Aligning incentives with income share agreements

Published 2019-07-14.

As a rule of thumb, the more aligned incentives are, the better. When you’re dealing with someone whose incentives are aligned with yours, you can usually trust that they’ll do you good.

The problem

A classic counterexample is moral hazard in the financial sector: Managers can cash in bonuses in good times while other people pay when things break.

The problem of misaligned incentives in finance is well known. Lesser known, however, is the case of investing in people. Consider, for example, a school that gets paid by the government when students graduate (which, for example, is the case with higher education in Norway). Such a school will work to get as many students to graduate as possible. But for students, graduation alone is usually not the only point, or even the main point—students attend schools to get better jobs than they otherwise would.

So, contrary to students’ interests, schools can be tempted to admit them to programs for which the employment opportunities are bad in general and/or the particular students is a bad fit. They can also lower standards to cause more students to graduate.

The solution

To my knowledge, the solution that is now known as income share agreements was first proposed by economist Milton Friedman in his 1955 essay The Role of Government in Education:

The counterpart for education would be to “buy” a share in an individual’s earning prospects: to advance him the funds needed to finance his training on condition that he agree to pay the lender a specified fraction of his future earnings. In this way, a lender would get back more than his initial investment from relatively successful individuals, which would compensate for the failure to recoup his original investment from the unsuccessful.

The crucial element is that “counterparts for education”—schools, investors, etc.—are only paid when students are paid.

In the wild

are examples of current implementations of earning share agreements. If you know any more, I'd love to hear from you.

Disclaimer: I’m currently mentoring a Lambda School graduate.

More information

NPR’s Planet Money did a great episode on income share agreements on 29 March 2019. Another good podcast episode is Y Combinator’s interview with Austen Allred, CEO and co-founder of Lambda School. Allred also wrote an opinion piece in Wired, To End Student Debt, Tie Tuition to Post-Graduation Salaries.

To read more, I’d recommend Wikipedia’s article on the topic.