Putting Income Share Agreements to the Test

Core invests in mission-aligned companies that seek to improve financial well-being for everyday people. To that end, it’s often the case that companies operating on the periphery of financial services are positioned to make outsized impacts on our financial success. So now we’re taking a close look at an old alternative financing idea that we believe is coming into the mainstream: income share agreements (ISA). Huh? In short, ISAs are a financing vehicle whereby a recipient of funds agrees to pay a percentage of future income for a fixed period of time.

ISAs can be used to finance anything, though education is the most popular application today. As tuition costs soar and alternative education models emerge, we believe student outcomes will play an increasingly important role in a school’s viability. To that end, ISAs represent a unique tool for schools to self-enforce an outcome-centric philosophy.

First proposed by the Chicago school of economics leader Milton Friedman in 1955, ISAs were used sparingly in the 20th century. Yale launched a program in the ’70s, though it was deemed a failure in part due to decades long repayment terms and dependence on fellow borrowers’ compliance.

Today ISAs are seeing renewed interest amidst a student debt crisis characterized by $1.5T in outstanding balances nationally and a $30,000 debt load for the average borrowing graduate. In 2016 Purdue University launched its Back a Boiler program, providing juniors and seniors with an ISA slotting in as a Parent PLUS substitute in the typical student’s waterfall of education financing options.

Coding bootcamps and other alternative education models have also experimented with ISAs over the last several years with some, like Lambda School, making them a mandatory component of the program. Still, while alternative education became a popular venture capitalist target, Core’s interest remained tepid. Concerns revolved around the alternative education market size and the uneasy balancing act of scaling a program while maintaining outcomes.

Though alternative education technology has been growing for years, more recently, the crescendo of interest in ISAs accelerated. Over the last twelve months, Core saw more startup activity around ISAs than in the prior five years combined — Base Capital, EdAid, Edly, General Assembly’s Catalyst program, Leif, Align, Make School, MentorWorks, Modern Labor, PassRight and Vemo to name a few! The companies are joined by new capital providers, accelerators as well as venture capitalists focused on education and financial technologies. Meanwhile traditional institutions are taking note too, with many leveraging the expertise developed by Purdue.

While ISAs appear to be gaining momentum, they certainly remain a controversial topic. Core believes many common critiques are misguided with risks mitigated by federal regulation, contract transparency and borrower education.

Indentured Servitude: Perhaps the most common critique is that ISAs create a framework for indentured servitude. Committing a portion of future income through an ISA in a way does feel like a trade of money for labor. Unlike early American immigrants paying Atlantic passage, however, a student with an ISA has freedom in her career. She may even choose never to work (and therefore never pay the ISA) at all! But we believe in ceilings and floors.

Adverse Selection: Some believe ISAs are doomed to fail because they’ll disproportionately attract students who expect to pursue relatively lower paying jobs in their field of study, leading to adverse selection. It’s true that asymmetrical information about future plans (e.g., pursuing a lower-paying job) between students and investors sets the stage for adverse selection. Still, students often inaccurately predict individual outcomes, while investors are sophisticated about creating a contract matching a student profile.

In addition, well-designed contracts implement reasonable payback caps. For example, an ISA recipient will never need to pay more than three times the amount exchanged at the start of the contract. Once a recipient hits the payment cap, the ISA contract is terminated. With respect to adverse selection, this protection acts as a mechanism to keep individuals, who expect relatively higher future incomes, from being dissuaded by the contract.

Field of Study Bias: The former critique dovetails into another common complaint — ISAs favor higher earning majors (typically STEM). This discriminates against students (and demographics) pursuing lower earning fields of study. It’s true that compared to the art history major, the computer engineer receives a contract with a lower percentage of income and a shorter term. Still, the contract does not create more favorable terms. For example, a graduate paying 10% of a $40,000 salary pays the same $4000/year as one owing 5% of an $80,000 salary. Students are underwritten to the same return.¹

Underwriting Discrimination: Another critique is that because certain demographics are more likely to land higher paying jobs after graduation, ISAs underwriters will adopt similar biases. For example, the wage gap incentivizes investors to offer ISAs to men over women. Indeed, ISAs should be (and typically are) underwritten blind to gender, race and fair lending characteristics.

Income Threshold Misalignment: Some believe the income threshold of an ISA contract is often too low. ISAs are often presented a means to align school with student outcomes. In 2017, workers with high school diplomas earned an average of $30,500. Back a Boiler uses a $36,000 income threshold for art history majors. Is Purdue adequately incentivized to see its graduate succeed?

Given that ISAs remain a nascent market, it’s important to consider elements of a responsible ISA program. Such a framework is a requirement for long term success in the space, a tenet of Core’s pro-consumer, mission-driven approach to investing. Here are a few characteristics Core considers important:

• Schools should have skin the game, with their balance sheet tied to student outcomes
• ISA program designers should employ a reasonable cap on total payback. We think that’s 3x, though could be less based on the circumstances.
• ISAs need reasonable floor and ceiling mechanisms to ensure a student is never impoverished by the contract. In order to prevent ISAs from demanding too much of a recipient’s paycheck, the commitment cap² should never be more than 2.25 and typically well under 1.0 for ISAs shorter than five years. For the floor, an ISA’s income threshold should ideally be flexible and internalize varied costs of living so as not to limit geographic mobility.
• Robust student education about the contract. Students need to understand the ISA product, its terms and have the means to compare it to alternatives. We believe it’s important for students to understand the nuances of ISAs which make them more than a simple loan alternative. This responsibility rests with the institution’s student finance office.

How can we ensure best practices become standard practice? Ultimately we likely need help from the federal government. Today, the ISA regulatory landscape fragmented across states, which keeps both investors and schools on the sidelines. The Investing in Student Success Act is a bipartisan effort on Capitol Hill which designates a federal regulator of ISAs. It requires certain consumer protections like presenting ISA recipients with terms of a comparable loan.

Core is interested in the future of income share agreements. With nosebleed student loan balances, rising defaults, and spiraling tuition discounting practices, we believe ISAs represent an exciting solution for education financing. If you or someone you know is shaking up education finance, please reach out!

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1. There’s a small wrinkle — the lower-earning major student does pay a higher break-even interest rate. This considers career trajectory and periods of un/underemployment. Unlike a traditional loan, ISA holders have no obligation to pay during these chapters in life. Students more likely to face such situations effectively pay a small premium for the protection.
2. An ISA’s commitment cap is calculated by multiplying the income contribution percentage by the term, in years. For example, a four year ISA with 20% income contribution has a 0.8 contribution cap.