Over the past few years, there has been a lot of buzz around ISAs (income Share Agreements) in the tech-world, with projects like Lambda School and PandoPooling leading the charge. Concurrently, with the sudden disruption of college life due to COVID-19, students have been frustrated at having to pay the same tuition fees upfront without the expectation of a rigorous academic experience. Colleges themselves have had to adapt to online classes, which then begs the question — does an Ivy league education warrant a 10x (or more) price markup to Udemy/Coursera, especially when the risk of finding a job post-graduation is completely borne by the students, leaving students with crippling debt for almost a decade after they graduate? A quick look at student loan debt statistics over the past few decades shows a pretty startling story.
Colleges do not bear the responsibility of guaranteeing jobs for graduates, although that is a critical reason why a majority of students choose to go to college in the first place. It has become abundantly clear that the risk/reward of a college education has worsened significantly over the past two decades and ISAs are one potential answer to the problem of transferring the risk of finding a job to the education provider.
In this article, we motivate a larger framework of Capital Exchange Agreements (CEA), encompassing ISAs and other forms of capital exchange. We highlight the need for liquid CEA markets and providers with a discussion of Human Capital and the transfer of risk as one makes decisions in their life.
Introduction
For most of recorded human history, the primary concerns of life for the majority were intricately related to survival — food, clothing, and shelter. Rudimentary metrics such as the percentage of the world in extreme poverty and the average lifespan of healthy adults reflects the general state of the world. Humans have (on average) healthier, wealthier and (hopefully) happier lives today.
We are now living in a time when primary concerns at the bottom of Maslow’s hierarchy of needs are taken care of for over 80% of the world (by conservative estimates, see graph).
While this is great news for the world, we are now left with the question of how we can live an optimal life that is regret-free and have the means to make decisions that are not limited by constraints on our current conditions (with respect to physical location or resources).
While it may be hard to accurately quantify a “happy” life, we can take large steps toward the direction of quantifying the change in the resources (capital) accrued by a single individual. This leads us to the discussion of “human capital,” an important concept in economic and psychological literature.
The original idea of human capital can be traced back to the 18th century in the writings of Adam Smith, but the modern theory was popularized by nobel laureate economist Gary Becker. As he emphasizes, “Education, training, and health are the most important investments in human capital.” And while initially obvious, “Many studies have shown that high school and college education in the United States greatly raise a person’s income”. What is non-obvious, however, is that “…even after netting out direct and indirect costs of schooling, and even after adjusting for the fact that people with more education tend to have higher IQs and better-educated, richer parents,” the studies indicate that investment in higher education leads to an increase in income that offsets the cost of education. While this trend has been oft-cited, there has been a recent divergence between the payoffs from a college education (increase in job-market value) and the cost of the education itself.
At this point it is relevant to address whether an increase in income actually leads to an increase in general self-reported life-satisfaction. While it has often been argued that richer people are not necessarily happier, the evidence from larger scale studies suggests otherwise.
As can be observed from the graph, one of the main reasons we fail to see a correlation between wealth and happiness in everyday life is because the wealth needs to increase exponentially for a noticeable effect in self-reported satisfaction.
Our primary proposition with respect to the graph above is that the notion of GDP is too constraining when considering the capital of an individual human and to really correlate happiness to wealth, we must instead consider the notion of human capital in addition to wealth. We henceforth refer to the standard notion of wealth (stock options, real estate, currencies, etc.) as “tangible capital.” We can then separate the notion of tangible capital from that of intrinsic human capital:
C = Tangible capital
Human capital ‘H’ = f(t,k,s), where:
K = Knowledge Capital , S = Social Capital , T = Time remaining
And combining the two notions, we have:
Net Capital = H + C
A quick note: Social capital here refers to the intangible asset of connections to other people, whether it be real or online. The validity of online connections being a valid form of human capital has been confirmed with the rise of social media (Instagram influencers, thought leaders on Twitter, viral stars — Kim Kardashian). Knowledge capital is more easily understood and can typically be thought of as a function of the skills (and signaling) accrued via education and training (college and advanced degrees, coding bootcamps, etc.).
Risks
As we go through life, we face a variety of life events that require careful thought and consideration as we build up our personal human capital. These events bridge society, family, education, career, health, and values (and other intangible concepts). We can also view them as “human capital risk factors.” Some natural questions that arise:
- Are there expectations, implicit or explicit, that family and society have brought forward to the youth such that they must meet a minimum threshold of success? (Eg. High percentage of STEM graduates in India)
- How does one choose a career in which they can have achievement (personal vs. societal) and accumulate resources?
As Becker states in his exploration of human capital, “Parents affect educational attainment, marital stability, propensities to smoke and to get to work on time, and many other dimensions of their children’s lives (Becker).” Studying other countries and their cultural and societal expectations yields similar insights. How are humans equipped to handle these factors during the course of their lives? Are there ways to reduce variance in outcome to yield more deterministic outcomes? Humans have a natural tendency to be loss averse, as documented by Daniel Kahneman and Amos Tversky’s prospect theory. This motivates the need for transfer of risk and the benefits of financial instruments that allow for it.
Transfer of Risk
In order to address some of these “human capital risk factors,” certain financial instruments have been developed in order to help humans achieve their goals while (sometimes) minimizing their risk.
- Student loans, for example, allow one to borrow funds to use for one’s education (increasing their human capital) and then pay back those funds in the future with interest. This is a clear exchange of tangible (monetary capital) for more (relatively) instantaneous knowledge. For example, one can borrow funds for a 2 year masters degree and then pay back this loan over a decade. Meanwhile, one can accrue more tangible capital throughout one’s career.
- Life insurance exists to provide a lump sum payout mechanism should one die in exchange for a small monthly (or regular) premium. There are future earnings that the human can expect to earn which will be paid to a family (or designated individual) should the policyholder die, in return for a reduction in current capital.
Through these transfers of risk, a savvy individual can balance/hedge between tangible capital and human capital, as well as consider future expectations of human capital. In the first case, a student trades future tangible capital for current human capital (in the form of knowledge). In the second example, one reduces risk for their family by exchanging small monthly payments for a potentially large cash payout if they die (“human capital collapse”). In this sense one trades tangible capital today (money) in exchange for a safety net that encompasses family, education, society, and health.
This leads us to the open ended question: Are there additional instruments that can be created to novelly transfer human capital risk?
Capital Exchange Frameworks
Income share agreements, or ISAs, were first pioneered by Yale in the 1970s. These initial ISAs specified that students may get a “free education” but as an entire class they must pay back the cost of the education as a group via giving up a % of their income. They allowed students to buy out the agreement early on (for example, if they had expectations for a high income). This early experiment ultimately failed, however, as there was too much pushback from the Yale students who ended up paying a disproportionate amount of the fees from that class year (and paying for the low income of the lagging members). Despite this, the experiment demonstrated that the idea of human capital and tangible capital exchange could be viable if the incentive structure worked appropriately for both the education provider and the students.
Today, several colleges and startups across the world (primarily in the US for now) have begun offering ISAs with better incentive structures (geared towards the individual). Purdue, for example, has a watered down version of an ISA today wherein the school can provide (interest-free) loans of up to 10,000 USD which will be paid back as a % of future earnings with some stipulations. Many software engineering programming schools have implemented similar structures.
In the domain of social capital (a component of human capital), we have seen a rapid acceleration of social media influencers infiltrate the likes of new-age social media such as Twitch, Tik Tok, Instagram, etc. These influencers often position themselves to be successful by leveraging their talents, beauty, and even bots to gain social media followings, which can then be monetized (brand endorsements, job opportunities). Take for example Ninja, who is a likable personality who has streamed on Youtube and Twitch. On Twitch, he has gained 14 million followers while streaming games such as Fortnight, PUBG, and Apex Legends. He has successfully capitalized on his personality, fame, and following (social human capital) to get monetary compensation via endorsements and sponsorships.
We will look at possible CEAs in coming articles.
Conclusion
We’ve demonstrated a strong interplay between human capital and tangible capital. Further, we also believe in the potential for exchange between subtypes of human capital and liquid financial instruments to make this possible (and the need for people to have the option to enter these agreements). In coming articles, we will explore CEAs, trends in education and decision making related to capital exchange, and the possibilities of CEAs in emerging markets.
References:
- https://en.wikipedia.org/wiki/Human_capital
- https://scholar.harvard.edu/files/goldin/files/human_capital_handbook_of_cliometrics_0.pdf
- https://www.econlib.org/library/Enc/HumanCapital.html (Becker)
- https://paulromer.net/human-capital-and-knowledge/ (Paul Romer — NYU)
- https://www.inc.com/peter-cohan/will-10-million-make-you-happier-harvard-says-yes-if-you-make-it-yourself-give-it-away.html — Making money from scratch makes you happier.
- https://www.forbes.com/sites/katevitasek/2018/11/19/paul-romer-the-path-to-economic-growth-and-innovation/ — Human capital investment — path to economic growth (macro view)
- https://en.wikipedia.org/wiki/Prospect_theory