By Bill Matson, CrowdFundBeat Sr. Contributor, MBA, CFA, CPA (Retired), CFP
In April 2014, Florida Senator Marco Rubio and Representative Tom Petri of Wisconsin introduced the Investing in Student Success Act (Rubio-Petri). Implementation of Rubio-Petri would entail minimal budgetary impact, since its purpose is to provide guidelines for the regulation and interpretation of Income Share Agreements (ISAs). ISAs involve individuals selling portions of their future incomes to investors, and this flavor of crowdfunding may be particularly tasty to students, as well as those with sizeable student loan debt obligations.
ISAs may also provide investors with a useful way to diversify their portfolios and boost returns by mentoring investees. This opportunity for investors’ personal involvement in the careers of investees is analogous to the hands-on involvement of venture capitalists in their portfolio companies, though with less potential for intrusiveness. Aside from whatever incremental financial returns may arise from their mentoring, many investors are likely to derive enjoyment from personal relationships with investees, in addition to a variety of other tangential benefits.
Income-contingent student loan payment arrangements are currently available, but they differ in several important respects from Rubio-Petri that are particularly unfavorable for low income individuals. As an alternative to debt that accumulates interest and continues to be payable for an indefinite period, Rubio-Petri proposes an equity-like arrangement prescribing income-contingent payments for a maximum of 30 years (albeit with payments suspended and the clock stopping during years with sub-$10,000 income). As a carrot for investors, it also allows for the possibility of deriving extremely high returns when they fund individuals who achieve great financial success – despite investees’ payment obligations being capped at 15% of their annual income in excess of $10,000.
ISA proponents argue that such transactions would provide a desirable alternative to more commonly used forms of education financing and alleviate the severe nationwide problem of student loan defaults. Opponents, however, assert that expanded use of ISAs would entail unacceptable risks of consumer abuse, some labeling them a form of indentured servitude.
Lack of clear federal guidelines has led to uncertainties regarding ISA enforceability, tax treatment, and regulatory interpretation (e.g. whether they should be characterized as debt or equity). As a direct result of these uncertainties, investment in ISAs has been stifled.
Even pessimistic observers, however, concede that clarification of ISA guidelines at the federal level is likely a matter of when and not if. Given the unique array of benefits that ISA transactions may generate for both investees and investors, tens of millions of individuals may ultimately become participants in the ISA marketplace. Though the matching of ISA investors and investees represents a huge opportunity for businesses currently operating crowdfunding platforms, it would be naïve to believe that a market of this size will escape the mainstream financial services industry’s notice.
Handicapping the Political Fortunes of Rubio-Petri and ISAs
In early May 2014, Upstart, a promising crowdfunding platform founded by ex-Google executives stopped offering new ISA deals. “We’re still huge fans of income share agreements, and their potential to provide a better means of paying for college and funding aspiring entrepreneurs,” wrote Dave Girouard, the company’s CEO, on Upstart’s blog. “And while many regulatory and policy efforts are underway to facilitate the development of the market, these efforts will likely take many years—a time frame ill-suited for a startup like ours.”
Potential sources of delay include concerns raised by opponents that ISAs would entail unacceptable risks of consumer abuse, some labeling them a form of indentured servitude. Macalester College professor Morgan Adamson argues that: “By investing in a student’s human capital, the investor thus possesses legal rights over the capital gained through the student’s participation in higher education, which is then embodied in the worker… One’s human capital can in no way be separated from her physical person. Thus, the Human Capital Contract amounts, by any measure, to a form of indentured servitude.”
There may be potential for compromise, however, through a formula that allows for 15% caps with shorter durations or 30 year durations with lower caps.
The possibility of raising the $10,000 exemption constitutes another area of potential compromise. The chances of unconscionable exploitation would certainly diminish as the exemption is increased, not only due to greater portions of investees’ income being off limits to investors, but also because the financial sophistication of investees subject to repayment obligations would tend to increase as the exemption rises.
Logic dictates that there be a point at which the danger of exploitation is outweighed by the benefits to be gained by investees – and society as a whole – through greater access to a new source of capital, whether those benefits involve funding of education expenses or the financing of entrepreneurial ventures.
Is $10,000 the right exemption number? That subject is open to debate. Perhaps the magic number is $100,000. How about $1 million? Investors having appetites for ISAs with seven-figure exemptions do exist, and it’s difficult to envision hand wringing over the plight of those who bargain away significant percentages of their annual incomes if they are able to keep the first million.
Ultimately, compromise may take the form of a three factor guideline formula. One such possibility would be:
Income share percentage, subject to 15% maximum times ISA duration, subject to 30 year maximum divided by Square root of exemption, subject to $10,000 minimum exemption must be equal to or less than x.
The maximum “x” allowed by Rubio-Petri would be (15 x 30)/100 or 4.5. Keeping two Rubio-Petri terms constant while lowering the x to 1.5 would, for instance, allow for:
a 5% income share, 30 year duration, and $10,000 exemption, or
a 15% income share, 10 year duration, and $10,000 exemption, or
a 15% income share, 30 year duration, and $90,000 exemption.
Obstacles to compromise — At present, organized support for clarifying ISA legislation is minimal. This is primarily attributable to:
· Lack of familiarity with the ISA concept among financial professionals, as well as the general public,
· Lack of funding to educate those who might benefit from expanded use of ISAs, and
· Lack of a trade association to marshal financial support from firms in the ISA industry, promote standards of ethics, and spearhead educational efforts regarding potential ISA benefits and risks.
The absence of organized support for federal ISA legislation is largely responsible for the inattention accorded Rubio-Petri by lawmakers and media alike. This problem is magnified by the necessarily quantitative nature of any meaningful discussion involving ISA benefits and risks vis a vis alternative forms of financing. The plain truth is that the public has little aptitude for, let alone interest in, running the numbers for various financial scenarios – and politicians don’t win elections by giving math lectures.
In the absence of math lectures, most people will tend to judge ISAs on the basis of qualitative considerations. Free market supporters, libertarians, and conservatives will likely favor them, while those holding other philosophies will tend to be opposed. Without clear countervailing political benefits to promoting the use of ISAs, few elected officials will publicly support initiatives that might somehow connect them with exploitation and indentured servitude.
Potential Future Support from Wall Street for Legislation Promoting ISAs
Securities brokerages, mutual funds, and other investment management firms are a likely source of those countervailing political benefits, which might include education of the investing public casting ISA supporters in a favorable light, as well as generous campaign contributions.
The quid pro quo is that financial professionals stand to reap sizeable revenues from selling ISAs as a means of diversifying their clients’ holdings. A strong case may be made for the potential of properly vetted ISAs to enhance clients’ returns while lowering overall risk in their portfolios, while providing a variety of less quantifiable benefits (e.g. opportunities for mentorship).
Wall Street’s growing need to justify Its fees — Firms purporting to add value through the active management of clients’ stock portfolios are having an increasingly difficult time justifying their fees – which is to say justifying their existence. A growing body of historical performance data indicates that actively managed portfolios, on average, significantly underperform market indexes. Moreover, given recent revelations regarding high frequency traders’ ability to front-run other investors’ orders, passive strategies that involve buying exchange traded funds (ETFs) and holding them for many years – if not for the rest of one’s life – make more sense than ever.
Because an ETF can own thousands of stocks in some cases, while providing exposure to virtually every area of the economy, ETF buyers can assemble diversified portfolios without the assistance of a professional advisor. If they use discount brokers, the sales commission charged for buying unlimited numbers of ETF shares may be as little as $5.
Some might argue that Wall Street justifies its fees and commissions by providing financial planning services to retail investors. In many cases, though, relying upon a financial advisor with commission-based compensation to create one’s financial plan is akin to retaining a wolf to guard one’s henhouse. Rare indeed are advisors compensated in this manner who will counsel clients to buy and hold ETFs, since this group tends to be more interested in earning commissions than in making money for clients. Due to their day-to-day activities being more focused on prospecting and selling, they also tend to be less competent than financial planners whose income is solely derived from charging flat hourly rates for their analytical expertise.
Though some investment managers and commission-based advisors to retail clients actually are capable of beating market averages on a consistent basis, they are few and far between. Since the vast majority of them are not, Wall Street stands to eventually lose the lion’s share of its revenues from actively managed products (i.e. mutual funds, hedge funds, and the like) and from the commission-based advisors who actively manage clients’ portfolios.
Consequently, it is imperative that Wall Street develop new actively managed products that can compete effectively with ETFs for clients’ investment dollars. ISAs may well represent Wall Street’s best opportunity to accomplish this on a scale equaling or surpassing the revenue losses in its traditional products and services.
Analyzing the investment merits of individuals rather than companies will call for the development of new skill sets, as will sourcing ISAs and appropriately incorporating them in client portfolios. The effort involved in doing so provides credibility to these activities’ claims of value creation – and the fees that may be charged for them will be a function of the value investors perceive them to add.
ISAs as Door Openers — Financial services firms who originate and market ISAs are likely to find them to be effective door openers. Many retail investors would appreciate the opportunity to enhance their returns by playing meaningful roles in supporting ISA investees’ businesses and careers. Thus, the salesperson bringing this opportunity to prospects’ attention first is likely to open accounts with them and quite possibly sell them additional products in the future.
Investees who are either university students or recent graduates may well have affluent parents. Other things being equal, they will want to do business with a firm that is involved in promoting their children’s careers.
Investors often have a keen interest in backing other students or alumni of their alma maters. This was confirmed through conversations with Dan Macklin, Co-Founder and VP of Business Development at SoFi, a crowdfunding business that is able to make student loans at very low interest rates by focusing on students and alumni of schools whose graduates seldom default. According to Macklin, investors attach significant value to the personal relationships they develop with current and former students of their alma maters when lending to them through loans arranged by SoFi.
Consequently, many investors may prefer to buy ISAs that fund those with this connection and donate the ISAs to the school, rather than donating to the school directly. Aside from whatever commission might be earned on the transaction, this will get the salesperson involved in conversations regarding charitable gift and estate planning – conversations that often lead to five- and six-figure life insurance commissions.
As recipients of ISA funding progress in their careers and build their net worth, they will probably be inclined to direct their financial services business to those who helped them get their start. Albeit relatively few in number, the investees who become highly successful entrepreneurs and their companies will be in a position to generate significant fees, not only from wealth management and insurance, but also from investment banking and employee retirement plan business.
In addition, the administration of ISAs will create opportunities for investment salespeople to develop relationships with CPAs that may give rise to significant referral business. Investees may be required to execute powers of attorney authorizing the IRS to provide copies of their tax returns to third parties, such as reputable CPA firms, for the purpose of calculating their ISA payment obligations. Inasmuch as recently enacted SEC regulations require verification of accredited investor status, rather than merely taking investors’ word for it, requesting this authorization should not be viewed as an unreasonable demand. To the extent that salespeople are able to steer this business to CPAs who reciprocate in kind, these CPAs will become valuable referral sources.
Federal legislation clarifying ISA guidelines for enforceability, tax treatment, and regulatory interpretation is likely to be passed more quickly than the current consensus would indicate. Though Rubio-Petri’s progress has to date been slow, the bill is likely to generate a great deal more interest as the ISA concept finds additional champions in the financial services industry – an industry sorely in need of new revenue sources with credible claims to generating value for its clients. The growing distress of student loan debtors will provide an additional catalyst for congressional action, though the specifics of the ISA guidelines that are ultimately enacted may differ markedly from Rubio-Petri.
Wall Street encroachment upon this turf may well be interpreted as an existential threat to current operators of crowdfunding platforms. On the other hand, it also offers opportunities to create hybrid – and enormously lucrative – business models marrying their online savvy with the face-to-face sales capabilities of financial services professionals, bringing network effects and the power of community to bear in novel ways.
Bill Matson is the CEO of a stealth crowdfunding startup that will be specializing in human capital equity investing. He is the co-author of Data Driven Investing and may be reached at BillMatson@aol.com.