Major principles in Islam: Halal earning and financial contracts in Islam – part 9 (final) The Mudaraba Contract (profit-sharing partnership)
Introduction to Mudaraba
In this section, we will explore the contract of mudaraba, following the sequence of Imam al-Ghazali, in his renowned work Ihya Ulum al-Din, particularly in the section about al-kasb (earning). Imam al-Ghazali divided earning into six common contracts that people frequently use in business transactions. We have already discussed most of them, and now we turn to the final one: mudaraba.
Mudaraba is classified as a trust-based contract (ʿAqd Amanah). It is a special type of transaction with its own distinct definition and principles. Scholars describe mudaraba as a unique kind of partnership in which one party provides the capital while the other contributes labour and expertise to engage in a commercial venture.
According to Shaykh Taqi Usmani, in his book An Introduction to Islamic Finance, mudaraba is defined as:
“A special kind of partnership where one partner gives money to another for investing in a commercial enterprise.”
An earlier definition by Imam al-Quduri, a scholar of the fourth century Hijri, states:
“Mudaraba is a contract of partnership in profit, with capital from one person and work from the other.”
Hence, mudaraba can be described simply as a profit-sharing partnership. In essence, mudaraba is a contract between two individuals:
One has experience but no capital.
The other has capital but no experience.
These two come together under a shared agreement to engage in trade. Sometimes both may have experience, but in its simplest form, one provides the money, and the other provides the skill.
Terminology
In the terminology of fiqh, this arrangement is called mudaraba, especially within the Hanafi school. However, in the Shafi‘i and Hanbali schools, it is commonly referred to as qirad. Thus, in their books, you will rarely find the term mudaraba; instead, you will find qirad, though both refer to the same concept.
In essence, mudaraba is a contract between two individuals:
- One has experience but no capital.
- The other has capital but no experience.
These two come together under a shared agreement to engage in trade. Sometimes both may have experience, but in its simplest form, one provides the money, and the other provides the skill.
Conditions and structure
Trust plays a crucial role in this contract. The investor must have confidence in the trader’s honesty and competence. The investor should conduct proper due diligence, asking about the trader’s background, ensuring he has a good reputation and a record free from fraud or dishonesty. Once satisfied, the investor may entrust him with the money.
The capital (raʾs al-mal) in a mudaraba must be in the form of money, either physical or digital. It can also include equivalents widely accepted as currency, such as cryptocurrencies, provided they are recognised by the public.
The division of profits is determined by mutual agreement between the two parties before the transaction begins. In this partnership:
- The person who provides the capital is known as رَبُّ الْمَالِ (rabb al-mal), the owner of the capital.
- The person who engages in trade and business using that capital is known as مُضَارِب (mudarib), the working partner or entrepreneur.
Profit and loss
The mudarib manages the business on behalf of the rabb al-mal, and both share the profit according to the ratio they agreed upon at the outset. However, if the business makes no profit, the mudarib receives no payment, and the rabb al-mal regains only his original capital.
One of the essential conditions for the validity of a mudaraba is that the mudarib cannot guarantee the capital. If he does so, the contract becomes invalid. This is because mudaraba is classified as an ʿAqd Amanah (trust-based contract), meaning that the mudarib’s role is based on trust.
However, if negligence, dishonesty, or misconduct can be proven, such as recklessness, fraud, or misuse of funds, the mudarib then becomes liable for the loss. As the Prophet ﷺ said:
لَا ضَرَرَ وَلَا ضِرَارَ
“There should be neither harm nor reciprocating harm.” (Sunan Ibn Majah)
If the mudarib acted responsibly, followed best business practices, and yet the market conditions caused losses, he is not responsible for the financial loss. In such a case, the rabb al-mal bears the monetary loss, while the mudarib bears the loss of his time, labour, and effort. Both parties therefore experience loss, but of different kinds, one material, one non-material.
Types of Mudaraba
Mudaraba contracts are divided into two main types:
1. Restricted mudaraba (mudaraba muqayyadah)
In a restricted mudaraba, the rabb al-mal sets specific conditions on how and where the funds should be invested. For example, he may instruct:
“I want you to invest my money in livestock, only in sheep and camels.”
In this case, the mudarib is not permitted to invest in anything outside those conditions. He cannot buy cattle, textiles, electronics, or other products unless explicitly authorised. Restriction ensures that the investment is in accordance with the owner’s wishes and risk preferences.
2. Unrestricted mudaraba (mudaraba mutlaqah)
In an unrestricted mudaraba, the rabb al-mal grants the mudarib full discretion to invest in any lawful and profitable area. The investor may say,
“Use your business experience to invest in any profitable venture but avoid excessive risk.”
Here, the mudarib may trade in electronics, vehicles, textiles, or any field that matches with his expertise and market insight, and avoids excessive risk. This flexibility allows the mudarib to seize opportunities across different sectors, provided all activities remain halal and within Islamic business ethics.
Duration and completion of the contract
The mudaraba contract can also be time-bound. The parties may agree that it lasts for six months, one year, or two years, depending on the business cycle. When the term ends, the mudaraba concludes, but if there are still unsold goods or ongoing transactions, the contract continues until those are settled and profits (or losses) are finalised.
There are, of course, additional conditions in classical fiqh governing mudaraba, such as transparency, record-keeping, and adherence to Sharia principles, which ensure fairness and trust between both parties.
Agreement on profit distribution
A key condition of mudaraba is that the profit-sharing ratio must be clearly agreed upon at the beginning of the contract. For example, they may agree that the mudarib will take 60% of the profit and the rabb al-mal 40%, or they may agree on 50–50. What matters is that this percentage is set before the business begins.
It is not permissible for the rabb al-mal to demand a fixed monthly return, such as saying, “I gave you £100,000, so I want £10,000 every month.” This is invalid and constitutes riba (usury). Instead, profit can only be a percentage of the actual profit earned through business activity.
For example, it is valid to say,
“I want 30% of the profit,”
but not valid to say,
“I want 10% of my capital as a return.”
The Prophet ﷺ said:
كُلُّ قَرْضٍ جَرَّ نَفْعًا فَهُوَ رِبًا
“Every loan that draws a benefit is riba.” (Bayhaqi, Shuʿab al-Iman)
Hence, any guaranteed or fixed return on capital violates the principles of mudaraba.
In practice, Islamic banks and investment portfolios often achieve returns ranging from 3% to 10%, and occasionally up to 15% under exceptional circumstances. These profits are based on actual business performance, not on fixed interest-like returns.
Clarifying the scope of partnership
It is important to understand that the mudarib is not a partner in the capital itself. His partnership exists only in the profit. For instance, if the rabb al-mal invests £100,000 and the business earns £10,000 profit, only that £10,000 is shared between them according to their agreed ratio, for example 60:40.
Thus, the mudarib’s share applies only to the profit, not to the original investment. He has no ownership of the capital, only a right to a portion of the returns it generates.
Market practice and unspecified ratios
If the parties begin a mudaraba without agreeing on a profit ratio, due to oversight or ignorance, the default approach is to refer to customary market practice (‘urf). For instance, if it is widely accepted that the mudarib usually takes 60%, that ratio can be applied. However, scholars emphasise that it is always better to agree explicitly at the outset to prevent disputes later.
Profit-sharing percentages vary according to the nature of the business, the level of risk, and the expertise of the mudarib. Each case may differ based on circumstances and market norms.
Termination of the mudaraba
The contract may be terminated if it has no fixed duration, but if the mudaraba is time-bound, neither party may withdraw before the end of the agreed period.
For example, if they agreed on a one-year term, the rabb al-mal cannot demand withdrawal after six months unless the mudarib consents. If the mudarib already has active contracts and obligations, he is entitled to continue until the end of the period. However, if both parties agree, they may mutually end the mudaraba early.
Mudaraba in Islamic Banking
Modern Islamic banks frequently use the mudaraba model. When depositors place funds into an investment account, the bank acts as the mudarib, and the depositors are the rabb al-mal. The bank invests the pooled funds in Sharia-compliant ventures, and any profit is shared according to a pre-agreed ratio, while losses, if incurred without negligence, are borne by the depositors in proportion to their investment.
This structure reflects the same principles found in classical Islamic jurisprudence. It maintains fairness and transparency, as well as trust in financial dealings.
Modern application of mudaraba
Not all Islamic banks operate strictly through mudaraba contracts, but whenever a depositor opens a mudaraba-based account, each depositor becomes a رَبُّ الْمَالِ (rabb al-mal), the owner of the capital.
For instance, if you deposit £10,000 or £5,000, you are the rabb al-mal, while the bank acts as the مُضَارِب (mudarib), the working partner. From the moment you sign the account agreement, the bank must clearly state the profit-sharing ratio, specifying what percentage goes to the depositor and what percentage to the bank.
In such arrangements, profits are usually calculated on a monthly, semi-annual, or annual basis, depending on how long the depositor locks their funds. Generally, the longer the investment period, the higher the potential profit, as the mudarib has greater flexibility to engage in more profitable ventures.
This demonstrates how mudaraba has evolved from its classical form, once used mainly in trade, sales, and physical products, to a modern financial model applied in Islamic banking and investment portfolios.
Practical examples
The mudaraba model can still be applied to traditional business ventures. Suppose someone wishes to open a barbershop or a small halal grocery, but lacks the skills or time to manage it. They may know someone with relevant experience who is currently unemployed and lacks capital. In this case, the investor can say:
“I will provide the capital, and you will manage the shop. We will share the profit according to an agreed percentage.”
This arrangement is a valid mudaraba. The mudarib manages the business, pays all expenses (such as rent, electricity, bills, and taxes) from the gross revenue, and then divides the net profit according to the agreed ratio.
For example, if the gross profit is £5,000 but after deducting all expenses the net profit is £2,000, the profit-sharing applies only to the £2,000.
Liability and responsibility
In the course of trade, the mudarib may sell for cash or on deferred payment. However, if the rabb al-mal explicitly instructed,
“Do not sell on deferred payment, only for cash,”
and the mudarib violates this condition, he becomes liable for any resulting losses.
If a deferred payment sale defaults and the mudarib acted against instruction, he must repay the loss from his own pocket. This is because mudaraba is a contract of trust (ʿAqd Amanah), and as the Qur’an commands:
إِنَّ اللَّهَ يَأْمُرُكُمْ أَنْ تُؤَدُّوا الْأَمَانَاتِ إِلَى أَهْلِهَا
“Indeed, Allah commands you to render trusts to whom they are due.” (Surat al-Nisa 4:58)
Thus, violating agreed conditions breaches that trust, and financial accountability follows.
Collateral and pledges
A common question arises: can the rabb al-mal request a pledge or collateral (rahn) from the mudarib, such as his car, property, or valuable assets, to safeguard the investment?
The answer is yes, this is permissible as a precaution, but the collateral may not be used or sold unless the mudarib is proven to have committed misconduct, negligence, or breach of contract. Only in such cases can the pledged assets be sold to recover losses.
This practice is also common among Islamic banks, where the bank acts as rabb al-mal and invests funds through external mudaribs. To mitigate risk, the bank often requests collateral to protect its capital in case of proven misconduct or negligence.
In business, some level of risk is inevitable, and losses may occur naturally without fault. Allah says:
يَا أَيُّهَا الَّذِينَ آمَنُوا أَوْفُوا بِالْعُقُودِ
“O you who believe, fulfil your contracts.” (Surat al-Ma’idah 5:1)
Thus, mudaraba does not resemble interest-based loans, where returns are guaranteed regardless of performance. The spirit of mudaraba is based on trust, transparency, and shared risk, not guaranteed profit or capital protection.
In the case of Islamic banks, the money being invested often belongs to shareholders or depositors, so it is a fiduciary duty to put safeguards in place. Yet even there, any collateral can only be used when misconduct or contractual violation is proven.
Termination of the mudaraba
A mudaraba contract may be terminated in several legitimate ways:
- Expiry of the agreed duration. When the fixed period (for example, one year) comes to an end, the mudaraba concludes automatically.
- Mutual notice. Either party may give notice to end the contract. If the mudarib can sell remaining products or settle existing business obligations within the notice period, the termination is valid. Otherwise, ongoing contracts must be honoured until completion.
- Death of the mudarib. The mudaraba automatically terminates upon the death of the mudarib. It cannot be transferred to his heirs, spouse, or partners.
- Proven misconduct or negligence. If it is shown that the mudarib acted dishonestly or recklessly, the rabb al-mal may terminate the mudaraba to prevent further loss.
These conditions ensure that both sides remain protected while maintaining the ethical integrity of the contract.
Relevance and contemporary use
Although mudaraba is an ancient Islamic contract, its relevance continues in the modern era. It was widely practiced during the lifetime of the Prophet ﷺ and remains a cornerstone of Islamic finance today. Over time, it has been revitalised and adapted to modern business structures, particularly within Islamic banking and entrepreneurial ventures.
Mudaraba offers a powerful mechanism for those with business experience but no capital to partner with investors who have capital but no expertise. It promotes cooperation, reduces inequality, and encourages ethical enterprise. When conducted with mutual trust and clear terms, both parties benefit: the investor gains lawful profit, and the entrepreneur gains the opportunity to rebuild and grow.
Core principle of profit sharing
If a business venture under mudaraba yields no profit, the mudarib receives no payment, and the rabb al-mal simply recovers his capital (if no loss occurred). The Prophet ﷺ’s statement applies here:
الْخَرَاجُ بِالضَّمَانِ
“Profit is only justified by bearing risk.” (Sunan al-Tirmidhi)
This reflects the very soul of the contract, a partnership in profit, not a guaranteed return.
Role of each party
The rabb al-mal is a silent partner. He provides capital but may not interfere with the mudarib’s day-to-day management. If he begins to actively manage the business, the contract is no longer considered a mudaraba, it transforms into another form of partnership, such as musharaka.
Hence, the rabb al-mal must remain non-interfering, allowing the mudarib the freedom to operate within the agreed terms, while both share in the profit or loss in accordance with Islamic principles.
In summary, the mudaraba contract remains an example of how Islamic finance comprises trust and accountability, as well as social justice. It bridges traditional ethics with modern economic realities.
Delivered by Shaykh Haytham Tamim on 11th November 2025 to the Convert Club.
Disclaimer: Any financial institutions or companies mentioned in this book are included for informational purposes only and do not constitute endorsements or investment recommendations.
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