Old, dusty but trustworthy concepts-the kind that make you money- may get lost when presented in unusual and exciting enough settings, but are no less important. What seems straightforward presented one way can be overlooked presented another.
A prospectus was recently filed detailing a company's business model allowing investors to buy into the future earnings of individuals. The inaugural individual is an NFL running back. Equity proceeds will be used to pay the athlete a sum of $10 million in exchange for a 20% claim on his future earnings (with restrictions: some types of earnings are exempt) forever forward.
This gentleman's earnings are, as might be expected, almost exclusively from his NFL contract. The distribution of retirement ages for NFL running backs (one of the most physically taxing positions in football) would have a mean in the high 20's but we'll say it's 30 years old. The subject athlete is now 27. He has a contract valid through 2016 which makes him eligible, in the best case scenario (some of his compensation is bench marked to performance achievements and much of it is not guaranteed), to receive $25.5 million. Additionally he is eligible to receive about $700,000 (again under a best case scenario) from endorsement contracts through 2015.
Back to those usually straightforward concepts. If I asked you to buy an uncertain series of future cash flows, you would presumably apply what you felt to be an appropriate interest rate and discount them to the present. Necessary to this calculation you would, of course, have an undiscounted future value of that earnings stream. This is where there may some trouble with the proposed deal. Let's look at the basic math.
It appears from the prospectus that the company is using a discount rate somewhere in the 13% neighborhood and assuming that the individual will have a 12 year NFL running back career (he's already 3 years into it). Using this 13% discount rate and fifteen years to earn, the implied future value of his earnings at a present value of $10 million is over $150 million (assuming annual payments to the company).
The prospectus talks about some hope of the athlete landing movie jobs and possibly commentating jobs, but I think it's fair to say that he'll get paid the most as a well-performing player. So, if we suspended disbelief that he may be at his prime and suppose that he will get contracts with the NFL for the next fifteen years (making him a 42 year old running back by the end of it) and further assume that despite the grueling toll taken on a running back's body, he is able to perform at 27-year-old levels the entire length of his elongated career enabling him to achieve a 10% raise above the best case scenario compensation of his existing contract, he would earn approximately $7 million annually during these fifteen years. Under this VERY rosy (and major injury free) scenario, his gross earnings will total $105 million, of which 20% would be payable to the company. This is still only 70% of the expected number implied by the price being paid for those future earnings.
It seems relevant to mention that Phil Fisher used an analogy years ago in his book Common Stocks and Uncommon Profits of buying an individual's future earnings. It was a terrific and sensible illustration of intelligent investing. One noteworthy disparity between his illustration and the proposed equity offering is that in Phil's story you were buying a student's future economic value, not someone who is arguably at the height of their earning potential. Buying high and selling low is no way to become rich.
There are other potential problems with such an arrangement, not least of which is the reality that a service fully rendered quickly diminishes in value to a recipient who promises to pay for it in the future. Your three year old may be very enthusiastic and sincere in her promise to finish all her dinner in exchange for dessert first; however, when the going gets tough and those carrots are looming large on her plate, the already eaten dessert may seem a distant memory. How motivated will individuals be ten years after receiving their lump sum payment to provide annual financials and write those checks on an unsecured debt?
In short, numerous improbable things will need to happen, in my view, for purchasers (at least at the initial offering price) of the above arrangement to have a satisfactory investment result. On the other hand, the individual who sold 20% of his future earnings under the terms stated, I think was pretty shrewd.