Monday, July 16, 2012

The Human Startup

Start up mode
Young people such as myself are a lot like young companies. Whether human and corporate, we startups both require capital for investment and are uncertain about our future earnings.

And yet, while startup companies have a choice between debt and equity -- and largely choose the latter -- startup humans are, with the most limited of exceptions, confined to financing investment through debt.

There isn't any wisdom in our approach to investing in human capital. Equity financing makes sense for startups because of the potential for upside; debt financing makes sense for mature corporations because the room for growth is more limited, and repayment is more certain.

The same logic applies to human startups: although investments in human capital such as higher education are risky, the average real rate of return for bachelor's degrees is 15 percent per annum by one estimate. Another estimate pegs the median lifetime pay premium at $2.3 million. When you remove majors with low expected rates of return -- sorry, fine arts -- and keep the more financially valuable investments in human capital -- engineering, math, sciences -- the estimated returns move far higher.

In essence, the idea is that human beings should be able to buy and sell equity stakes in their future earnings. Instead of a $25,000 loan to cover college expenses, the average student would pay some percentage of their annual income. The proposal could be also tweaked so that the repayment period expires after a given number of years or repayment kicks in after an income threshold is hit.

And it's an idea which has been around for a long time. Milton Friedman put forth the idea in the 1950s, wrote Alex Tabarrok of "Marginal Revolution." James Tobin had Yale test the program in the 1970s, said Timothy Noah in Slate, only to see the wealthy beneficiaries default on their obligations later in life. Cato proposed it in a policy analysis paper in 2002. The New York Times reported that "human capital contracts" exist in a limited fashion for low-income students. The Economist revived the idea on its "Free Exchange" blog this spring.

There is reason to think that financing human capital acquisition via debt makes even less sense than by comparison to startup firms. When a startup firm takes on debt, there is collateral -- the capital goods purchased by the borrower can be sold off by the lender almost immediately if it is willing to take a loss -- but when a human startup takes on debt, what's the collateral? The bank cannot sell you into slavery and immediately recoup investment, and garnishing wages is such imperfect collateral that banks are transformed into equity stakeholders in the worst-outcome students -- but remain debt stakeholders in the best. These risks generate systemic underinvestment in human capital (see this paper) despite heavy subsidies on student loans and a ban on student-loan defaults enforced by government.

What would be efficient, however, is to have vibrant and inter-competitive debt and equity financing markets for human capital. Demand for equity capital would come from students with little means to afford debt payments in the near term; supply would come from investors who want to take risks on selective students. Demand for debt capital would persist, particularly for wealthier families who have low discount rates on future income; supply would come from banks who want the safer, more senior position.

But my favorite idea that comes out of this is what I call the Equity College. Equity College would provide a world-class education to its students in return for an equity stake as I've defined it earlier. I think the marketing would write itself:
Equity College is the only university which stakes its survival directly and entirely upon the success of its students. We do this because we're confident we can prepare every student for the world -- and our curriculum is tailor-made to help you achieve your potential and to get the most out of your four years at Equity College.

We are built around the premise that a college should truly invest in its students in action and not just in words. To that end, we ask no tuition or fees from any student. Instead, students at Equity College pledge 5 percent of their annual income over $50,000 in 2010 constant dollars for the next 50 years.

Think about what this means for both the college and the graduate. When Equity College helps you succeed, we prosper together. If you get nothing from an Equity College education, Equity College gets nothing from you.
The Equity College doesn't have to just be about producing high-income graduates, either. I think it could take money it receives in voluntary donations and charitable giving, as well as a percentage of its profits, and with it encourage graduates to do good within the equity model. By this, I mean that if you enter a profession which produces positive externalities -- doing basic scientific research, for example -- you would receive a credit against future payments to Equity College worth the estimated value of your contribution to society. Suppose your participation on a 1000-man development team results a solar panel which, through pollution reduction, creates a billion-dollar positive externality; your Equity College education will be free until your cumulative lifetime income surpasses the $1 million mark.

4 comments:

  1. Evan,

    Really great post, but I think you implicitly acknowledge why there will be little to no real innovation in education finance in the near future. You say that the supply of equity financing for education "would come from investors who want to take risks on selective students."

    When you say "selective students," it becomes immediately apparent that banks would be clamoring to either lend to or invest in smart, accomplished, ambitious young high school graduates heading to Princeton, and not the bad credit risks like a community college student. I don't think, as a society, we're willing to tolerate a system that systematically helps those with the most advantages at the expense of the less deserving.

    If lenders were able to discriminate among students, people like you would be able to get very, VERY cheap financing for education. But I think the distributional reality makes it a nonstarter.

    ReplyDelete
  2. Actually there already exists an "Equity College", it is called "government subsidized education" coupled with "progressive taxation".

    ReplyDelete
  3. Evan,

    It's nice to find someone else interested in the idea of human capital contracts. Check out my blog at rhymeswitheducation.com. I'd love to hear your thoughts and talk further.

    Best,
    Jeff

    ReplyDelete
  4. upstart seems to be a startup exploiting this idea -- http://www.upstart.com.

    ReplyDelete