Could Income Share Agreements Displace Payday Loans?

Income sharing is not a common method of financing as of 2019 — though, as of late, it has begun to get much more interest from investors and innovators, particularly in the context of student loan financing. The basic structure of the program in a student income share agreement is that an investor essentially fronts a student’s college tuition under the condition that, when the student graduates and begins working, they will surrender a portion of their future income for a given period of time.

There is a variety of players in the field pursuing these kinds of educational financing agreements. Purdue University was the first major research university in the U.S. to offer an income share agreement to its students. On the startup side, the best-known and best-funded player in the space is the Lambda School, founded in 2017. Valued at $150 million, Lambda has seen investments from the likes of Bedrock Founder Geoff Lewis, along with Google Ventures, GGV Capital, Vy Capital, Y Combinator and actor Ashton Kutcher.

In education, the model makes sense, according Austen Allred, co-founder and CEO of Lambda, because it more correctly aligns incentives in the education industry. Students have collectively taken on $1.5 trillion in debt, and they have to pay no matter what actual professional outcomes they encounter post-graduation. Schools, he noted, should have some skin in the game.

“There are no schools that are incentivized to make their students successful anywhere. The schools get paid up front, they get paid in cash — whether that’s by the government or whether that’s by an individual doesn’t really matter,” he told PYMNTS. “At the end of the day, the schools get paid no matter what. I think, in order to create better outcomes, the school has to take the hit.”

Moreover, this is a sensible investment to make — young, motivated students at the beginning of their lives as earners, who have every motive to succeed, are an excellent investment in aggregate.

However, will the model work as well for people who are not training for their careers, but who have actually begun it already. Can income sharing be a traditional loan alternative for working people? Adam Ginsburgh, COO of Align Income Share Funding, said his firm was founded under the theory that it could work, offering working people a much better alternative for income-smoothing than payday loans.

“When we started looking at this model, it occurred to us [that the same] mindset could be applied to working people for general household purposes,” Ginsburgh said in an interview.

The system works in a similar fashion to its educational counterpart. The customer applies, and is evaluated based on Align’s assessment of their income level, credit history and other (proprietary) data features. They are then offered an opportunity to borrow between $1,500 and $12,500 against their income. The consumer then agrees to pay the loan back at a set rate that runs between two and five years. The average term of a loan on the platform, so far, is about three years, and the average loan amount is about $5,000. Customers get a repayment schedule running from two to five years, and the contract states it will take no more than 10 percent of someone’s income.

However, in this case, the use of the term “loan” is a bit misleading. Align applies underwriting standards when it evaluates customers because what it is offering is technically — and more importantly, and legally speaking — not a loan. In an income share agreement, the entity supplying the funds isn’t lending the borrower money, but investing in a worker’s future earnings with the hope of a return.

A hope, notably, but not a guarantee. That is one of the important points that separates invested funds from loaned funds, but more on that in a second.

As a result of that legal status, it is not clear if Align and firms like it are required to comply with federal “truth in lending” regulations, which require for borrowers to be given a sheet, showing them the effective interest rate, or whether they must conform to things like state-regulated caps on APRs. The most common view is that they do not, though the arena is still so new that it remains a grey area.

The most differentiating facet of the status is that the payment time period is set at five years — and consumers are not obligated to pay if they lose their jobs (through no fault of their own). The payments “continue,” but the consumer makes a $0 payment during every month they are not employed. If the time frame runs out before the full amount has been repaid? The investor is out the money, just as they would be if they purchased a stock that went down in price, or invested in a startup that failed to perform.

Align’s underwriting standards are meant to avoid those kinds of losing bets, and the repayment period and terms a consumer is offered reflect the level of risk an investor is taking on. Yet, given the option between an income share agreement and a payday or short-term loan, the comparison is favorable. There are no never-ending, inescapable debt cycles, or years of calls from a collection agency — the consumer always has an expiration data in sight that is known at the outset of the agreement.

However, Align can also charge high rates, particularly if a consumer’s income goes up a lot during that five year period. This was an issue that created controversy when Arizona Attorney General Mark Brnovich recently allowed the startup to operate in Arizona, despite the fact that its products effectively charge an APR in excess of the 36 percent at which Arizona state law caps interest rates. Brnovich is allowed, though, under a new state “sandboxing” law, to authorize exemptions from consumer lending to allow companies to try out new or unusual financial programs in Arizona.

“Allowing Align into the sandbox is about giving a potentially new business model the chance to show that it’s different under state law,” Brnovich noted in a release. “We think they have a legitimate argument that it’s not a consumer loan under state law.”

Moreover, he noted, because it is unclear if the business model is subject to state lending laws, it is also unclear if Align even needed his permission to operate in Arizona.

“Here, we have a chance to see how this works in a controlled environment, how the company interacts with consumers and, ultimately, whether their product proves out,” he said.