Student Equity: The New Student Loan

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Many thousands of years ago, circa 1950, if you wanted to start a company, you had to take out a loan from the bank and use your house as collateral. If your company went belly-up, you lost your house.

One day, some guy realized that this whole idea was kind of silly, and instead of taking out a loan to start his business, he offered a share of it to someone with capital who wanted to take a risk. If his company went belly up, he couldn’t promise them his house, but higher upside kept the investor happy. People liked this idea, and venture capital was born.

To accommodate different risk profiles, term sheets gradually accumulated new features such as anti-dilution clauses, convertible debt, and liquidation preferences.

Finally, the most recent dramatic shift: crowd-funding, which allows startups to raise from many different investors at once, like a miniature IPO.

I firmly believe there’s a place in business for each of these different structures — debt, private equity, complex securities, and public equity — provided that they’re logically regulated. Each one occupies a different space on the risk spectrum, and satisfies different preferences for both the investors and entrepreneurs.

Which is why it’s strange to me that another huge capital market — the market for student loans — is still massively dominated by plain vanilla debt.

Hasn’t the world of startup funding proven that other capital structures work too, even in a highly uncertain environment? Shouldn’t students (and investors) also have the option to choose one of these capital structures, starting with student equity?

Thankfully, I’m not the only one with this idea, and there are a few startups tackling it in various ways:

  • SoFi connects students with alumni to allow a student to issue a bond, at more favorable rates than a bank loan. It’s only available now at a handful of prestigious schools, but will likely expand as they prove out the model.
  • Upstart and Pave allow students to sell a part of their future earnings as student equity. Like Kickstarter, they’re intended to spread a fund-raise out across many investors to mitigate risk.

These companies are off to a great start, emphasizing social benefits as an additional differentiator versus the incredibly impersonal experience offered by a bank.

Still, there’s a lot of room for additional innovation in the space, and judging by the dissatisfaction with the status-quo, there’s a lot of demand too. Over the next few years, I expect to see student loans follow a similar path as startups did, expanding far beyond debt into public equity, private equity, and complex securities. Except instead of 60 years, I think it’ll take about 10.

More specifically, startups can put a dent in debt’s dominance by filling some of the most obvious unfilled gaps in the capital structure:

  • Options: While Upstart and Pave tackle student equity pretty well, I find their limitations puzzling. For Upstart, returns are only applied to income between 30k and 5x the backer’s investment. It seems to me that both the investor and student would be better served by an option agreement with a higher floor and unlimited ceiling (i.e. a call option with a high strike price). From my perspective as a backer, if I invested in someone who makes $35k a year, I shouldn’t be taking any of it. On the other hand, if I invested in Mark Zuckerberg, I deserve much more than a 5x return!
  • The Secondary Market: Another aspect that the ‘equity’ model of education funding is missing is the ability to trade securities. Wouldn’t it be cool to see the price of your stock rocket up after you got an A on your Stats exam? Wouldn’t it be fun to buy some failing guy or girl’s distressed stock and try to turn them around?
  • Securitized Portfolios: Investing in a single 18 year-old kid is risky. But what if you and a group of friends from your Freshman dorm got together and sold a piece of your joint income? Sure, a couple of you might end up selling Chia Pets in the mall, but the investment bankers in the group would more than make up for them. What could possibly go wrong?

You say the kids are our future? Put your money where your mouth is and buy their equity.

Or, better yet, build a platform that encourages others to do the same.