Idea: 138Monday, 18 May 2015By. Alex Foster & Francis Pedraza

Derive

—Financial instruments for investing in individuals

Name is a play on words between “derivative” and “drive”. “Derivative” both in the sense of “to originate from”, and in the sense of structured financial instruments.

Our brainstorm topic last week — Brainstorm #44: “Silences” + Discussion — got me thinking. What ideas are we overlooking because of some cultural blindspot?

One of the biggest problems in the world is under-investment in individuals. This is what the socialists are always saying. We need to invest more in the poor, because the poor can’t invest in themselves, so they end up in a vicious cycle — with less education, worse health, and basic needs unmet, it is very hard for them to succeed in the modern economy.

I agree with them. Which may come as a shock, for those of you who know I’m a libertarian. But yes, so far in the argument, I agree with them. Where I disagree is them is the part where they say, “therefore we should invest in state-sponsored entitlement and social programs.” I always prefer to think of market alternatives.

Here’s a big question:

? How might we create a financial instrument that would result in at least $1 trillion ($1,000,000,000,000) of investment in the education and welfare of people without access to capital?

So I’ve been thinking about a market alternative. And the reason why it hasn’t been explored as fully as I think it should, is because of the history of slavery. Let me explain.

Last year, Alex and I bounced around an idea about “taking equity in kids”. I think the conversation started with, “Remember Professor Xavier’s School for Gifted Youngsters” in the X-Men movies? We were revisiting the old apprenticeship model, which has a history that goes back to Medieval times and beyond. How could you incentivize successful adults to invest in kids? In an apprenticeship model, the master is incentivized to teach the apprentice because the apprentice represents long-term access to cheap, skilled labor. Apprenticeships were usually long-term relationships, lasting seven years or more.

In a modern contract economy, making a seven year contract with a kid is… illegal? Yeah, it is probably illegal. Ok, fine. But by the time the kid gets to college, and can’t afford college, we saddle the kid with debt. And the government has to subsidize most of that debt, because it isn’t attractive to the market.

What is the alternative to debt? Equity. Debt represents limited risk and fixed upside. Equity represents shared risk, but unlimited upside. Taking 100% equity in a person would be tantamount to slavery, so we dismiss the concept too soon. What if there is room for a third instrument? Something between debt and equity? Structured, but not unlimited, upside.

For example, suppose I invest $1,000,000 in a child’s education and upbringing. Assuming all of the parenting costs. Giving this child a first-rate education and a world of opportunity. In exchange, I get 0% of his first $50,000 in income, 10% of his next $50,000 in income (from $50K to $100K), 15% of his next $50,000 in income (from $100K to $150K), 20% of his next $100K in income (from $150K to $250K), and 30% of his income above $250K.

After a certain age, or after making a certain amount of profit, the “pseudo-equity” would be structured in such a way that it can be unwound, so it is not permanent. Perhaps it is convertible from equity back into debt, so the individual can buy out his/her investor. Perhaps upside is just capped at a certain multiple, like 5X. Perhaps it just goes away after a certain age, like 50.

Hmmmm.

? Ideas on how to structure pseudo-equity to incentivize investment without creating modern slavery?
? Would this incentivize broad-based investment in humans as an investment class?
? Would it only result in investment in high-potential people, leaving “ordinary” people left behind?
? Going back to the “How might we” statement… do you have any alternative ideas?