Hi all,
*To foreworn, the following investment idea appears impractical from a legal standpoint and this exercise merely services as a theoretical excercise in assessing risk and pricing it appropriately
An ex-hedge fund manager I am close with proposed to me a question - "What % of your future income in the form of a perpetual royalty could I purchase for $XXX" which roughly translated, is asking "What is the NPV of your future income to perpetuity?"
Asked for context on the concept, I was told that this individual wanted to make a business out of investing in young, bright minds with a high propensity to generate large sums of income through their career. The effective skillset he brought was identifying career capital in a person before the individual could practically realise it themselves or price it correctly. I.e Can I purchase a royalty at a discount to IV?
I've been left with a tempestuous point of view after some thinking from the perspective of the purchasee. I'm less interested in the estimates on the income generated over n+t and more affixated on how to price the risk / discount the $XXX of income in the future back to an IV.
Perhaps I could stagger the discount rate for various stages of life whereby the probability of failure ( < income) is higher. Would it be more appropriate to average a discount rate for the sake of simplicity. I'm not sure if there's any better appropriated risk models to solicit an answer.
I'd love to hear anyone else's thoughts on the discount rate on the concept more broadly. Again, let me emphasise that for legal loophole-reasons (In Australia at least), I'm engaging this topic as a theoretical concept only.
I'd also like to see peoples viewpoints on whether or not theyt think this exercise is ethical and why/why not.
Cheers!
Hey there,
What an intriguing concept you've stumbled upon! It's like a venture capitalist investing in people rather than companies. Let's break down the idea of pricing future income as a perpetuity and the associated risks:
Net Present Value (NPV) of Future Income: To calculate the NPV of future income to perpetuity, you'd typically use the perpetuity formula. Based on the most helpful WSO content, the formula for a perpetuity is the annual cash flow divided by the discount rate. If there's growth expected in the cash flow, you'd adjust the formula to account for this growth rate.
Discount Rate: The discount rate is essentially the risk premium you're adding to the current risk-free rate. It's the rate of return that could be earned on an investment in the financial markets with similar risk. For a person's future income, the risk is significantly higher than a typical financial investment. You might consider factors like the individual's career volatility, industry stability, and personal life events that could affect their income.
Staggered Discount Rate: Your idea to stagger the discount rate for various life stages is insightful. It acknowledges that risk isn't static over time. For instance, the risk of income fluctuation might be higher in the early career stages compared to when an individual is more established.
Simplicity vs. Accuracy: While averaging a discount rate might simplify the calculation, it might not accurately reflect the risk profile over time. A more nuanced approach could involve creating a model that adjusts the discount rate at different stages, reflecting the changing risk.
Ethical Considerations: This is a complex topic. On one hand, investing in someone's future income could provide them with immediate capital that they might need to jumpstart their career or pursue education. On the other hand, it could be seen as a form of modern indentured servitude, especially if the terms are not favorable to the individual in the long run.
In conclusion, while the concept is theoretically fascinating, the practical and ethical implications are quite profound. It's a reminder that finance isn't just about numbers, but also about the human impact of those numbers.
Cheers!
Sources: DCF Modeling Course ~ Pre-training text.pdf, Trying to understand the concept of IRR, Beyond the guide: a list of real interview technical questions
Well there's an agency problem you have missed beyond the valuation problem. If a person sells a significant amount of their forward income stream they are less incentivized to maximize future income and are less likely to make short-term sacrifices for long term income growth. E.g. If I sold 50% of my income stream to you I'd be much less likely to pull the all-nighter required as a banking analyst. You'll also see pay structures change to non-cash comp etc. that would try to be outside the scope of your agreement (say corp housing/company paid car/benefits).
The concept does already exist somewhat via ISAs in the US (students borrowing money for college with a future income-based repayment), and usually have a capped rate of return and percent of salary for the investor, which limits the agency problem.
You do raise a few legitmate points however I believe a few design tools to extricate issues you have raised.
The agency problem could be addressed by either;
a) a hard cap on the % of royalty. Let's call it 5%, which could, in theory, discentivise effort leading to future income generation by the same 5% (or more, depending on the elasticity of the response). In principal I think the cap serves to keep the parties with a common vested interest. I don't believe a person will change their level of sacrifice over 500 bips of lifetime income.
b) Designed clawbacks for hurdles as you highlighted via the ISAs. If you don't meet $XXX by year YYYY then it triggers a penalty.
I believe a) is the panacea response and is more practical (despite the theoretical nature of this concept) given it allows the investor or 'VC' to take relatively small stakes in few bright minds with earnings potential. The risk of outside influence (e.g getting hit by a bus) is, for obvious reasons, extremely unknown and therefore high and I don't think big chunks of royalty (~30%) in exchange for $'000's would make sense from a financial engineering perspective. It's also impractical because the investee probably doesn't require $'000 in 'seed capital' either.
To address the any pay structure or 'accounting gimmicks' you could alter the royalty to reflect any monetary reward instead of just financial incentives. Good point, but I think it's can be comprehensively addressed.
You could look at coding bootcamps, record labels, and poker staking for a situation where something like this currently exists, although the income stream is limited and the "royalty holder" is also typically increasing the party's earning potential. There's a few example of professional athletes making ISA deals that are more pure financial arrangements.
This actually happens in a sense. There are investment funds (Big League Advantage is the big name) that "invest" in primarily foreign-born baseball players. These players often come from nothing, so BLA gives them cash in exchange for xxx% of future earnings with the goal that they make the MLB and sign multi-million dollar contracts. Elly De La Cruz, Fernando Tatis Jr. and Jazz Chisholm all did this.
Usually it is like $50k cash per % of future revenue. There are some legality questions atm, I think one player is suing. How ethical is this? I am not sure, but it can be seen as a win-win as both sides will be rich if the player makes it big.
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