Why Income-Based Finance is So Damn Hard
Income-based finance is a product where you lend money to a person in exchange for a percentage of their future income.
It’s a financial product a lot of companies have tried to commercialize with little success.
I talked with someone about another income-based finance business today and for the first time was able to clearly lay out why it’s a product that only would work in certain cases:
When people buy equity in private companies they get preferred equity. That equity comes with minority rights, governance rights, liquidation preferences, and a number of other structural advantages. If VC’s weren’t able to get preferred equity, they likely wouldn’t invest in startups at the same velocity at which they do now.
And when people lend money, they receive covenants, governance rights, they control the cash flows, they have information rights and a number of other protections that keep them secure.
But if you invest in a person, you can’t request the same structural advantages because doing so would simply be immoral. Can you imagine controlling someone’s checking account, or having governance over what they could spend each week? No way.
The structural advantages of what makes a private investment worth making, are immoral to apply to a person, meaning income-based-finance products simply cannot exhibit the features they’d need to be attractive to a rational investor.
The only way to make up for such structural deficiencies would be to invest in someone such that you earned so much of their income (invested at a low enough valuation or a high enough yield) that it would make the product completely unattractive to the borrower.
The only two ways you can make income-based finance work are as follows:
(1) Providing an income-based finance product to an institution who would otherwise be giving the money away (via scholarships or financial aid). That way instead of getting $0 back on their money, they are getting $0 + n back, which is… better.
(2) Or you can take a percentage of your yield out of customer acquisition spend.
a. Example: If you run a coding school, and it cost you $1k to acquire each customer who spends $10k on the coding bootcamp, you might be willing to give up $750 to any lender who was willing to refer a student to you.
i. The lender would then be able to front a student’s tuition for $9,250, and then charge that kid a 20% interest rate on their $10k loan.
ii. Between the discount and the interest rate, the lender would receive a 29% gross yield on the loan portfolio. This means the lender could incur a 17% default rate and still get a 12% net on the portfolio.
The bottom line is:
Income-based finance doesn’t usually work because the only features that would make it financially attractive are immoral. So you have to earn your spread another way.
One way is to give people some % of their money that would have otherwise been donated and never recovered on.
The second way is to take a percentage of your income in the form of earning a percentage of the cost that would have been spend on customer acquisition (tacking on customer referral fees to your marketed interest rate).