A Mudarabah contract is based on a partnership in which one partner is the financier (the investor, or rabb-ul-mal) and the other partner (the fund manager, or mudarib) manages the financier’s investment in a business activity. Both parties agree in advance to a profit sharing ratio.
With Human Capital Mudarabah, the mudarib receives a lump sum of money today and commits to sharing with rabb-ul-mal a portion of whatever income they earn for a fixed period of time in which they are fully employed.
Take the following example:
Adam just graduated college and needs $25,000 in financing to buy his first car.
An investor estimates Adam will earn $60,000 annually over the next five years.
Adam and the investor agree to an HCM agreement wherein Adam agrees to commit 10% of his income over the next 5 years he is fully employed in return for $25,000 in financing.
The investor’s return depends on how much income Adam earns.
Consider the following possible outcomes:
- If the investor’s prediction that Adam will earn a $60,000 average annual income is correct, an investment of $25,000 today will yield the investor a 6.4% annualized return.
- If Adam earns more than $60,000 annually, the investor’s return will be more than 6.4%.
- If Adam earns less than $60,000 annually, the investor’s return will be less than 6.4%.
- If Adam is unemployed for a year during the life of the contract (so the duration of the contract is 6 calendar years) and Adam earns $60,000 annually when he is working, then the investor’s return will be 4.7%
- Regardless of how much the investor’s return is, Adam will not be in default so long as he paid the agreed upon 10% of his income for 5 years in which he was fully employed.
There are a number of terms that need to be included in any HCM agreement in order to guarantee the rights of the investor and investee. For instance:
The term “fully employed” needs to be clearly defined in the contract. One possible definition of fully employed is to be gainfully employed for at least 40 hours a week.
Another stipulation is that there must be a limit on the total percentage of income a mudarib is allowed to commit to investors. For example, a mudarib should not be allowed to commit 50% of their income. A reasonable limit is somewhere around the 15% mark for any mudarib. This is because if the percentage is too high, the mudarib may decide that it’s not worth it to work anymore. However, if the percentage is reasonably low, the mudarib will always be incentivized to work towards maximizing their income because not doing so would mean they have less income to spend on themselves.
Finally, the mudarib should commit to share their income-tax returns (or depending on the country some other official proof of income) with their financier in order for the latter to verify that the mudarib’s payments are for the correct dollar amount.
What do you think of HCMs? Would you be interested in an HCM for financing or as an investment? Leave your comments below.