Tuesday, March 16, 2010

Why Don't Start Ups Have Debt?

This is not quite a stupid question. Start-ups have a future.  They have no present.  No earnings, no assets.  Maybe the management team has a track record.  Why would you lend to them?  Debt only has downside. Start-up investors take equity.  If they're taking the downside, they want the upside.

So, why do student loans exist?  Economically speaking, student loans look a lot like loans to start-ups.  They're a lousy proposition for the lender because you only have downside.  You can't take founders warrants in a career--slavery is illegal.  And the asset you finance, an education, remains with the borrower even if the borrower willfully defaults on the loan.

This story gives another tale that, on the surface might deserve sympathy, (call me heartless.)  The good doctor got herself $550k in the hole because she didn't "read the fine print" or keep track of the rules.  If you cannot borrow on sensible terms and you don't take the time to read the fine print then maybe this is exactly what is supposed to happen. Entrepreneurs evaluate their cost of capital and attempt to make good investment decisions.  This story signals really bad management and investment on the part of one individual.

I know, you say positive externalities (a better educated population means higher productivity, etc) mean we should subsidize education as a society.  This may be true, but we still need to address moral hazard and we need to efficiently allocate capital.  We shouldn't recklessly fund risky loans and let our sympathies after the fact worsen the situation.

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