Paytronage, Income Share Agreements, and the Future of Education Financing
Why isn’t there a vehicle to invest in the founder rather than the company? Many times founders eventually succeed in their third or fourth entrepreneurial endeavors, so wouldn’t you have preferred to invest in that entrepreneur rather than their first failed startup? What if there was a vehicle where you could have invested in that individual’s future earnings? That starving entrepreneur, rather than the failed startup, would have eventually hit it big and your investment would pay out. What if you could invest in Elon Musk, rather than Tesla, PayPal, or SpaceX? Wouldn’t you prefer to reap the returns of all of his projects rather than any individual company? This financial thesis was the origin of Paytronage.
While surrounded by high-achieving classmates at the University of Pennsylvania, we learned that many of our peers were pursuing high-paying, low-passion postgraduate careers solely to pay off their student loans. Looking into the issue more, we quickly realized that as the national student debt reached over $1.5T, and defaults were creeping higher and higher, students weren’t finding the solution they needed to finance their college education. We then realized how to implement Paytronage.
ISA Background
Throughout the summer of 2017, we began researching many potential solutions: human capital contracts, equity investing into individuals, and the venture capital model applied to students. Slowly through this process, we learned that our concept has been integrated into modern contracts known as income share agreements (ISAs).
So what exactly is an ISA? ISAs allow individuals to receive upfront capital investment in exchange for a set percentage of their future income over a fixed period of time. The idea actually originated in 1955 with legendary economist, Milton Friedman’s article The Role of Government in Education. ISAs have many protective mechanisms for individuals such as minimum income thresholds, maximum payback caps, penalty-free deferment, and no interest.
Since 1955, there have been several attempts at variations of human-equity contracts including Yale University, MyRichUncle, Pave, and Upstart, but no one has been successful in implementing the model. In 2016, Purdue University became the first major institution (since Yale University in the 1970s) to offer ISAs as a form of education financing.
In Purdue’s pilot program, 165 students received $2.2M of funding, creating the impetus for other higher education institutions to offer ISAs as an acceptable form of alternative financing to student debt. Since then, the ISA space has seen major legislative support with the introduction of the Investing in Student Success Act and the ISA Act in the House and Senate, respectively. They both seek to establish regulations which will reduce uncertainty and normalize the ISA investment. This would allow for large-scale institutional investors to feel more confident entering into the space.
Our Model
Paytronage was founded with a greater social purpose than simply investing in the next generation of students. We’ve both been preached the value of a quality education. With either grandparents or parents as first-generation college students, our roots have been tied to the pursuit of education since before we were born. It’s now our mission to offer a new vehicle to finance education with the hope that financial limitations never stand in the way of students obtaining an education.
We decided to approach the market differently. Rather than create school-by-school programs enabling ISA investment, at Paytronage we’re building a marketplace for income share agreements — leveraging many types of institutional lenders.
In the existing student financing market, most students only have the choice between different interest rates and loan lengths. There is no additional optionality for students. With traditional debt, lenders and students are fundamentally misaligned on earning goals, which has contributed to over 11.5% of students defaulting annually and the average student graduating with over $37,000 in debt. Paytronage is solving this macro issue with the creation of its centralized marketplace, allowing investors the opportunity to assist in the future success of students. We’re creating necessary optionality for all students, not just those at schools whose administration offers income share agreements.
In order for a lender to establish an in-house ISA offering, it needs to make significant upfront capital investment: create underwriting prediction models to set ISA rates, verify students’ backgrounds, draft legal contracts and understand the regulatory framework, collect and secure this personal data, collect a student’s income, reconcile IRS 1040 forms, facilitate money transfers, create a technical platform to house the process, develop a team to oversee the entire execution, and then allocate funding to offer ISAs. Alternatively, with Paytronage, lenders can simply set up a fund on Paytronage’s platform, choose their desired investment criteria, and we will handle the rest.
Paytronage’s core operational value proposition for institutional lenders includes underwriting technology leveraging machine learning for investment decisions, legal navigation with internal counsel, systematized fund structure, fund management software analyzing the underlying assets, simplified investment process for investment funds, and outsourced ISA servicing for management.
Paytronage’s value proposition to students is clear: we offer an alternative form of more flexible education financing. We’ve created ISA and student loan calculators, a fund-marketplace structure that enables students to choose and compare among potential ISAs, and a network of investors who are aligned with their success.
The Argument for Income Share Agreements
But why would any student choose an ISA over a student loan? What are the major differences?
The four primary arguments are as follows:
- Forward-Looking Vehicle
- Optimal Debt to Equity Hedging
- Career Flexibility
- Student Choice
- Forward-Looking Vehicle
For many investors and institutions, ISAs are viewed as a social impact asset class, especially when compared to a traditional student loan. To analyze the detailed mechanics of a student loan, we first review how a private loan is applied for and priced.
A student goes to a private lender’s site and fills out an application form. The private lender then pulls a credit check from one of the three credit bureaus to determine the student’s creditworthiness. An individual’s FICO score is largely determined based on credit used, credit mix, amount borrowed, and much more. Many of these qualifications will negatively impact individuals of low socioeconomic status as they have limited chances to accumulate and pay off debt.
The private loan provider then uses the FICO score in combination with their underwriting model to price the loan. The loan providers model will set different weights to variables that they think more accurately assess an applicant’s likelihood of payment. If someone is perceived less likely to pay back, then their respective interest rate increases, causing a dramatic impact on net payback.
The fundamental issue with the loan process for students is that a FICO score is almost entirely predicated on backward-looking qualities, such as previous loans or prior credit. For students who have a “thin file”, meaning very little credit history, they often receive significantly higher rates. In fact, as is the case for 90% of student loans, a student must have a cosigner. In that case, the decision is largely based on a parent’s financial history. And if the parent also has a “thin file” or poor financial history, then the student will receive a high-interest rate. This increases the risk of default, thus perpetuating the vicious economic cycle of low incomes and poverty.
We need to change the way we fund a college education, and this change can start with ISAs! With ISAs, students will fill out a simple profile, including school, major, and their financial request. A risk/reward model determines the percentage of their income they will be required to pay for a set period of time. That’s it. There are no interest rates based on your FICO score and no need for a cosigner.
The only variable rate is how much of a student’s income is to be paid back. This rate, however, is a forward-looking variable rate based on how much a student is predicted to earn. An ISA takes into account your university, major, GPA, likelihood of graduation, etc. These are all variables that students have significantly more control over than life scenarios such as their family’s financial situation. While yes, there are still some systemic effects such as lower income students being disadvantaged on the SAT, the ISA is a step in the right direction by basing the rates on a student’s potential earning, not their family’s past.
2. Optimal Debt to Equity Hedging
During the 2004 election, do you remember the issue surrounding treating a corporation as a person? While not proposing a political view on the matter, the fact remains that there are commonalities between corporations and people. In our instance, we believe that you can assess a person’s financial health similar to a company’s financial health.
A standard analysis of a company’s financial health is the company’s debt-to-equity ratio — an indication of the proportion of equity and debt used to finance a company. As the proportion of debt increases, the company is considered to increase its leverage, which ultimately increases the risk of potentially defaulting on this debt and going bankrupt. As an example, the median ratio for companies in the insurance industry is relatively low at 0.25. In comparison, the S&P 500 is much more highly levered with a ratio of 1.066 (meaning as much debt as equity). If you compare a company’s debt-to-equity ratio to an individual’s contrast is obvious. People solely finance their lives through debt since they receive no additional investments from outside sources other than themselves.
Furthermore, we can look to the debt-to-income ratio for further guidance. With a loan, a person is expected to pay back the loan with monthly payments. For example, Sarah has a student loan that requires she pay the lender $500 a month for 15 years. Compare this, to Sarah’s income. Let’s assume that her income is currently $2,500 a month. In this scenario, her initial debt-to-income ratio is 20%. This makes sense and is a healthy rate as seen by Sarah’s ability to make her monthly payment and still have $2,000 dollars a month remaining to put in savings and pay other expenses. However, then Sarah receives a big promotion! Her monthly income is now $5,000 a month. As a result, her ratio is now 10%. Even better! But what happens if she loses her job? What happens if the financial crisis of 2008 occurs again because the CFPB deregulates the financial industry? Sarah’s debt-to-income ratio then skyrockets. This puts her at risk of default which could potentially crush her credit score and additionally her morale.
Contrast this debt-only scenario with an ISA. An ISA has a fixed income to payment ratio. Using the above scenario, instead of paying $500 a month, Sarah might pay 5% of her income for 15 years. Initially, she would pay $125 per month (monthly salary of $2,500) leaving her $2,375 for other expenses and savings. As her earnings increase, so does her payment amount. In this example when her salary increases to $5,000 she repays $250 per month, leaving her $4,750. If she experiences times of hardship, the 5% ISA rate remains fixed and Sarah is better protected from falling into default.
There will be many situations where a person outperforms their expected income and they will pay more than anticipated (i.e. Sarah makes $20,000 a month and her repayment is $1,000). However, they will be paying a fixed percentage of their income and the net amount of their income available for other expenses will also be higher. Alternatively, with an ISA, the downside risk is dramatically reduced if a person’s income does not reach anticipated levels. It also allows for individuals to pursue riskier career paths, take a position that is more focused on social impact, attend graduate school, or even take career gaps.
An ISA is a flexible financing vehicle that can be used to fully fund a person’s education or to pay for a portion of the overall cost. We believe that there is an optimal mix of debt (loans) to equity (ISAs) for each student to hedge downside risk, but also protect them from paying too much if they become more successful than anticipated. If corporations are hedging their future financials, why shouldn’t people do the same?
3. Career Flexibility
Loans do not provide career and payment flexibility. Theoretically, a loan borrower is required to pay their fixed payments, regardless if they become an investment banker or teacher. As a result, students are driven into traditionally more lucrative career paths to pay off their loans.
With an ISA, students are able to pursue non-traditional careers because their payments are based on a fixed percentage of their income. A teacher experiences the same relative financial burden as the investment banker when they both pay 5% of their income. As a result, students are able to pursue less lucrative careers such as teaching, the Peace Corps, non-profits, etc.
An ISA allows flexibility for students who are passionate about entrepreneurship or working in riskier earning paths. For example, we could not have started Paytronage if we had high loan payments. With our current salaries, we simply would not have been able to live. Conversely, if we had taken out an ISA instead of a traditional loan, we could have comfortably started Paytronage because of the correlative nature of income and payments. The experiences that we have gained and skills that we’ve learned are immensely invaluable to our personal growth, which is what we’re trying to provide to other like-minded millennials — an opportunity to take that risk they’ve always wanted.
An additional component of an ISA, unavailable to loans, is the Minimum Income Threshold (MIT). An MIT is an agreed upon minimum income level that, if a borrower does not earn enough to surpass it, they are not legally responsible to make a payment during that time period. If they do not pay at that time, the responsibility to pay is added to the end of the contract. For example, Josh takes out a $50,000 ISA giving up 4% of his income for 10 years. He is expected to pay 4% of his income for ages 22–32 and is then free from further obligations. Imagine that at age 26, Josh wants to go get an MBA. During years 26 and 27, Josh will have minimal or no income and would not meet the MIT. Rather than an investor taking 4% of this little income, the contract would then required Josh pays from ages 22–26 and ages 28–34 (10 years total). As a result, both Josh and the investor win. Josh has the flexibility to pursue his MBA without facing accrued interest on his loans, and the investor is able to capitalize on Josh’s self-investment in an MBA and higher potential earnings.
In the current two Federal bills being pushed, the Investing in Student Success Act and the ISA Act, the minimum income threshold would be set at 1.5x the poverty line. This threshold protects students during tough economic times, enabling significantly more earning flexibility.
4. Student Choice
Lastly, and most importantly, students should have a choice of how to fund their education. Both ISAs and loans have an important position in the financing of a student’s education. However, in the current market, students do not have a choice because ISAs are a new alternative funding method that has not yet been properly accepted by the market. The current choice, after exhausting savings, scholarships, and other traditional sources is simply choosing which loan provider to borrow from.
We aren’t saying that ISAs are the right funding vehicle for every college student. Rather, ISAs should be an important part of the financing mix for many of the 20.5 million college students every single year. Students should be able to choose whether or not they want career hedging. Students should be able to choose whether they want to use a loan and pay fixed interest payments regardless of their income or pay a fixed percentage of their income through an income share agreement, paying less during low-income periods and more when they succeed. In a recent pilot study conducted by the AEI, over 50% of students surveyed stated that they would prefer an ISA over a student loan. In an early pilot study run by Paytronage, when asked which a student prefers, with 1 being heavily favoring a loan and 7 being heavily favoring an ISA, the mean student voted a 4.4. These studies indicated a preference of ISAs over student loans. The problem is roughly only 5% of people know they exist. Once learning about ISAs, people like the concept of an investor profiting more if students succeed and sharing in the loss if they fail. This vehicle is better aligned with the interests of today’s college students and will make a great addition to the funding portfolio.
Conclusion
While we understand that ISAs are very much in the early stage of development in the United States, there is a foundation that is growing and rapidly gaining momentum. We know of many major events occurring in the space in 2018, with some VCs we’ve spoken to predetermining 2018 as the “Year of the ISA”. If you hadn’t heard much of ISAs before now, you most certainly will very soon (and Paytronage expects to be a big part in that education).
The systematic issue of $1.5T of student debt and ~40% of students defaulting on their Federal Loans from 2004 is not sustainable. We are in one of the longest bull markets in history and these loans are still crumbling.
A major change is needed. New forms of financing are needed. Novel types of lenders are needed. Lowering the cost of education is needed. Tying university cost to outcome is needed.
We are not claiming to completely solve this problem, but we’re doing our best.
Because students deserve more choices.
