Bryan Caplan  

Upstart Bleg: Help Paul Gu Help You

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Paul Gu, one of the winners of Peter Thiel's 20under20 fellowships, has co-founded a company called Upstart.  In this guest post, he explains his idea, pre-answers common questions, and solicits novel questions.  And now... Paul Gu!



Human Capital Contracts for Real

Milton Friedman first proposed the idea of a human capital contract, a financial instrument by which, in exchange for capital today, a person agrees to share a percentage of his or her future income. His aim was to find a large-scale way to finance higher education, without creating unbearable risk for students in the form of high debt loads and interest rates. 

While bachelor's degree attainment has risen significantly since 1945, the broader problem still exists: young people often have no access to capital; when they do, it comes in the form of debt which significantly increases their level of financial risk. 

We founded Upstart to solve this problem. Individuals raise money on Upstart for a fixed percent of their future income. Upstart funds can be used for high-return investments in an individual's future like education or bootstrapping a startup, paying off loans and increasing savings, or simply consumption smoothing. Unlike debt, upstart payments are inherently affordable and flexible - if you earn less, you owe less. 

As an asset class, human capital has attractive properties for investors too. Investors get access to the upside of an individual succeeding in their career while facing limited downside. Unlike when investing in companies, especially startups, there is no chance of striking out entirely - almost everyone will earn income at some point in their careers. 

Below are a couple of the most common questions about Upstart. 

Is this indentured servitude?!

No. The essence of indentured servitude is the loss of freedom to make important life choices. Upstart aims to do the very opposite. Unlike debt, which forces people to follow certain career paths and lifestyles in order to make fixed monthly payments, upstart payments are inherently flexible and easy. With capital from Upstart and the non-distortionary income-based payments, upstarts have a much greater ability to make the best choices for their life. And no, investors do not get to decide what upstarts do! 

How do you deal with the adverse selection problem?

Adverse selection would happen if individuals with high expected income were less likely to participate than those with low expected incomes. To avoid this, Upstart determines a funding rate ($ per %) for each applicant using a statistical model that predicts his or her income based on academic and career achievements. In other words, different income expectations are already baked into the price of investing in each upstart's future income. 

Is this for real? Is it legal? How do you enforce these contracts?

Yes! Upstart is backed by some of the top venture capitalists, including First Round Capital, Khosla Ventures, KPCB, FoundersFund, Google Ventures, Eric Schmidt, Marc Benioff, Mark Cuban, Scott Banister, Joe Liemandt and Andy Palmer. Former US Senator and Governor Bob Kerrey is one of our advisors, and we have a very thorough legal team. To enforce the income-sharing contracts, we reconcile each upstart's reported income annually via their US tax returns. 

We would love to hear more questions from readers!



COMMENTS (19 to date)
Tom West writes:

What do you anticipate to be the maximum % of future earnings that someone could "sell"?

How long does the contract last?

Does the contract include a percentage of non-earned income (i.e. inheritances, etc.)?

Peter H writes:

Reading your FAQ and terms a bit I have the following question:

You permit a buyout at 5x the initial principal. You also reserve the right to convert the initial principal to a 15% fixed rate unsecured loan if the upstart fails to pay (I assume you need to do this conversion in order to be able to sue for the money).

For a person who is earning a high income, the 15% fixed rate loan with no prepayment penalty is a much, much better deal than 5-8% of their income for say 7 more years. Why wouldn't someone just switch to the loan once their income rises?* It seems like a much better deal than the 5x buyout.

*I understand that you are the ones who control if they get switched, but if they default you get nothing until you switch them, because you need to switch to a conventional loan to sue them.

woupiestek writes:

If people don't get higher education because they fear student debt, is that really an example of market failure? Doesn't that actually help to make education more efficient? For that reason, wouldn't college teachers prefer and favor students who signal self confidence by taking a loan?

Bryan Caplan writes:

What about bankruptcy? Under current law, you can't contractually waive your right to declare bankruptcy, so it seems like a big temptation.

Thomas DeMeo writes:

What good is allowing someone to sell the risk of meeting earnings expectations to a third party? The only students who would benefit would be those who would not meet earnings expectations. I would not be looking for ways to encourage that particular demographic group.

Silas Barta writes:

The answer to the adverse selection problem doesn't seem responsive. The problem is not that lower-expected-earning people would dominate the applicants, which would indeed be fixed by lower $ per %.

The problem, rather, is that people on the low end of any reference class are more likely to apply, in a way that puts their model "out of sample". For an extreme case, someone diagnosed with a terminal illness immediately applies for a human capital loan and essentially gets to blow it all for nothing in return.)

(Although perhaps this is technically an asymmetric information issue rather than adverse selection; I'm not keen on the exact distinction.)

Likewise, the legal issues response doesn't seem pertinent. It's just saying "smart people are investing in us and our legal team is smart". I would expect to hear something more about the legal precedent and specific laws with how this escape them. Plus, I'd also want to hear extralegal (but not illegal) methods of enforcement such as e.g. implications for borrowers' credit ratings.

Paul Gu writes:

@Tom West:

What do you anticipate to be the maximum % of future earnings that someone could "sell"?

7%

How long does the contract last?

By default, upstarts share their income for 10 years. However, a payment year is deferred and extended if the upstart earns less than a minimum threshold of income, for up to 5 maximum extension years.

Does the contract include a percentage of non-earned income (i.e. inheritances, etc.)?

Your total income is defined as the amount of income included on Line 22 of your Internal Revenue Service Form 1040 (or Line 4 of Form 1040EZ). As such our definition of income is dependent on how the Internal Revenue Service defines income. It currently includes salary, interest, dividends and most types of capital gains, but excludes inheritances.

@Peter H

*I understand that you are the ones who control if they get switched, but if they default you get nothing until you switch them, because you need to switch to a conventional loan to sue them.

You are right that we control whether we convert the income-sharing obligation into a fixed interest rate note. However, we do not have to do the conversion to enforce the contracts. In either case, we can pursue collections in the same way. The conversion clause is intended only for very extreme circumstances.

Paul Gu writes:

@woupiestek

If people don't get higher education because they fear student debt, is that really an example of market failure? Doesn't that actually help to make education more efficient? For that reason, wouldn't college teachers prefer and favor students who signal self confidence by taking a loan?

There can be substantial variance in career outcomes even for the best students. For example, graduating in a recession has long-term and significant impact on a person's lifetime income, but is an event entirely outside the control of the student. Therefore, a reasonably risk-averse student should prefer to avoid excessive student debt.

What good is allowing someone to sell the risk of meeting earnings expectations to a third party? The only students who would benefit would be those who would not meet earnings expectations. I would not be looking for ways to encourage that particular demographic group.

The benefits are generally twofold. First - this allows people to raise capital that otherwise could not be accessed. Second - people generally do not know exactly how much income they will earn over their careers, so the benefit of risk-reduction will accrue to all kinds of students.

Paul Gu writes:

@Bryan Caplan

Bankruptcy is a risk for us just like it is for any kind of payment obligation.

@Silas Barta

The problem, rather, is that people on the low end of any reference class are more likely to apply, in a way that puts their model "out of sample". For an extreme case, someone diagnosed with a terminal illness immediately applies for a human capital loan and essentially gets to blow it all for nothing in return.)

We have two types of answers to the deeper adverse selection question.

First - in order to overcome adverse selection, we don't need to be able to predict incomes with 100% accuracy, but only more so than upstarts can predict about their own incomes. In addition to our statistical models, the "crowd" of individual investors on our platform choose individuals to invest in based on their beliefs about those upstarts future income potential. On the other side, our general experience has been that most young people cannot easily estimate their own future income.

Second - there are certainly some cases of information asymmetry that neither our algorithm or the "crowd" will be able to overcome. However, these edge-cases exist in many industries (e.g. traditional loans, insurance, used goods, investing in companies) and their cost is small enough to be absorbed.

Likewise, the legal issues response doesn't seem pertinent. It's just saying "smart people are investing in us and our legal team is smart". I would expect to hear something more about the legal precedent and specific laws with how this escape them. Plus, I'd also want to hear extralegal (but not illegal) methods of enforcement such as e.g. implications for borrowers' credit ratings.

You're right to point out that I used an "appeal to authority" type of answer here instead of offering a fuller response. I opted for that approach because it falls a little outside of the purview of this post to write a (very) lengthy piece on all our legal arguments, precedents, and the like. Maybe another day though :)

In terms of extralegal methods of enforcement, we do reserve the right to report to credit agencies, use collection, and other tools of typical creditors. In addition, however, we believe that having individual backers and a real face and reputation attached to our platform will be a strong deterrent to default.

Bryan Caplan writes:

Bankruptcy isn't just a risk. It's an *exceptionally large* risk because you're offering unsecured loans.

Credit card companies do the same, but they almost never give students or the currently unemployed credit limits of tens of thousands of dollars. And if they did, the interest rate would be very high.

Or so it seems to me. Tell me why I'm wrong, Paul. :-)

Tom West writes:

It'll be interesting to see how this plays out politically.

This could essentially be the income-contingent student loans that many on the left have called for, but I can easily imagine it being demonized because of its association with Milton Friedman and that whiff of indentured servitude.

Personally, at first glance it seems a great option for financing education.

Glen S. McGhee writes:

Just another ".... using a statistical model that predicts his or her income based on academic and career achievements."

How elitist! How does this help everyman/woman? It doesn't! Corporate greed at its worst!

Not indentured servitude -- more like slave auctions!

Foobarista writes:

One problem: interest on loans for college and RE are tax deductible. I assume that this wouldn't be tax deductible (can't see how it could be as structured), making it rather expensive money, with the relative expense going up as income goes up (as the tax deductibility is more valuable with a higher income).

Paul Gu writes:

@Bryan Caplan

Bankruptcy isn't just a risk. It's an *exceptionally large* risk because you're offering unsecured loans.

Credit card companies do the same, but they almost never give students or the currently unemployed credit limits of tens of thousands of dollars. And if they did, the interest rate would be very high.

Actually, unsecured loans of $10k+ have become very widespread on LendingClub, Prosper, etc. They manage the risk by pricing likelihood of default and bankruptcy into their interest rates. We do the same and price the likelihood of default into our funding rates. Likelihood of default varies drastically from person to person, based on things like credit history but also on things like school attended!

@Foobarista

One problem: interest on loans for college and RE are tax deductible. I assume that this wouldn't be tax deductible (can't see how it could be as structured), making it rather expensive money, with the relative expense going up as income goes up (as the tax deductibility is more valuable with a higher income).

Good observation. This is one of a few reasons that we are not starting with the paying-for-college market. Instead, we are focused on young people early in their careers looking to pay for alternative education (where tax deductibility does not apply), start businesses, reduce risk, or consumption smooth.

Will writes:

@Paul Gu

You mentioned a payment year is deferred if someone makes too-little income. What is this threshold? Is it set per contract?

Andrew writes:

Interesting idea. Unfortunately it doesn't solve the problem of access to capital. If I am going to give up 7% of my income, and this is supposed to overcome the initial investment, I better have one heck of a good idea. But if I had that good of an idea, which would need such a small amount of capital to start, I wouldn't use this service to aquire it.

Expand it to include venture capitalists that actually put entreprenuers in touch for ACTUAL business investments, then you might have something useful.

Tom West writes:

But if I had that good of an idea, which would need such a small amount of capital to start, I wouldn't use this service to acquire it.

I don't know. I had friends fresh out of university that might well have traded n% of future income for 10 years for $10K to start their company (instead of 50% of the company, which is what they did use).

Not everyone has easy access to $10K.

By the way, they'd have been excellent investments. Their companies had a 100% failure rate, but being bright people, they were all very gainfully employed a few years later.

Bryan Caplan writes:

@Paul:

I have no problem believing in unsecured loans of $10k+. But I am very skeptical about unsecured loans of $10k+ for *students* and *the unemployed*. Are the websites you mention really offering such deals to such customers? Without co-signers or other indirect sureties?

Paul Gu writes:

@Will

The deferral threshold is set per contract. Conceptually, an upstart defers payment to a later year if he or she earns less than half of their projected potential income.

@Bryan

We, like LendingClub and others, are careful about who we approve to raise capital on our platform. For example, most upstarts today are actually a couple years out of school, employed at the time they apply, or are nearing graduation at institutions with low unemployment and near-zero default rates. For all upstarts, we enforce minimum credit and maximum debt limits to reduce the risk of inability to repay. We expect these features to reduce the risk of 'legitimate' bankruptcies, and the social and reputational features of our product to reduce the risk of deliberately trying to cheat the system.

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