Have you ever watched the popular television show “Shark Tank”? In it, entrepreneurs pitch their young businesses to five rich tycoons (the “sharks”) in hopes of attracting an investment from one or more of them. Some entrepreneurs are youngsters with a great idea, some are savvy veterans, and others are ordinary families hoping to turn a great idea into a million-dollar business. Not all get an investment. When you do get an investment, it usually takes one of two forms:
- An equity stake in your business
- A royalty on gross sales
The sharks don’t invest in every business that gets pitched to them. They especially don’t invest in businesses where where the pitch revolves around a tear-jerking story. They don’t care that you had hardships, no opportunities, or that you’re the most upstanding citizen on Earth. They only care about two things:
- Getting their money back
- Getting a handsome return, in addition to just their money
You may also have heard of Kickstarter and other sites which offer something similar: an opportunity for entrepreneurs to raise money to fund their ventures. But as the name implies, you don’t attract investments from one or a few individuals; you attract a crowd of investors to fund your idea. The crowd usually gets a financial stake in the new business in proportion to the money invested, but not necessarily. For $5 invested, all an investor may get is a discount coupon on the new product when it gets launched.
In one form or another, crowdfunding has been around as long as the human race, it seems, whether the person giving the money has a direct stake in the venture’s financial results or not. Grandparents giving kids money to start a lemonade stand or paper route are classic examples. Don’t let the down-home examples fool you, though. The City of Green Bay, Wisconsin, is a master at this: In 2011, they raised over $60 million for the NFL team it owns, the Green Bay Packers, by selling shares which have no votes and no share in any profits. It was just a huge civic-crowdfunding exercise.
You can think of venture capital as the halfway point between crowdfunding and “Shark Tank.” Anybody has access to venture capital, just like they have access to crowdfunding; but the venture capitalists (VCs as they like to be called) are even more stringent than the sharks in their focus on the money generated by a fledgling business.
What all of these funding mechanisms have in common is: They are not loans. Loans have to be paid back — with some interest — whether the venture fails or succeeds. None of these investments carry that requirement. If the venture pays off, they make way more money than the interest on a loan. However, if it doesn’t, investors lose it all with no recourse.
The essence of crowdfunding, venture capital and the “Shark Tank” is that they put up money and take a big risk. The risk is that the venture will be a bust. Think of when England would send merchant ships to the Far East to trade for tea and spices. Fifty rich shareholders would invest a million dollars (in today’s money) to build, outfit and crew a ship, which would take two years to sail to India, Indonesia and China.
Sometimes the ship would come back and the shareholders would split five million between them. That would be wonderful. They would throw lavish parties and hire painters to paint portraits of their wives.
Frequently, though, the ships would not return, and the shareholders would lose all that money. That would be a tragedy — no parties and no paintings.
In other words, every venture had a chance for either riches or tragedy. They called that chance risk. They understood that when they pony up the money for a trip, they might lose it all. However, they take the risk because, along with the risk, there’s the promise of a rich reward.
When you invest money for your retirement, you limit your risk with something called diversification. You are not alone.
Instead of three investors putting everything they have in a single ship in the olden days, fifty investors put a tenth of their wealth in a single ship. Instead of sending just one ship, they sent four or five. If one goes down, others will survive and make it back. Lloyds of London is a famous place where ship owners shared risk and reward. There are, as you can see, many ways for investors in risky ventures to alleviate that risk through diversification.
Imagine you’re a high schooler, and you’re thinking of going to college. College these days almost costs as much as one of those shipping expeditions to the Far East. “But, ” you think to yourself, “I should make a lot of money with a degree. Everyone tells me I’m smart, but I don’t have the money to pay for a college degree, and neither do my parents. Hmmm… I wonder if I could persuade all of those people who tell me I’m smart to put their money where their mouths are?”
The good news is that you can. And your friendly Congress is looking at ways to help you do it. The wellspring of three-letter acronyms is mulling yet another one for the Income Share Agreement (ISA).
ISAs allow students to raise funds to pay for their degrees by selling shares in their future earnings, kind of a cross between crowdfunding and venture capital. ISAs are financial instruments that can be administered by the government or by private financial institutions. Their defining characteristic is that an individual gains access to cash for a college degree in exchange for a promise that they will pay back a fraction of their earnings for a prescribed period of time to the entity that put up the money. And, by grouping a number of students’ funding, it spreads the risk over many students.
It is like a venture capitalist investing in You, Inc. A graduate who earns less than expected will pay back less than the full amount of the initial funding, while graduates who earn more than expected will pay back more than their share.
Does anybody do anything like that? The New York Times recently published an article about online “trade schools” like the App Academy, which charges no tuition, but will take 18 percent of the income graduates earn in their first year.
This is a classic good news/bad news situation.
Good News, Bad News
The good news is obviously that, with something like an ISA, more students will have access to increasingly expensive higher education. Furthermore, when a hundred investors invest in a pool of a hundred students, the diversification allows them to spread the risk, much like those old ship owners from days gone by.
The bad news is that outside investors, more likely than not, will, like venture capitalists and the sharks on “Shark Tank, ” focus strongly on the financial outcomes of the education. If you are a student looking to get investors to fund your engineering or medical degree, you are much likely to attract ISA money than, for example, for a degree in art or history.
But, is that a bad outcome? This is not to disparage a degree in the liberal arts; but the moment outside money, whether it be student debt or something like an ISA, enters the picture, the financial return on higher education becomes much more important.
What limits the use of ISAs? Uncle Sam. At the present time, there are well-used mechanisms in place for the Federal Government to assist colleges with grants and loans, but not ISAs. Because of that, most students would only elect an ISA over a traditional loan or grant if they were tapping into private sources of funding.
We live in a time of evolving technologies and opportunities. The student debt problem is pushing the issue of higher education funding into the crucible of change.
Would you, as an investor, invest in an ISA for a student you know? For one you don’t know? Would you, as a student, accept a form of education financing that, in effect, indentures you for a specified period of time?