By Bill Matson, CrowdFundBeat Sr. Contributor, MBA, CFA, CPA (Retired), CFP
The presidential race has game-changing implications for the future of crowdfunding in general, as well as for the democratization of individuals’ access to financing via crowdfunding. In particular, Senator Marco Rubio’s presence in the race is likely to generate significant media attention for his promotion of income share agreements (ISAs) as a means of alleviating the current student loan crisis.
Though ISA legislation sponsored by Rubio was entitled the “Investing in Student Success Act of 2014,” its enactment would result in virtually anyone being able to offer shares in their future personal income (i.e human capital) in exchange for immediate cash. Much of this activity would be transacted through crowdfunding venues.
The sums at stake are potentially huge. Miguel Palacios Lleras’s 2004 book, Investing in Human Capital, envisioned: “A global market where the value of Human Capital can be traded, in different forms, either directly or through derivative securities.” Given that the total 2006 dollar value of U.S. human capital was estimated to be in excess of $700 trillion by International Monetary Fund economists (di Giovanni and Matsumoto), it is clear that the global market suggested by Lleras could be enormous, even if only a tiny percentage of it ever becomes securitized and tradable.
Inevitably, widespread investment in ISAs would lead to greater connectedness between the ongoing fortunes of the financed and their financiers for years, if not decades, at a time. Whereas few investors in publicly traded companies are able to materially affect their companies’ fortunes, ISA investors can create tremendous value by providing mentorship, business introductions, and other assistance to their investees. Metaphorically speaking, ISA buyers and sellers are joined at the wallet, leading these transactions to be dubbed “Siamese Cash” deals.
The notion of unwashed masses having the ability to, in essence, print and spend vast amounts of Siamese Cash may seem highly inconsistent with commonly held perceptions of an anti-populist GOP. It is, however, 100% consistent with the free market philosophies at the heart of conservative ideology, being the brainchild of Milton Friedman himself.
In his 1962 book, Capitalism and Freedom, Friedman advocated “equity investment in human beings”, seeing this as a means of “strengthening competition, making incentives effective, and eliminating the causes of inequality.”
Only time will tell which candidates other than Rubio line up in favor of ISAs and which consider them existential threats to the republic. In any case, we can look forward to hearing a lot more about them in the year ahead.
Rubio’s Prospects for Influencing Political Dialogue
As of late May, Rubio has emerged as a strong contender for the 2016 GOP presidential nomination, in a five way tie for the lead according to a Quinnipiac University poll of Republican voters whose results were released on May 28.
Quinnipiac pollsters also sampled the general electorate in pitting four of the top five Republican contenders in head-to-head matchups with Hilary Clinton. Among the four, Rubio led in terms of ability to compete against Clinton, trailing by 4% (45%-41%), with Huckabee, Walker, and Bush falling short, respectively, by margins of 7%, 8%, and 10%. (Dr. Ben Carson, the other co-leader, was not among those matched against Clinton.)
Though the GOP nomination remains up for grabs, Rubio’s solid showing to date strongly suggests that he and his policy ideas will figure prominently in political dialogue throughout the presidential primary season – and possibly beyond. Given Clinton’s current status as the prohibitive favorite for the Democratic nomination, the GOP race is likely to receive the lion’s share of media coverage for the next year or so, as are the proposals of viable Republican candidates, including Rubio.
By clarifying guidelines for ISA enforceability, as well as eliminating a variety of other ambiguities in the law, the Investing in Student Success Act seeks to enhance investor and consumer protections. Chances are that such measures would lead to a boom in ISA transactions.
Let’s now consider in depth what Rubio has proposed, as summarized by the Congressional Research Service (CRS) of the Library of Congress, which (according to congress.gov) “works exclusively for the United States Congress, providing policy and legal analysis to committees and Members of both the House and Senate, regardless of party affiliation. CRS provides Congress with analysis that is authoritative, confidential, objective, and non-partisan.” (I’ve taken the liberty of underlining “other purposes” because these words greatly expand the scope of his proposal’s applicability.)
Investing in Student Success Act of 2014 – As summarized by the CRS
“Investing in Student Success Act of 2014 – Declares that income share agreements that meet this Act’s requirements are valid, binding, and enforceable contracts that are not subject to state usury laws or state laws regulating assignments of future income.
Defines an ‘income share agreement’ as an agreement between an individual and any other person under which the individual commits to pay a specified percentage of the individual’s future income, for a specified period of time, in exchange for payments to or on behalf of such individual for postsecondary education, workforce development, or other purposes.
Requires such an agreement to:
* specify the percentage of future income the individual will be obligated to pay, but it must exempt, at a minimum, the first $10,000 (adjusted annually for inflation) of income each year;
* specify what will be considered the individual’s income;
* prevent the individual from obligating more than 15% of the individual’s future income toward such agreement;
* specify the maximum period that an individual will be obligated to make payments, not to exceed 360 months (excluding any period during which an individual’s income was below the agreement’s exempt amount); and
* specify the terms and conditions for early termination of an individual’s payment period.
Requires individuals, before entering into such an agreement, to be provided with a document that clearly and simply discloses:
(1) the terms of the agreement,
(2) that the agreement is not a debt instrument,
(3) that such individual may be required to pay more or less than the amount received, and
(4) that an individual’s obligations under the agreement are not dischargeable in bankruptcy.
Prohibits such agreements from being construed as giving the contract holder any rights over an individual’s actions.
Excludes payments that are made under an income share agreement from the individual’s gross income for tax purposes.
Amends the Internal Revenue Code to include income share agreements as qualified education loans, but denies the deduction for interest paid on such loans.
Prohibits amounts individuals receive for entering into an income share agreement from being included as income or assets in the computation of the expected family contribution for any program funded under the Higher Education Act of 1965.
Amends the Investment Company Act of 1940 to exclude any person from being treated as an investment company if substantially all of that person’s business is confined to making income share agreements.”
Siamese Cash Mechanics – An Example Consistent with Rubio’s Proposal
An entrepreneur, for example, could agree to a ten year commitment obligating her to pay an administrator of ISAs (an AOI) up to 10% of her annual taxable income over a $100,000 threshold. The AOI would be responsible for recordkeeping, as well as for marketing the entrepreneur’s ISAs, typically through crowdfunding venues.
Consistent with guidelines proposed by Rubio, the threshold amount would be adjusted annually for inflation. The entrepreneur’s payments (less the AOI’s fee) would then be distributed by the AOI to those who invest money in her or otherwise support her business ventures (or support her career as an employee if her business fails).
She would credit her supporters with what we’ll call “Siamese Dollars” (SDs). Up to a total of 1000 SDs per month, for example, might be available for these awards.
Though awards of SDs would be made at her discretion, imposition of a monthly limit on these awards would be essential. Investors could take comfort in knowing that the number of SDs outstanding at any given time could never exceed a pre-defined limit. Thus, there would be no chance of a printing press-driven, Weimar Republic-like hyperinflationary scenario diluting their value. Unlike virtual currencies such as Bitcoin, her SDs would be backed by real economic substance: i.e. her future earnings potential.
In years when her income exceeds the threshold amount, the payments she makes to the AOI would be distributed (net of the AOI fee) to her investors in proportion to the cumulative number of SDs she has awarded each of them over time.
If there’s a month when she’s getting little or no support, she may decide to award them less than 1000 SDs – or none at all. This would reduce her future obligation to pay the AOI. Note that she is obligated to pay “up to” 10% of her above-threshold taxable income. If nobody ever gave her support worthy of SDs, she would never have to share any of her income with the AOI.
Assume that the AOI keeps 10% of her payments as its fee. If she has inflation-adjusted taxable income of $200,000 per year for the next ten years, each SD she awards this year will earn her investors roughly $2.20 plus inflation between now and the expiration of her commitment. If that income assumption is raised to $1,000,000, each SD’s expected payout increases to almost $20.
Note that the monthly limit on awards serves to limit our entrepreneur’s potential losses from ill-conceived deals and/or exploitation by unscrupulous “supporters.” If she makes a questionable, monthly maximum 1000 SD award in the first year of her commitment, the loss arising from it will total about $2200 in inflation-adjusted dollars over ten years – only 11/1000 of 1% of her total taxable income.
ISAs – Societal Risks and Benefits
Concerns have been raised that ISA exchanges 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.”
Inasmuch as any unsecured debt constitutes a claim on the debtor’s future earning power (i.e. human capital), one can not logically argue that all human capital contracts equate to indentured servitude unless one is also willing to concede that unsecured debt is synonymous with indentured servitude. Being an active credit card user who zeros out his balances every month, I can’t say I’m particularly bothered by Bank of America’s claims on my human capital.
Perhaps it is best to recognize that ISAs, like other forms of unsecured obligations, may occupy a spectrum ranging from highly beneficial to the obligor to downright abusive. If one believes Rubio’s proposal creates excessive potential for consumer abuse, might it not make more sense to explore opportunities for mitigating this risk than to dismiss the underlying concept out of hand?
The framework of his proposal offers much potential for compromise. For example, a formula that allows for 15% caps with shorter durations might be in order. Or maybe 30 year durations with lower caps.
The possibility of raising the $10,000 exemption constitutes another area ripe for negotiation. 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.
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 a requirement that:
Income share percentage, subject to 15% maximum
ISA duration, subject to 30 year maximum
Square root of exemption, subject to $10,000 minimum exemption
must be equal to or less than x.
The maximum “x” allowed by the Rubio bill would be (15 x 30)/100 or 4.5. Keeping two 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.
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, the financing of entrepreneurial ventures, coping with the loss of a job, or paying medical bills.
Whereas few of us have the ability to add significant value as activist investors in publicly traded business, many of us can make a meaningful difference in the life of someone with potential likely to go untapped. “The Blind Side” (both the book and the movie) offers an extraordinary real life example of this. Unfortunately, similar stories are rare – unless one counts scholarship athletes plucked from ghettos by college coaches – largely because opportunities are lacking to financially profit from setting the lives of disadvantaged individuals on productive paths.
Admittedly, the value of degrees earned by college athletes from disadvantaged backgrounds is often questionable. Nevertheless, it is instructive to note that their opportunity to pursue higher education is generally attributable to the profits and alumni donations their talents can generate for the colleges who give them scholarships.
Other things being equal, if the profit potential of doing something is increased, more of that something will get done. It follows that creating financial incentives for helping others survive and succeed must inevitably lead to more help being given.
To the extent that controversy regarding income sharing exists, it boils down to conflicting assumptions regarding Americans’ ability to survive without government regulations to save us from our own stupidity. In other words, under what circumstances does the amount of societal benefit to be derived from giving us greater access to our future earnings outweigh the societal cost of us doing stupid things with it?
Bill Matson is the CEO of INTERKEX, the International Karma Exchange division of BrainFutures.com, Inc., a community that monetizes the exchange of favors through crowdcasting, gamification, and innovative financial arrangements. Bill is the co-author of Data Driven Investing and may be reached at BillMatson@interkex.com.