The Case for Unlimited ISA Upside

Over the last few weeks, I have been listening to the audio recordings of the Life Capital Conference in SF (unfortunately, I was not aware of its existence until after the event). An interesting thought that I took away from the panels has been the implementation of return caps in Income Share Agreements, which limit the amount of upside an investor can generate from a specific ISA if the person is very successful. This limitation has been implemented into modern-day ISAs with good reason — to protect people from repaying disproportionate amounts of money — although as I will discuss further in this essay, there are a few problems with the return cap.

The “return cap” for an Income Share Agreement is typically represented as a multiple of the initial amount borrowed, for example, if you have borrowed $10,000 you may be bound to a multiple of 1.5x. In this scenario, this means that if the borrower is very successful, they are only liable to pay $15,000 for the initial amount borrowed, and nothing else. There is a historical precedent which states the importance of these return caps, which I will delve into further in this essay. Return caps are likely to be one of the most well-debated topics in the Income Share Agreement landscape, and there are good-faith arguments on both sides that state both the necessity and the burden of this legal term.

An example which best illustrates the problem of return caps is commonly referred to as the “Jeff Bezos problem”, although you could technically substitute the name for any very wealthy person. The idea behind this problem is that if an investor has entered into an ISA with Jeff Bezos when he was 18 and going to college, then they would make money if he were to succeed. However, the return cap would mean that Jeff Bezos would only repay a small multiple of the ISA, as aforementioned, which would not at all be proportionate to his overall net worth at the current moment. The issue here is that if somebody has taken a large risk in investing in Jeff Bezos before he was successful, then why should the return cap be instituted which limits the return on the ISA to be very small in comparison to the overall worth he has generated.

In 1971, economist James Tobin — who later earned a Nobel Prize — theorized a scheme that would allow Yale University to raise tuition without discouraging too many students to apply. He was given this task by the Yale management who wanted to significantly raise fees and was concerned that it would add additional burden onto students to the point where some may drop out, be unable to cope with stress, or otherwise suffer from the change. In the end, Tobin developed the Yale Tuition Postponement Option (TPO), which allowed students to defer part of their tuition until after they had graduated and were earning a certain amount of money. In total, around 3,900 students enrolled in the Yale TPO program.

Eligible undergraduates could enter into the TPO and join a “cohort” or a batch of people who committed a portion of their future income in exchange for repaying their student loans. Those who registered to repay their student loans were required to pay four percent of their annualized income for every $1,000 that they had borrowed until the debt of the entire group had been paid off. The idea behind this was that by allowing people to defer payment to the point where they were earning a good salary after college, then they would not be burdened with the additional stress associated with the rise in tuition fees.

There were a few issues with this model. The first being that those who earned high salaries could buy out of the batch early by paying 150% of what they borrowed plus any accrued interest. This meant that the wealthier people who earned more money could leave the fund early and therefore not be subjected to the requirement of paying back a certain percentage of their future income. The poorer members of the fund who could not afford to buy out early started to default on their loans, and because the richer students had bought out of the fund, they were left to manage the debt burden for the remaining fund members. In essence, those that were poorer were left with a disproportionate amount of debt which they could not repay — there was no return cap.

Ultimately, the Yale TPO program failed. Decades following the creation of the fund — some students reported returning money 35 years after they had borrowed it — Yale started to forgive the debts of the people who had enrolled in the program. Yale also issued refunds to those who bought out their loans and were still paying money and required those who had defaulted to make up for the money they had lost. There are a few other reasons why the Yale TPO failed, although they are outside of the purview of this essay. [1]

The main lesson that we can learn from the Yale TPO was that because they did not institute a cap on the amount that people returned, and because people could buy out of the fund early if they had enough money, lower earners were left to repay a disproportionate amount of debt. This event has been largely attributed to being the first instance of ISAs being used that somewhat resembled the modern day ISA. The Income Share Agreement-based programs that were created following the ISA by other parties started to institute a return cap which meant that students would repay a fair amount of money to the fund, and other structural terms were also changed to make the documents more student-friendly.

Modern-day ISAs continue to use return caps to prevent against a Yale TPO situation from occurring again. One of the major reasons that return caps were required was that the Yale TPO program had created a lot of skepticism around the concept of ISAs — although it was the structure to blame — and therefore newer ISA issuers wanted to ensure that students could trust their services. Most return caps are in the 1.5-3x multiple ranges on the total amount borrowed from the lender.

This number ensures both that the lender can make back more money from the students that are very successful, and also ensures that if a borrower is very successful, they are not obligated to make continuous payments to the lender. Because of the nascent stage of ISAs on the modern market — which is now used by companies like Lambda School and the University of Utah — extra precautions have been taken to limit the upside and to ensure that negative publicity of these documents is limited. ISAs present the potential to democratize access to opportunity and help lenders attract new applicants for their programs, and return caps have been necessary to protect this vision. [2]

This shows the importance of the return cap in protecting people, but what about the Jeff Bezos problem? The solution to this problem is not to remove return caps, because that would likely result in some people paying back disproportionate amounts of money, and thus blurring the differences between debt and ISAs, which resemble equity in some senses. Rather, ISA issuers could instead reserve pro-rata rights to invest in the individual’s company if they were successful. This would mean that instead of repaying the rest of the debt owed to the lender, an individual could give an ISA issuer the ability to invest in the next round of their venture.

There are a couple of benefits to this model. Giving ISA issuers pro-rata rights means that they have the option — but are not required — to invest in the individual’s latest company. If the individual is on a strong trajectory for success, then this option allows the ISA issuer to join the journey of the individual more intimately, and they will be further incentivized to provide advice to the individual regarding their company, as well as themselves as an individual. If an ISA issuer invests in the individual’s next round, they may also be able to secure a board seat which means that they can get even more involved with the individual’s work and offer additional advice to ensure the company and the individual succeeds.

The overall goal of this would be to closer align the incentives of the lender and the borrower and give entrepreneurial individuals the ability to repay their ISA through allowing lenders to invest in their company if they succeed. The investor would be more closely affiliated with the lender’s entrepreneurial endeavors, and if they provided more advice to the individual, the company has a higher chance of succeeding. This could perhaps be at a discounted rate depending on the amount left on the ISA which would provide an additional incentive for ISA lenders to invest in the company. By investing in the company, the investor stands to make significant gains if the individual succeeds, which would not be capped at any limit. If the company is acquired or goes through an Initial Public Offering, the investor could stand to make millions — or even tens or hundreds of millions — in exchange for investing in the young person further. [3]

A secondary effect of giving ISA lenders pro-rata rights to invest in a borrower’s next venture would be that it would allow them to protect their investment. If an individual has decided to pursue a career as a founder rather than as an engineer like they initially intended, then the investor benefits from some protection as they can invest in the individual’s entrepreneurial endeavor. In the first few months or years of a company, founders take very low salaries, if any, due to the limited amount of capital available. What they do earn is typically reinvested into the business in order to succeed. Therefore, if a borrower graduates from college and starts a company, the ISA issuer would stand to make very little due to their reduced expected salary. ISA issuers cannot control the individual’s career choices, but pro-rata rights would give them an additional mechanism to earn returns without interfering with the individual’s liberties.

Of course, this model only applies to those who pursue entrepreneurial positions — upper-level management and CEOs. People pursuing a career in medicine, mathematics, engineering, or any other subject matter will not be able to exercise this option. However, most billionaires (and millionaires, for that matter) have earned their money through some entrepreneurial endeavor, and so giving pro-rata rights to Income Share Agreement lenders would represent an adequate solution to the Jeff Bezos problem. Another possible alternative would be to allow ISA lenders to convert the remainder of their ISA to equity in the business. The difference between equity conversion and pro-rata rights would be that instead of being given the right to invest more money into the ISA lender’s company, investors could instead forgive the ISA and take back equity in return.

An added protection that may need to be added into the equity conversion mechanism would be that the ISA lender must consent to the conversion before it happens, or they will continue to pay back a portion of their future earnings to the ISA issuer. This would ensure that the lender could not take part of the founders’ equity if the individual doesn’t think that they would provide value to either themselves or the company if they were to become more closely involved. The main benefit of this model would be that, as with giving investors pro-rata rights, investors would be able to benefit from the significantly larger upside. If an investor takes 2% of the founders’ equity in the company at an early stage, they could stand to make very large gains if the company goes through an exit. Therefore, the value of their ISA would be more closely correlated with the individual’s entrepreneurial path — the lender only earns a return if they help guide the company to success. [4]

I must also add a word of caution regarding the exploration of these more ambitious terms in Income Share Agreements too soon. The values of equity conversion or granting pro-rata rights to investors are clear: to allow them to benefit more from helping the individual succeed and ensure that their ISA is more closely correlated with the success of the individual. However, ISAs are at a pivotal moment wherein companies must operate under a strict set of best practices in the absence of a firm regulatory framework in order to demonstrate the true value of these documents. This must be done before we start to explore additional terms to help investors because any negative publicity will have a large impact on the growth of ISAs. These provisions have promising prospects, but perhaps we need to gather more data on the benefit of traditional income-based ISAs before exploring equity-based clauses for entrepreneurs.

In sum, the aforementioned options aid in achieving one main goal — helping increase the flow of capital into Income Share Agreements. One of the major problems of ISAs in the future will be sourcing enough capital to make the model viable, and so adding additional incentives to encourage people to invest in others may help increase the potential flow of capital into the asset class. At this stage, it is unclear whether equity-based or pro-rata-based provisions will result in adverse selection, although if implemented in all ISAs, it would allow investors to benefit in the case that any portfolio individual becomes an entrepreneur, not just those studying towards an MBA.

It is clear that removing return caps outright may subject borrowers to restrictive terms that impose on them large repayment burdens which they cannot handle. Implementing provisions such as equity conversion or pro-rata rights allow investors to more closely correlate their financial returns with the success of the individual while joining in on their exciting journey. Giving ISA lenders equity in an individual’s company would give them more “skin in the game”, and therefore they would be incentivized to provide more hands-on support to the founder and the company. Although these options must be used with caution while ISAs are still in an early stage, they are very interesting provisions that recognize the specific intricacies of entrepreneurship and help solve the Jeff Bezos problem. There may be other options to help increase the amount of upside that investors have access to without compromising the individual’s rights or the spirit of ISAs as well, although equity conversion and pro-rata rights seem to be the most logical at this stage.


[1] It is worth noting that all prominent companies that issue ISAs have taken inspiration from the student loan industry regarding how to appropriately structure disclosures that ensure that students understand the agreement before entering into one. One of the most common strategies these institutions are using is to issue a disclosure sheet to those considering an ISA and to provide general advice regarding the risks of ISAs.

[2] At the time, Yale did not expect the program to yield such poor results and impose a disproportionate amount of debt on less wealthy students. Perhaps the best lesson we can learn from Yale is how not to structure future ISA programs, and their work did emphasize the importance of return caps, and so the program was not a complete failure.

[3] The adoption of these models would also require more logistical maintenance — equity valuations, fundraising notifications, et cetera. If these models were to become more popular, there could be room in the market for a company which helps both parties stay compliant with these terms. The company could act as an intermediary between the lender and the borrower and ensure that the borrower was sending the right information and at the right times to the lender.

[4] An interesting question to consider would be what if the company failed. Equity conversion would mean that the lender would forgive the debt in exchange for a portion of the founder’s equity. Therefore, if the company failed then the debt would no longer exist and the founder would owe nothing to the lender. I am not sure how we could prevent people from starting companies to mitigate debt, other than by stating that it would be at the discretion of both parties to enter into the agreement to convert equity. This would ensure that people did not try to use this as a mechanism to have their ISA forgiven, but there are still a few other issues to consider as well.