In a recent interaction at a reputed MBA school, I was stunned to hear a student tell me, “The day I got my placement was the most depressing day of my life.” He further explained that he wasn’t looking forward to a life in cubicles and his heart was in starting out on his own venture. I asked him why he was taking the job instead of becoming an entrepreneur. ‘Student loans’, was the answer.

Unfortunately, he isn’t the only one giving up crucial years of his life to a bank. It is common for older adults to take expensive home loans and then, in essence, give three of the most productive decades of their life to the bank to repay the loan. Student loan repayment schedules ensure that the individual has very little flexibility to take risks and try something innovative. The loss of human potential is borne not just by the individual who compromises on dreams, but also by society that depends on innovation to move forward.

How can we reorient such an essential financial instrument so that we can offer young people the freedom to follow their hearts and talents instead of restricting them? The answer comes from an old idea by economist Milton Friedman: through the proposal of future income contracts, or Income Share Agreements (ISAs).

An ISA is a contract that an investor enters into with borrowers whereby borrowers commit to pay a fixed percentage of their future income for a fixed number of years. Friedman thought this would only become feasible if we figure out how to come up with complex customised agreements and keep track of repayments. While the latter is no longer an issue due to computers, the former has received a big boost with the development of decision analysis.

Of Saraswati and Lakshmi

At Stanford University, Andrew Carver from the Decisions and Ethics Center wrote his 2004 dissertation, ‘Income Collateralised Loans’. Startups were tried using Carver’s idea, including the one I tried with three others. We had to stop at that time because the regulatory climate did not support ISAs.

Thankfully, other people didn’t stop. Germany’s ‘Career Concept’ has been investing in education using ISAs for a while now, as their legal system allowed such contracts. In 2013, the state of Oregon in the US passed a bill to investigate a pay-itforward system where students would attend college tuition-free and then pay a percentage of their income forward to fund future students.

As an ISA repayment involves paying a percentage of current income, the repayment automatically adjusts to the borrower’s current situation. Let’s assume an engineering student agrees to pay 10% of her income over the next 10 years — starting only after she graduates — to her investor, who has put in Rs 10 lakh. If she starts with an annual salary of Rs 6 lakh, she would owe Rs 60,000 the first year (as opposed to Rs 1 lakh in a traditional loan at 10% interest).

As she starts getting raises, her repayments increase. For instance, if she ends up with an annual salary of Rs 25 lakh by Year 7, the investor will annually receive Rs 2.5 lakh.

Now let’s say this engineer, in the middle of her career, gets laid off or wants to take a break. In those months, she will have no income at all. In a traditional loan with 10% interest, she will have to make a repayment of Rs 8,333 a month (Rs 1 lakh a year) even though she may not be in a position to make a repayment. In the ISA, she would owe nothing in the months she has very little or no income.

This protection is the primary benefit to the borrower, where she does not face financial ruin when life takes a downturn. Second, she may get disgruntled with her mainstream career, and decide to become an entrepreneur. The ISA can include entrepreneurial clauses so she can take arisk and defer payments until she is more comfortable, or pay with stock. This would be of great value to the investor, as entrepreneurs can generate high returns when they finally break through.

Even in a situation where the borrower remains in the same job, her career advancement would typically end up giving a higher return to the investor than a traditional loan. Conscientious ISAs would also have a repayment cap — for instance, no more repayment than three times the principal — to avoid exploitation.

Banks Too are Welcome

A financial institution disbursing ISAs will likely share the risk across many investors so that the exposure to a single investor is low. An ISA could be easily set up using decision analysis to be roughly equivalent to a traditional loan with much better benefits to both investor and borrower.

An entrepreneurial opportunity lies for banks to invest in understanding and designing ISAs. They have the potential to free us to follow Howard Thurman’s exhortation, “Don’t ask what the world needs. Ask what makes you come alive, and go do it. Because what the world needs most are people who have come alive.”

First Published in The Economic Times, Mar 17, 2015

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