suppose the business must also contribute 1 billion Toman under this contract, so the two parties contribute 2 billion Toman in total.
When the business activity ends, profit up to 400 million Toman — equivalent to 20% of the total — belongs to the investor, and any profit beyond that, however large, belongs to the business.
If the project’s total profit after seven months is less than 400 million Toman, all of it belongs to the investor and the business takes no profit.
If there is a loss of principal, losses up to 1 billion Toman are borne by the business’s contribution, and anything beyond that falls on the investor’s contribution.

Risks of this contract

1. Risk to principal and profit: Under this contract the principal is more exposed to risk than under murabaha or salaf, and the profit is somewhat less certain — but in return there is the possibility of a higher profit.
2. Fit with non-manufacturing activities: For activities that do not produce goods — where the business provides services — this contract is preferable to the other two.

Download sample contracts

Sample murabaha, salaf and musharakah contracts will soon be available here to read and download.

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