Income Share Agreements
The Future of Funding: Part 1
All views in this series are my own, and not representative of Impact Labs.
If you’ve been following the trends of startups and VC funding, you may have come across the acronym ISA in recent years. It stands for Income Share Agreement, and it’s the hottest financial trend since the subscription model stepped on the scene 10 years ago.
Many people believe that the ISA model can replace venture capital funding for startups, but we’ll see whether that’s a good idea.
ISAs are simple. Basically, you’re given something for free (usually a service like education) on the condition that you’ll pay for it with a portion of your income over a period of years. For example, an ISA provider may pay my tuition for a masters degree in exchange for 5% of my income during the 10 years after I graduate.
ISAs can be particularly useful arrangements for higher education. They’re seen as friendlier alternatives to student loans, which can be unforgiving and brutal. We’re currently facing a massive student debt crisis that looms into the trillions of dollars in which the average student graduating today will have upwards of $30,000 of debt to pay off, often with terms like harsh interest rates and no absolution in bankruptcy. Many private loans aren’t even discharged after you die, making student loans a particularly damning form of funding. Yikes. 😬
ISAs, on the other hand, are much more manageable. Instead of a loan in which a recipient has to pay the money back no matter what, ISA providers take a more “high risk, high reward” approach. True, some of the people who receive the funding upfront may not earn much, but that loss can be compensated by those who become very successful. In that way, some people liken ISAs to venture capital funding, since the providers are practically “betting” that a handful of the people they fund will strike it rich and make up for the comparative “losses” of those who don’t.
Let’s look at an example.
Let’s say Alice and Bob use the same ISA provider to pay for their undergraduate tuition at a 4 year university, whose cost totals $120,000 each. The terms of the ISA are such that Alice and Bob both owe the provider 10% of their respective incomes over the 15 years following graduation. Alice studies computer science, and she takes a job at a non-profit earning $50,000 per year after graduating, while Bob studies sociology and graduates into an unpaid internship.
Sorry Bob. 😭
After seeing her friends from her CS classes post sunsets in Malta and artisanal espressos on Instagram, Alice determines she made the wrong choice and follows their footsteps. She leaves the non-profit that was rescuing puppies and works as a software engineer for Goldman Sachs. She makes $250,000 per year and is unhappier than ever.
Bob, meanwhile, is suddenly famous. His unpaid internship leads him to question the ideological legitimacy of capitalism, and he writes a bestseller titled “So You Wanna Be Bougie AF?” His book deal at Penguin nets him a cool quarter million, plus royalties on all books sold, and Ashton Kutcher will be playing Bob in the upcoming film adaption.
Way to go, Bob! 🎉
In both of these cases, the ISA providers probably started out pretty unenthusiastic with Alice’s and Bob’s career choices. After all, if they had stayed in their initial roles after graduating, Alice would have paid back a total of $75,000 (10% of $50,000 x 15 years), while Bob would’ve payed back nothing. The provider’s $120,000 “investments” would have lost them a lot of money. After they become “successful,” though, Alice starts paying $25,000 per year and Bob… well, who knows about Bob? He’s hard to reach when he’s at his Malibu house.
Income share agreements are swiftly rising in popularity. Startups experimenting with ISAs like Blair were hugely prominent in YC’s most recent edtech cohort, and computer programming bootcamps like Lambda School and Make School are particularly well suited to the ISA model, since they fast-track students into high paying careers. ISAs are already commonplace in Europe, with 40% of German students using ISAs to finance their education.
However, there are some hidden downsides to this form of funding. For instance, ISA providers may be hesitant to give funding to a prospective undergrad who intends to study philosophy, and more likely to fund a student planning to major in chemical engineering. Some providers account for this by lengthening the terms of repayment, so that the philosopher may pay 10% over 20 years, while the engineer may only pay for 10 years.
At least student loans are agnostic. I’ve never heard of a loan provider denying a loan because their recipient planned to study something that didn’t lead to a lucrative career. I worry that with the increasing prevalence of ISAs, we may see fewer people study the humanities, since the conditions to do so would be too costly for their future selves.
Additionally, ISAs can wind up siphoning a significant portion of a recipient’s income, particularly in their early years when they should be saving and investing. Thankfully, some ISAs are capped, meaning that a recipient will never pay above a certain threshold. For example, if I received $20,000 with a 2.5x cap, my agreement would stipulate that I will never have to pay more than $50,000 over the years. That’s a huge advantage, and it’s for this reason that I believe ISAs could be a tremendously useful tool in the fight against our massive student debt crisis.
Most ISA providers today have caps, and that’s a critical way in which ISAs are dissimilar to venture funding, since the whole ethos of venture capital is to soar on 10x returns. While the comparison is somewhat apt, VCs and ISAs serve different purposes.
But this hasn’t stopped people from trying to borrow the ISA model and apply it to venture funding.
In an even more recent trend, we’ve seen examples of new firms that brand themselves as “talent investors,” “human investors,” or (my personal favorite), “human capitalists.”
I’ll be exploring this phenomenon in part 2 of the series.
