What Is Musharakah? Meaning and How It Works in Finance

What Is Musharakah?

Musharakah is a joint enterprise or partnership structure in Islamic finance in which partners share in the profits and losses of an enterprise. Since Islamic law (Sharia) does not permit profiting from interest in lending, musharakah allows for the financier of a project or company to achieve a return in the form of a portion of the actual profits according to a predetermined ratio. However, unlike a traditional creditor, the financier also will share in any losses should they occur, also on a pro rata basis. Musharakah is a type of shirkah al-amwal (or partnership), which in Arabic means "sharing."

Key Takeaways

  • Musharakah is a joint partnership arrangement in Islamic finance in which profits and losses are shared.
  • Profits from interest are not permitted in Islamic practice, necessitating the need for musharakah.
  • A permanent musharakah is often used for long-term financing needs since it has no specific end date and continues until the partners decide to dissolve it.

Understanding Musharakah

Musharakah plays a vital role in financing business operations based on Islamic principles. For example, suppose that individual A wants to start a business but has limited funds. Individual B has excess funds and wishes to be the financier in musharakah with A. The two people would come to an agreement to the terms and begin a business in which both share a portion of the profits and losses. This negates the need for A to receive a loan from B.

Musharakah is frequently used in the purchase of property and real estate, in providing credit, for investment projects, and to finance large purchases. In real estate deals, the partners request from a bank an assessment of the property's value via imputed rent (the sum a partner might pay to live in the property in question). Profits are divided between partners in predetermined ratios based on the value that was assigned and the sum of their different stakes. Every party that puts up capital is entitled to a say in the property's management. When musharakah is employed to finance large purchases, banks tend to lend by using floating-rate interest loans pegged to a company's rate of return. That peg serves as a lending partner's profit.

Musharakah are not binding contracts; either party can terminate the agreement unilaterally.

Types of Musharakah

Within musharakah, there are differing partnership arrangements. In a shirkah al-‘inan partnership, the partners are simply the agent and do not serve as guarantors of other partners. Shirkah al-mufawadah is an equal, unlimited, and unrestricted partnership in which all partners put in the same sum, share the same profit, and have the same rights.

A permanent musharakah has no specific end date and continues until the partners decide to dissolve it. As such, it is often used for long-term financing needs. A diminishing musharakah can have a few different structures. The first is a consecutive partnership, in which the share of each partner stays the same until the joint venture comes to an end. It is often used in project finance and especially home-buying.

In a diminishing partnership (also known as a declining balance partnership or declining musharakah), one partner's share is drawn down while it is transferred to another partner until the entire sum is passed over. Such a structure is common in home-buying where the lender (generally a bank) buys a property and receives payment from a buyer (via monthly rent payments) until the whole balance is paid off.

In the case of a default, both the buyer and lender get a share of the proceeds from the sale of the property on a pro rata basis. This differs from more traditional lending structures, which have the lender alone benefiting from any property sale following a foreclosure.