Human Capital is Not Venture Capital

Human capital investments, such as Income Share Agreements, have been frequently compared to startup equity, in more ways than one. I have personally made the mistake of adopting a view of human capital based on the economics associated with venture — although I now understand why this was not the correct way to categorize the asset class. The most common comparison drawn between Income Share Agreements and equity is that they operate on the same economics as venture capital, especially in terms of something economists and VCs refer to as the “Babe Ruth effect”.

This effect states that a VC only need 10 out of 100 companies to be very successful in order to offset the losses incurred by the other 90 companies in the portfolio and to earn a reasonable return on their investment. This is, of course, a figurative example, as many venture investors, especially angels, do not have a portfolio of this size. Either way, venture works on the principle that a few companies will generate a great return for the portfolio and cover all failed companies. I feel as if it is necessary to make clear the fact that human capital is not venture capital, and they operate based on different economic concepts which makes their comparison unwise.

Venture capitalists expect around 9 out of every 10 startups that they invest in to fail because of the “Babe Ruth effect”. Income Share Agreement lenders and issuers do not expect 9 out of every 10 students that they invest in to return nothing. If that were to happen with someone who invested in a variety of ISAs, it would mean that their investment strategy was off-base and that they had not spent enough time on due diligence. If the issuer was a school who was educating the student, then realizing that ratio would discourage a lot of people to even apply to their school because of the lack of success from students. Schools whose student failure rate was 9 out of 10 would indicate something very wrong with their educational approach, or the relevance of the institution itself is questionable. Venture capital operates on a few outliers earning the returns, but when people look at humans, they want many people to succeed, not just one.

Humans are not companies. Humans are dynamic bodies who have a variety of different complexities that cannot be easily quantified in a spreadsheet. Sure, it can be difficult for startup investors to analyze potential investments due to their early stage, but there are still a variety of accounting practices which can be used to evaluate and predict the financial health of the company. Investors in people would not be able to use any existing accounting principles that apply to companies for a variety of reasons.

Firstly, there is a growing trend toward people moving jobs on a more frequent basis. The average tenure of a software engineer is around two years, which shows just how prominent this effect can be in an area where many ISA bootcamps exist. The income of individuals who were bound to an ISA would vary as they transitioned to different careers, and is not predictable to the extent of companies based on their past earnings history. Lambda School has taken great pride in helping people earn $70,000 per annum who have never earned more than $25,000 per annum, which shows just how difficult it can be to predict the outcome of a person’s income, especially where the incentives of the institution are aligned with the individual through an ISA.

Humans do not react like companies either. Humans do not have a board of directors, and ISA issuers cannot make decisions on behalf of the individual or force a certain outcome on their investment by restricting their employment choices. People are free to do whatever they want, and therefore the value of an ISA could be nothing if somebody chooses to pursue a career which pays a very low amount — for example, they go to work at a non-profit. This may mean that the individual has found their passion, which is a secondary aim of ISAs, however, it also highlights the fact that the state of an investment can change very quickly depending on the individual’s thoughts. Further, individuals can easily make impulsive choices which could end up affecting the value of the ISA in the end, whereas companies would normally need board approval from investors before making any radical changes.

Human capital returns through ISAs, unlike venture returns, are capped at a certain limit. Income Share Agreements have a capped return which is represented as a multiple of the initial investment (1.5x-2x are the most common), and therefore the upside on this investment class is limited. Venture capitalists stand to make millions — potentially billions — if they invest in a company that becomes the next Facebook or Lyft. Those that issue ISAs can only earn a certain amount even in the best circumstances where the person becomes very successful. Therefore, venture economics of large multiples and the “Babe Ruth” effect cannot possibly apply because investors can only make so much, and there is no equivalent of a human “unicorn” in the current ISA landscape. This was implemented for an important reason — to ensure that people don’t pay back more than they should — although this issue deserves an essay of its own. [1]

To unpack this argument further, Income Share Agreements have been carefully articulated to ensure that lenders do not have pay to back a disproportionate amount of money. Therefore, the expectation of human capital investments yielding a return similar to that of investing in venture-stage equity should not be made. ISAs will never yield a return of 100x their initial investment, for the reasons aforementioned. The returns realized by an ISA could be compared to that of debt — they are good, but not like equity. This is important to note because investing in an ISA should not be purely about profit expectations because, after all, many different asset classes such as hedge funds will be able to earn high returns that are relatively consistent year-over-year. Overall, this highlights the issue with calling ISAs “equity-like”. Indeed lenders only pay back money if they succeed, like equity, but there are still fundamental differences in the economics behind the two arrangements. [2]

There are a few reasons why comparing ISAs to venture capital will have serious consequences on the future of the asset class. The most important being that a venture capital classification would mean that large profits are required in order for the asset class to be successful. In a sense this is true, as investors want to realize at least some profit because it is correlated with the success of the individual — the higher the return, the more successful the individual has been.

A large motive behind investing in the asset class is the ability to invest in a person at their earliest stages and join in their journey toward reaching their full potential. This is present in venture capital too because investors want to see companies succeed, but when you are investing in a human there is a personal dynamic added to this effect. People want to see people succeed. There is a stronger attachment to the investment than in venture. VCs may decide to redirect their time towards portfolio companies that are on a strong trajectory for success — but they are working with companies. If you have invested in a person, there is an emotional aspect to consider. If a person succeeds, it can generate great feelings of liberation and satisfaction. However, if a person does not succeed, it can be more difficult to process because the underlying security is a person — not a corporate entity.

One major large source of capital in the future for ISAs will be from the crowd or friends and family, which will formalize an arrangement of raising money for one’s education or startup that already exists today, with an added monetary incentive for people to invest. These people want to invest not because of the possibility of returns, but rather the ability to see someone grow and succeed.

Schools using ISAs have a similar non-fiscal motive: the more people that succeed, the better their reputation will be, which will help them in attracting new applicants for their institution in the future. Many human capital investments in the future could be made based on the fact that they see a “spark” in the person and feel as if there is a massive amount of untapped talent that could be accessed in the individual — irrespective of their past financial history. In contrast, in venture, if a company has poor financials then most respectable firms would stop pursuing the company for prospective investments. [3]

The fact that people are thinking about human capital in terms of venture capital is not irrational, however. Income Share Agreements and human capital investments are very new. Indeed, companies like Lambda School and Make School have only been operating for a few years, and we are yet to see comprehensive reports on the long-term viability of ISAs at scale. Because there is a lack of data, it can be easy for people to make unintentionally false characterizations of the nature of human capital investments. This effect will remain until the point where enough studies have been done to showcase the true value of human capital investing that reinforces what we have seen from companies like Lambda School, but at a larger scale.

Income Share Agreements have evolved a lot from Milton Friedman’s initial theory that one could “buy a share” in one’s future earnings prospects, in exchange for financing their education. The fundamental concept still exists, although it has taken many different experiments in order to reach the point where we are today. Yale University’s Tuition Postponement program was the first modern-day implementation of an ISA-like arrangement, which ended up failing due to the uncapped returns and overall structure of the program. Since then, companies like Upstart and Lumni, and more have tried to leverage ISA-based arrangements, and have improved on the model each time.

The relevance of this is that human capital investing is changing so much that if we continue to compare it to venture capital, then there is a high risk of the asset class becoming less attractive. ISAs are very interesting arrangements which could become a very popular alternative to debt in the future — and have even broader applications as well — and their constant evolution means that we need to make clear the difference between human and venture capital before ISAs reach a critical mass. If we continue to think of human capital investments as venture capital investments, that may shape the future regulatory and social landscapes on which the growth of investing in people is dependent.

Many of the current criticisms of Income Share Agreements and other similar economic arrangements are based on the perception that they operate very similarly to venture capital. This view can obscure the true value of ISAs and human capital investments and also creates a trend where people are more focused on the prospects for profit, rather than being able to help someone achieve their goals and live a great life in the process. To be clear, this essay does not advocate for the specific flaws which are realized by human capital investing. To the contrary, I am merely stating the case for referring to human capital as its own independent asset class that is economically different from venture capital.

It is vitally important that people understand that ISAs have their own set of potential issues — adverse selection (although there has been none proven thus far), recovering money from those who lie about their salaries, et cetera — and that looking at human capital as if it is venture capital will mean that these issues don’t get the attention that they need in order to be properly addressed. It makes sense why people compare human capital to venture capital, especially due to the nascent stage of the idea of human capital investments at scale, but they are two different concepts, each with their own intricacies, benefits, and problems.


[1] There has been an increasing interest in capped-profit companies, jumping on the trend started by OpenAI in order to ensure that people were fairly compensated for their work while allowing the organization to retain their focus on curtailing the potential negative effects of Artificial General Intelligence in the future. Perhaps “impact-focused” venture capital firms will experiment with this structure as well, although this does not affect the argument of capped ISA returns.

[2] “equity-like” is still a good explanation of ISAs in comparison to debt based on the fact that there is no consistent repayment schedule that does not account for changes in circumstance, like debt. I merely caution against using this to describe ISAs from an economic standpoint, because the economics behind the two are different and it is important to make that clear for those who are potentially entering into one of these agreements.

[3] Equity investments involve a significant amount of risk, which is why venture capitalists can be very cautious when it comes to investing in a company. The total value of an ISA will be less than the millions pledged in a venture investment, and thus there is less risk. This is another issue with referring to ISAs as “equities”, as people may draw the comparison that ISAs embody equity-like risk with lesser returns than can be realized in other asset classes. Investors cannot discount the main benefit of investing in a person: joining on their journey toward success and helping them along the way.