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Niels Hoven

Income Share Agreement Incentives and Dynamics Part 1: Consumers

In recent months, income share agreements (ISAs) have captured the imagination of the tech world. ISAs make higher education accessible to disadvantaged students by charging no upfront fees, and allowing students to pay instead with a fixed percentage of their future income. Lambda School, one of the best known coding schools with an ISA model, reports that their average incoming student has an income of $22,000, and the average graduate increases their income by $47,000.

In these next few essays I’m going to be discussing the impact ISAs will have on the education market, primarily as a result of the incentives they create. My tentative plan for the series is as follows:

  1. The customer perspective – How demand for ISAs will evolve
  2. The company perspective – How ISAs shift company strategy
  3. The operator perspective – Key metrics for ISA product teams

This essay explores the customer perspective (i.e. the demand side of the market), introduces a framework for thinking about ISAs, explains current market trends, and makes some predictions for how the market will evolve.

What are ISAs?

Most articles describe ISAs as an innovative funding mechanism. On the other hand, some pedants like to say that they’re nothing novel – just standard financial instruments under a new name.

If you find “unsecured loan with a forgiveness clause, variable performance-based payback, and no covenants” more intuitive, good for you. You are not this essay’s intended audience. For the rest of us, ISAs are a little bit like a loan with a money-back guarantee:

  • If you fail to get a good job, your loan evaporates and you owe nothing.
  • If you get a good job, you pay back your loan.
  • And if you get a really high-paying job, you pay back your loan, plus a generous tip.

ISAs’ immense traction so far is primarily because of the “money back guarantee” aspect. Removing the downside risk has made programs accessible to a huge but previously untapped market of potential students.

Capitalizing on uncertainty

ISA are most appealing to consumers when there is high uncertainty in a system. For a consumer, this manifests as uncertainty about what results they can expect. The root cause of this uncertainty can stem from many potential sources, such as:

  • Uncertainty about the effectiveness of the product being purchased
  • Uncertainty about one’s own ability
  • Uncertainty about changing market conditions
  • Uncertainty due to inherent randomness

In the case of a coding bootcamp, for example, students may have doubts about the value of the program. This could be concerns about the quality of the program, or simply unfamiliarity with the value of software development skills.

Uncertainty about one’s own ability is also a compelling reason to opt into an ISA. Even if a program has a 95% success rate, there’s always the lingering doubt of “what if I’m that last 5%?” Being liable for a $20,000 loan would be crushing for someone already in a difficult financial situation. Paying with an ISA removes that risk.

Additionally, some products simply have inherent randomness involved. As a thought experiment, imagine someone selling lucky four-leaf clovers that increased your chances of winning the lottery by 1%. With a $100 million jackpot, one of those clovers would be worth about a million dollars, but you would be hard pressed to find someone willing to pay that. On the other hand, purchasing a pile of clovers by promising to share your future lottery winnings is a very compelling proposition.

There is similar randomness/uncertainty in salary negotiation. Due to the number of unknowns in any given situation, it’s hard to know in advance how strong a candidate’s negotiating position is. Sometimes a negotiation results in a few thousand dollars for the candidate, and sometimes it results in hundreds of thousands of dollars. As a result, it’s hard for coaches to name a one-size-fits-all upfront price. Paying with a percentage of the post-negotiation upside makes more sense for most clients.

The future of the ISA market

The appeal of ISAs in high uncertainty situations brings up one of their most interesting dynamics.

Ironically, the more successful a school is, the fewer students will opt into an income share agreement. If every class has 100% employment guaranteed, then there’s no risk in just paying with a standard loan.

When uncertainty is low, students see less value in downside protection. And if they’re confident that they’ll land a high-paying job, they would actually prefer to pay a flat fee, rather than something based on their income.

This tendency is known as “adverse selection”, and refers to the fact that ISAs have the most appeal to the students who are least likely to be able to pay them back. Income-based repayment is also least appealing to students who expect to land high-paying jobs.

“The target audience is people who are focused on financial optimization but don’t plan to make a lot of money, and I am not sure how big a group that is.” – Matt Levine

In my opinion, this problem is wildly overblown, as it is mitigated by just offering both upfront payment or an ISA as payment options, and letting students opt into whichever payment method they prefer. I think the much more interesting market dynamic will be the declining proportion of students opting into ISAs at each school as their programs result in more and more reliable successes.

Rather than a dominant payment option, what ISAs will become is a strong signal of a school’s effectiveness. The simple availability of an ISA payment option will be a means for schools to signal their confidence in their own program, even as the fraction of students opting into the ISA declines. Over time, the lack of an ISA payment option will become a red flag, alerting potential students that a program has unreliable results.

Schools will have to offer ISAs to maintain their credibility, but it’s not as simple as just adding a new payment option. Businesses offering ISAs must recognize how fundamentally it shifts their incentives and day-to-day operations. I address this in Part 2.