ISAs — Would You Share Future Income?
Income Share Agreements (ISAs) are an interesting concept offering an alternative to traditional debt or financing options. ISAs are a contract stipulating an individual or entity will receive a sum of cash and in return pay a percentage of future income, usually over a fixed period of time.
Would you agree to an income share agreement?
First, it might be helpful to figure out precisely how these things work. Next, the pros and cons of these financing vehicles. Finally, some practical and possible use cases will be reviewed. I’d love to hear whether you would enter into one of these agreements in the comments below 👇.
The Science Behind ISAs
One reason working with contracts is my favorite area of law, other than not needing to use bluebook citations, is because they are often open for negotiation. There are core staples of contracts that must be present such as offer, acceptance, and consideration. There are also certain requirements covering whether an agreement must include a written contract/evidence or may be an oral agreement. But for the most part, contracts can get pretty creative.
Stock purchase agreements, convertible debt, mezzanine debt, traditional loans, and Simple Agreements for Future Equity (SAFEs) may vary depending on the terms negotiated by the parties involved. So, many people argue ISAs aren’t really a new concept and just offer a variation of the above. However, I’ve tried characterizing these agreements below and think ISAs offer an interesting twist.
Comparisons — How should ISAs be Classified?
Debt
First, let’s compare ISA’s to traditional debt. Everyone is familiar with a loan. You agree to pay the principal amount plus interest that accrues over time. There are generally minimum payments paid at a predetermined time or recurring payments (e.g. once a month). While the terms of a loan may vary, the borrower may typically pay off the entirety of the loan to prevent the need for future payments and additional interest accrual.
ISAs are very similar, and in my opinion, are more similar to traditional debt than any other financing instrument. For ISAs, one is given a lump sum of money upfront (similar to the principal amount of a loan). Then, payments are predetermined and set at a percentage of income. The key difference is the amount paid may increase or decrease since the payment value is derived from the income of the individual or entity. Meanwhile, traditional debt predetermines the amount paid regardless of income, which may be good or bad depending on your payment vs. your income. ISAs are much more flexible for one not making much, but may also be less advantageous if more income is generated.
So, traditional loans do not have the upside that ISAs provide where a high income will produce higher returns. However, the converse is true since ISA payments are directly correlated with income, so a lower income leaves the ISA holder with a lower return.
Equity
Equity or stock purchase agreements are also worth contrasting. Stock generally offers dividend payments, often adjusted depending on the amount of income an entity generates. This is similar to an ISA. However, ISAs do not have a principal amount to sell — the period eventually comes to an end leaving the note holder with no principal amount to sell. Conversely, one holding stock in an entity is able to sell the stock for a lump sum.
While the dividend adjustments based on income is similar, it’s tough to analogize ISAs with stock and is probably not a great comparison.
Mezzanine Debt
Finally, I want to touch on mezzanine debt. While I’d love to take credit for this characterization, my friend and colleague Erik Berg offered this analogy. As Erik explained on VC twitter, ISAs offer consistent payments but with additional upside if the obligor achieves a higher income. However, they do not offer as much upside as equity. Mezzanine debt is a high-risk form of debt with additional upside offering the possibility for warrants due or other embedded equity instruments.
While they do not function entirely the same, they do have similar characteristics. More risk than traditional debt, but more upside as well.
Use-Cases — Student Loans, Micro Loans, or Financing a New Venture
Financing Your Education
There has been a lot of talk lately about universities offering ISAs as an alternative to student loans. I’ve also come across a few pitches of startups essentially investing in college students, mainly graduate students with potential for high-income careers, to avoid traditional debt obligations.
It may be helpful to read this sample ISA used by Purdue University, one big-name school to recently offer these financing instruments.
However, this may not be in the best interest of the student. If the student struggles to find employment then it’s great to mitigate risks of default. However, most universities will likely use an underwriting method to ensure they offer these opportunities to students likely to find high-paying jobs. This will then lead to a fairly significant portion of their income going directly to the university — more than a traditional student loan.
This function helps eliminate default risk on the lender (school) side. If a handful of students go on to high-paying jobs, their large payments may help subsidize loss from small to no payments from students struggling to find employment.
The topic has seen a lot of controversy and differing viewpoints, so it will be interesting to see how this works out for schools like Purdue.
Micro Loans
One interesting use case is offering micro-loans as an alternative to payday loans or loan sharks taking advantage of low-income individuals. While I’d love to say I’m the best person to ask about this topic, Abhishek Punia is building Heroic Finance to specifically address this issue using ISAs. (Highly recommend connecting with him on this topic).
ISAs allow individuals to access a small amount of capital to get through a tough spot or get to a better financial position. Individuals can repay this loan as a percentage of future income thus eliminating issues of incurring ridiculous interest payments and the debt spiraling out of control. This option provides a more viable and friendly financing opportunity.
Alternative to Venture Capital or Other New Venture Financings
So this one is a fresh idea that probably has a lot of holes. However, I have to take a chance to get the concept out there.
There has been somewhat of a shift in venture capital with many firms transitioning to a “venture studio” model. I have a wild theory about the evolution of venture capital (which I plan to write about in the near future). One piece of this is fewer small, $5–10M pre-seed funds operated by one or two people. Rather, firms will either raise large funds and provide growth capital, or they will help with initial financings but mainly offer operational support in the beginning stages. More on this later.
This is relevant because these venture studios could potentially help finance startups with an ISA. Rather than trying to take 10–20% of the company at the outset and causing the investor heightened fiduciary duties forcing the entrepreneur to spend time on reporting and updating investors, the financing can have minimal negative impacts on the entrepreneur. Yes, convertible debt and SAFEs are great tools for initial financings, but conversion takes a huge chunk of equity leaving less for employees and future investors where capital is crucial. Where these venture studios don’t have LPs, or raise capital with the strategy of offering smaller yet lower risk returns, they could help finance ventures with heightened upside but remain extremely entrepreneur friendly.
I have a lot more to say about this, but to refrain from getting into unrelated topics, ISAs could offer an interesting financing instrument for these very early ventures.
Would You Agree to an ISA?
I still have a lot to learn and a lot to write about this topic. So please feel free to offer your feedback, critiques, or anything you’d like to add in the comments. Would love to hear if you would agree to an ISA and under what circumstances.
