Income Share Agreements

With the total student debt rising to all-time highs around $1.6 Trillion, many college students are afraid to take on debt to pay for college out of fears it will be too big a financial burden. Students are often looking for alternative ways to pay for college, and one such alternative has been garnering attention as of late: income share agreements, or ISAs. An ISA is what it sounds like: an agreement to share a portion future income with an investor in turn for an investment.

The late economist Milton Friedman introduced the idea of ISAs as the equity alternative to student loans in the education-finance market. In the case of college students, the investor is the school and the investment is paying for the student’s college tuition. A student borrows money from the school with the agreement to pay them back a percentage of their income for a certain amount of years. Traditionally, the nature of student loans placed the risk on the students. Now, with ISAs, the risk has shifted from the students and their default to the investor and the risk of not profiting off the investment. Let’s take a look at what an investor and student looking to agree to an ISA are looking for.

The Basics

As with any market, there is always competition between the two parties engaging in an investment. The student will look to get the investment and money as cheaply as possible while the investor will look to gain as much as possible from the investment. With student loans, cheaper loans were those with lower interest rates. The same holds true with these ISAs: students will be looking to give away as small a percentage of their income as possible because they want to keep as much of their income as possible. 

The student also likes the flexibility an ISA provides. Unlike paying off debt, on a fixed payment schedule, the student, after getting a job, can pay off more of his or her obligation to the investor as he or she becomes more financially stable and successful. This is similar to how shareholders in a company earn larger returns when a company and its stock do well, only in this case the shareholder is the one providing financing for the student, while the student is the company.

Stock Analogy

More specifically, the student’s varying income is analogous to the company and its stock price. This may worry some investors because a student’s income after graduation can vary, which introduces the risk of not getting the amount they gave to the student after the period of time is over, which means the investment is unsuccessful. The flip side is also true: the investor can make a good return on financing the student’s education if the student’s income varies in the positive direction.

In other words, the investment returns positively if the student’s income grows. But in this case, the risk has now been transferred from the student, who needs only to pay a certain percentage every year, to the investor, whose risk comes from the fact that an ISA doesn’t promise the safety of a loan’s return and doesn’t promise a positive return either.

As a result of the added risk, investors in ISAs look mainly at the student’s potential income after graduation. They base that on a number of factors, such as the student’s major, and factor it into their investment. If a student doesn’t earn much after graduating, and they have student loans, then they have to pay back the same amount, regardless of what portion of their income it is. 

Comparison to Student Loans

However, with an ISA, a student not earning much just pays a set percentage throughout their agreement’s period, which may be a lower overall percentage than what they need to pay if they had student loans. A student who gets a high salary after graduating will still pay the same percentage of their income, which is what investors want. So, there is the risk of losing money on the investment, due to the risk of inadequate income, but there is also the potential to earn a positive return if the student earns a more than adequate income throughout his or her agreement’s period.

Post-graduation income, for investors, is heavily influenced by the student’s major. Due to the demand for STEM jobs and the relatively high salaries they offer, a student majoring in a STEM subject may get better repayment terms than a student majoring in art or English. Better repayment terms are typically either a smaller percentage taken from income, a shorter period of time to repay, or a combination of both.

Valuing ISAs

As mentioned before, Milton Friedman initially introduced the concept of “equity” for college financing, which he described as follows:

“[Investors] could “buy” a share in an individual’s earning prospects: to advance him the funds needed to finance his training on condition that he agree to pay the lender a specified fraction of his future earnings. In this way, a lender would get back more than his initial investment from relatively successful individuals, which would compensate for the failure to recoup his original investment from the unsuccessful.”

If an ISA is to a loan as a stock is to a bond, then the valuation of an ISA could be done using equity valuation techniques. An ISA seems to have characteristics of both bonds and stocks, as it has a maturity date and payment schedule, like bonds, but also has a varying payment from a dividend-like structure. It’s like if a company paid dividends not based on a sum of money to pay out per share but rather based on a fixed percentage of the share price.

Valuation Using Discounted Cash Flow

If we consider using discounted cash flow, we could use the projected payments to come to a present value for the student’s ISA investment. For simplicity’s sake, let’s say the payments are annual, rather than monthly, and the agreement is for 8 years. If the student who graduates starts out making $75k a year, and we assume that income grows at 5% every year and that we take 5% of the student’s income as payment. Figuring out the numbers aren’t hard from there.

The total future value of the student’s payments is simply the sum of the payments the student will make over the 8 years, which amounts to $35,809.16. Using discounted cash flow, our cash flows are the student payments which the investor needs to discount at a rate that represents the risk the investor is taking with this investment. We are assuming that the income will grow at a 5% rate and that a student will get a job, but that may not happen. The discount rate, therefore, needs to represent two risks: the risk of the student not getting a job and the risk of the student’s income not being as high as we predict.

Potential Risk Factors to Income

As mentioned earlier, the potential income is influenced by a whole host of factors, ranging from the student’s major to the parent’s income, and is riskier than providing a student loan. The interest rate on a student loan can be estimated as the loan’s discount rate. The average student loan interest rate from 2006 to 2019 is, for undergraduates, about 4.81%. I am going to do some estimation here now, and I will give my reasons for each one, and I may be wrong in the end about how ISAs will be priced since they are a relatively new investment.

The typical risk-free rate, which is the rate of return on an investment with no risk, can be estimated by the US 10 Year Treasury, which is about 2%. The S&P 500, over the past 90 years, has an average return of 9.8%, which is 7.8% more than the risk-free rate. Adding that same amount to the typical interest rate for loans, we get 12.61%, which I’ll round up to 13%. This is a reasonable discount rate, perhaps on the slightly higher end, as it is in the typical range for more risky equities and their estimated discount rate. Discounting the payments to the present value using 13% as the discount rate, we get $20,823.78.

Final Value

This means that given the risks around the consistency and growth of the student’s income, the present value of cash flows added up to $35,809.16 is $20,823.78. Over 8 years, that represents a compound annual growth rate (CAGR), which is the effective rate of growth for each time period to the next for the duration of the investment, of about 7.01%. That represents a higher potential return than the interest on a typical student loan (7.01% > 4.81%), but that comes with a higher risk as well. The investor then would give the investment of $20,823.78 to the student, who’ll be very happy that he or she is receiving almost $21,000 to pay for college (not a bad deal, if I may say so myself).

Clarifications

I want to clarify a few things about what I just wrote above. What I wrote is just one potential way to value ISAs based on their similarities to equities. I may be wrong, I may be right, and only time will tell. Additionally, the numbers I used were for examples and simplicity. I made a lot of assumptions too, such as the discount rate.

The discount rate was calculated based on the prevailing typical interest rate on loans and the market risk premium, which is the difference between the expected return from the market for equities and the risk-free rate. I calculated that by subtracting the historical growth rate of the S&P 500, 9.8%, from the risk-free rate, which is about 2%, based on the US 10 Year Treasury. There are different numbers investors use for their market risk premium because of the different expected rates of return from equities and different risk-free rates.

Another way to get the discount rate for an ISA discounted cash flow valuation could be to base it on the student’s major and the likelihood of getting a job from that major, the job market of the location they plan to work in, graduation rates, the typical salary for a graduate of the college he or she attended, and other factors based on the student. That could provide a more accurate way to model the risk rather than using the discount rate and risk premium from equities because it takes the student into consideration. Again, I can’t say for sure yet what will be the most widely used methods and parameters of ISA valuation.

ISA Marketplaces

With the rise in popularity of ISAs, there has been a consequent rise in online ISA marketplaces. One such marketplace is Edly, in which educational institutions list shares of their student’s ISAs. Prospective investors can see if they want to invest in them. This is similar to a stock exchange, as investors get to pick and choose what shares to buy. Wall Street has begun to watch the ISA market.

The founders of Edly, Charles Trafton and Christopher Ricciardi, also manage FlowPoint Capital Partners, which is a firm that invests in ISAs. They view the returns on ISAs to be alternative to fixed income investments like bonds. Ricciardi says, “Even though the return might not be high compared to venture capital returns, or equity returns, if they are higher than other fixed income returns it could be attractive to investors.”

Vemo and Leif also entered the scene. Vemo and Leif help schools design and implement ISA programs for their students. Purdue University used Vemo to create their ISA program, Back a Boiler.

ISA Structures

There are some ways that providers structure ISAs to provide students with some protection. For example, some schools don’t require payment from the student until a certain income level is met. The Holberton School in San Francisco, which is a 2-year software training program, only requires payment only when its graduates start earning a salary of at least $40,000 a year. Purdue’s graduates don’t need to send payments until they are making at least $20,000 a year.

Some schools put a cap on the total amount a student needs to pay back. The Holberton School will collect payment up to the point the students pay the $85,000 tuition cost. Purdue’s ISA profit cap is at 2.5 times the amount students took. The school decides whether or not there is a cap or minimum income as the law does not require to have those limits in place.

Paying for college is a complicated process, and the pile of student debt doesn’t seem to be getting smaller. So, if you’re looking for another way to pay for college, it may be worth your while to do some research on alternatives to student loans, like ISAs.