The ballooning student debt crisis has created a lucrative market opportunity for startups and venture investors.
At Y Combinator's annual Demo Day this week, founders got on stage to pitch their companies to a room full of hundreds of investors. As the two-day event wore on, it became clear that founders and investors have found common ground and are betting on income share agreements, otherwise known as ISAs.
The model, which takes a percentage of a user's future income instead of an upfront payment, became popular with the rise of online coding school and YC alum Lambda School. That startup, a venture capital favorite, has raised more than $48 million and is valued at $150 million after two years, according to Pitchbook data.
"Lambda School was the first example that showcased how ISA works, and that they do work – in the end this is a relatively novel financial instrument. That's driving more founders and potential employees, as well as capital," Masha Drokova, founder and general partner at Day One Ventures, told Business Insider.
The model is particularly popular among education startups, who get a cut of the graduate's income after a set number of months or years after completing the course. From a founder or investor's perspective, this presents an appealing market opportunity.
"Venture capital investors talk about how you should invest in people, not companies. ISA literally allows you to do that and I could see the model used almost anywhere," Drokova said.
'A skeptic would call it indentured servitude.'
Because there is no upfront cost to a user, that also means there isn't upfront revenue for the startup. Lambda School acts more like a bank offering a student loan, according to some investors, and should be regarded as such by customers eager to take an offer that feels too good to be true.
"The idea is popular because it appears to offer a clever and attractive 'pay for performance' alternative to traditional student debt which is reaching crisis levels in the US," Merus Capital cofounder and managing director Sean Dempsey told Business Insider. "But students should not mistake ISAs as anything other than debt. There is no free lunch. Depending on the terms of the specific ISA, a skeptic would call it indentured servitude."
Unlike a loan, where terms and repayment are clearly outlined when the borrower signs on the dotted line, students can be caught off guard by the repayment structure in an ISA. And if they aren't employed, language in an ISA's terms might require them to start payment anyway.
"While it is certainly helpful to offer financing alternatives to students, ISAs do not help solve the core problem in the US which is the skyrocketing cost of education and the lack of commensurate increase in the market value of a degree broadly," Dempsey said.
Investors are all in on a new asset class.
Because the terms of ISAs can very widely, and there are no set standards, they can be a bad deal for lenders too.
According to Dempsey, an ISA should be treated the same as a loan from any bank or financial institution. That means there is a lender on the other end hoping to capitalize on the investment. But that is where the economics of an ISA get tricky, he said.
"It's equity-like risk with debt-like returns," Dempsey said. "In fact, the more lenient the terms of the ISA, and therefore more attractive for students, the worse the expected return profile. Given the mismatch of incentives, ISA funding is more suited to government or philanthropic sources, rather than private investors seeking to maximize ROI."
But investors in the room at Demo Day were interested in hearing from the three startups presenting similar models on stage. Microverse, billed the Lambda School for emerging countries, wrapped up the pitch to applause throughout the room with a multi-billion market opportunity just laid out in front of investors. The two other startups, ScholarMe and Blair, also use variations of the ISA model.
"As investors, mechanically we are buying equity but the ultimate value of that equity is dependent upon the performance and success of the founding team that we are betting on at the Series A, which is very much a people-driven decision," Dempsey said.
