Financial technology has never been a more exciting or innovative category — especially in New York City. Oddly, tech is not the driving force in many of these ventures. The Blockchain and Bitcoin notwithstanding, most of what we’re seeing now is financial product evolution and the unbundling of the large bank. Most of these companies could have been built 20 years ago.
Outside cryptocurrency and a few tools that enable better trading decisions, most of these startups developed a proprietary model to score the credit risks of potential customers and paired it with a clever go-to-market strategy that will appear to a new class of debt holders.
In the consumer space, this could be financing for home flippers, school loans, high-deductible health plans or even Uber drivers who want to buy new cars as a means of earning income. On the B2B side, companies have formed to help small business get financing by creating obscure products, like securities based on accounts receivable financing.
As a seed-stage VC that invests across many categories, these are hard businesses to assess. The industries they serve are varied, obscure and almost impossible to do due diligence on. Their technology typically feels like a black box that requires blind faith in their assertions. On the surface, this would make them seem unattractive.
But often these businesses have made hundreds of thousands of dollars in “transactional volume,” with promising metrics, like repayment rates and customer acquisition costs. So, from the standpoint of initial traction, there is evidence of a product market fit, and they look attractive.
In finance, size matters.
Almost all of these startups make sense as businesses, but I think founders and investors need to spend time thinking through two key questions. First, as an investor, would I want to buy the debt OR the equity? Do I want to be a customer or an investor? Second, from the founder standpoint, would it be better to take venture money or run the business from cash flows and keep the profits — the typical approach for Wall Street finance firms.
Would I rather be a customer or investor?
From an equity investment perspective, one must start by looking at the financials. In these types of ventures, the gross loan portfolio appears large — but consider that the actual net revenue or return from these businesses is anywhere from a tenth of a basis point, topping out at 1-2 percent. Thus, to be a venture-worthy investment, literally billions of dollars must be loaned. In finance, size matters.
The yields are generally double-digit; as a retail investor, I’d love to invest in clever debt structuring products that can return 10 percent a year with little volatility. Perhaps that’s why a lot of “smart” hedge fund and institutional money is flowing to these platforms (like Lending Club, OnDeck, etc.). Demand outstrips supply of loans on many of these platforms.
So they’re clearly good businesses. But it’s often harder to see how these deals become attractive from an equity perspective. As a VC investor, do I see the potential for 10X returns in under a decade? A few lucky winners will IPO, but it’s hard to envision who these businesses will ultimately sell to — the lion’s share of our returns come from M&A. Even if the startup does find a buyer, these kinds of companies often have low valuation multiples, making them less attractive venture capital investments.
Strengths and weaknesses of stockbrokers turned startup founders
The question for founders is, do they really want to play the VC game? Many come from Wall Street and, contrary to popular belief in the startup ecosystem, many of these folks are quite entrepreneurial and almost definitionally risk takers.
They see opportunity in the seemingly lucrative land of tech startups. As Willie Sutton said when asked why he robbed banks, “That’s where the money is.” While the motivations may be different than others drawn to startups, these folks seek to enact the same sorts of disruption in the market they know best, finance.
All that said, fintech entrepreneurs (and I’m certainly generalizing here) are less focused and experienced in product development. Finance is centered around transactions rather than building cumulative experiences. This is probably the right focus for such ventures — and sometimes I wish other company founders had such focus on generating profits! — but it runs contra to building a business where you have to put off a dollar today to make 10 next month.
The founders get this conceptually, but sometimes they can be fixated on making the company grow linearly by getting more “paper” under management, rather than developing a solution that unlocks exponential growth.
Financial technology has never been a more exciting or innovative category.
This mindset is even reflected in the way they incorporate their businesses. Further compounding the challenge for equity investors is that some of these attractive companies are incorporated as LLCs. This is because of the nature of these cash flows, the losses from these ventures can be used to offset gains from the founders, and from other investors in the venture. Most VCs, ourselves included, almost exclusively invest in C-corporations.
Great businesses but not always great VC bets
This isn’t to say these are bad businesses. We’ve made a number of investments in this area, including Bond Street, Venmo, Finxera, Blispay, BillGuard and other yet to be announced startups. We don’t take a one-view fits all approach when we’re reviewing a business opportunity, and there will be some big winners in this category.
This segment is just too large a part of the U.S. economy to be ignored by VCs. I believe there will be a new generation of Bloombergs, consumer financial products and B2B financial instruments in the coming years. Just as the ETF revolutionized the way consumers can index a plethora of investing strategies, so too will a whole new class of innovation come to the fore. I sure wish I could have seed funded Vanguard!
In many cases, such businesses will come down to whether they can buy capital for less than they can lend it out. This arbitrage can form the basis of a financial firm that could leave principals and agents pleased for years, even decades. But some great businesses will lack the combination of volatility, speed and scale that are the marker of great VC investments. In such cases, I’d rather hold the debt than be an equity investor. Maybe it’s time to start a debt fund?