Embedded finance, or why fintech mega VC rounds have become so common

How dozens of fintech companies finally found the formula for profits

Another day, another monster fintech venture round.

This morning, it was personalized banking app MoneyLion, which raised $100 million at a near unicorn valuation. Last week, it was N26, which raised another $170 million on top of its $300 million round earlier this year. Brex raised another $100 million last month on top of its $125 million Series C from late last year. Meanwhile, companies like payments platform Stripe, savings and investment platform Raisin, traveler lender Uplift, mortgage backers Blend and Better.com, and savings depositor Acorns have also raised massive new rounds this year.

That’s all on top of 2018’s record-breaking year for fintech, which saw $52.5 billion of investment flow into the space according to KPMG’s estimate.

What’s with all the money flowing into the fintech world? And what does all this investment portend not only for the industry and other potential entrants, but also for customers of financial services? The answer is that this new wave of fintech startups has figured out embedded finance, and that it is changing the entire economics of disruptive financial services.

First, this isn’t (really) about blockchain

Let’s get one thing out of the way right away, for whenever the topic of financial services and digital disruption come together, some blatherer always yells blockchain from the proverbial back row (often with a bit of foaming at the mouth I might add).

Blockchain certainly has been a major point of excitement in finance, and despite the crypto winter underway the past months, there are still an incredible number of highly-motivated and technical founders working to figure out decentralized technologies and popularize them to a broader class of users.

Yet, the commonality between all of these monster fintech rounds and the companies behind them is that they pretty much aren’t doing anything with cryptocurrencies or blockchain.

For sure, some of these startups are trying to make small forays into the sector. Stock trading app Robinhood for instance, which raised $323 million yesterday, allows users to trade certain cryptocurrencies on its service depending on the user’s jurisdiction.

In other cases, fintech companies have expanded much faster due to blockchain and its popularity. Charlie Delingpole, founder and CEO of know-your-customer (KYC) compliance platform ComplyAdvantage told me a few weeks ago that his startup’s revenues grew rapidly from $3 million to $10 million to $14 million ARR, much of it on the back of increased regulatory attention from blockchain companies eager to meet their KYC/AML needs. Delingpole didn’t start with the vision of being a blockchain enabler, but certainly has managed to take advantage of the wave’s crest.

That said, other forays have already been nixed. Stripe, for instance, offered the ability to pay using bitcoin until it shut off its experiment early last year. Other startups seem to just be ignoring the movement entirely, content with listening to blockchain discussions in the background and continuing on their current trajectories.

All those previous tech waves are finally hitting finance

So let’s ignore blockchain for the most part. What’s really been taking place in fintech isn’t something new, but rather something old: the combination of a bunch of technology waves over the past 15 years is finally catching up to the finance industry.

Mobile apps, cloud services, high-quality data analysis and extreme attention to consumer user experience have combined to create trillions of dollars of enterprise value across the technology sector. Yet, those trends have tended to be more elusive in financial services, which owing to its heavily regulated status, is incredibly conservative when it comes with adoption of new technologies.

Matt Harris of Bain Capital, one of the leading investors in the fintech space, explained that “there is a great deal of inertia in financial services” in a recent interview with TechCrunch. Take cloud services for instance, which have been popular in many verticals for approaching a decade now. Financial services is just now starting to really move to the cloud. “Moving to the cloud is a good and important thing, but doing so in a way that has less regard for security or compliance could be problematic,” for many financial institutions, he said. Newer startups are finally breaking through that hesitation to migrate.

Competition is also driving change. Take the spate of mortgage underwriting startups coming through the pipeline right now. Once an incredibly onerous and paper-intensive process, startups like Better.com and Blend have been built to both automate underwriting based around high-quality data modeling and also to collect documentation using fully-digital collection practices that simplify the application process. As these startups gain in popularity, incumbents are finally facing consumer pressure to compete to offer equally fast and comprehensive digital products.

In other words, the best practices we have seen in areas like ride-hailing, with its mobile-first simplicity and speed, are now finally creeping into all areas of fintech, both on the consumer side and also on the enterprise side.

Embedded finance is driving the new fintech value

The biggest challenge that has faced fintech companies for years — really, the industry’s consistent Achilles’ heel — is the cost of acquiring a customer. Financial customer relationships are incredibly valuable, and the cost of acquiring a user for any product is among the most expensive in every major channel.

And those costs are going up. As Mary Meeker of Bond Capital wrote in her latest Internet Trends presentation earlier this year, the cost of acquiring a customer is going up across all channels, making it even harder to grow a customer base.

Fintech companies are increasingly getting around that burden though by embedding themselves pretty much everywhere they can. On the enterprise side, companies like Stripe and ComplyAdvantage have created APIs that allow their products to be built right into existing apps and processes — both simplifying installation, but also making it easier for part of an organization to get started with a system without having to get universal buy-in.

The more interesting dynamic is on the consumer side though, where a wide number of growth strategies are being employed. Brex, whose business charge cards are targeted at startups, blanketed San Francisco’s Caltrain station with advertising to drive attention. Oxygen, which offers banking services to freelancers, bought ad space on the back of SF Muni buses since that is where delivery couriers and Uber drivers (i.e. their target customers) were most likely to see them.

Meanwhile, the smartest strategy has been embedding technology where customers are already located. Shopify processed nearly $4.9 billion in payments volume through its platform during its first quarter, driving huge gains in revenue. Uplift, which finances travel, works with partners like United Airlines and Southwest to offer their services at the point-of-sale, much the way Affirm has done in consumer financing through partnerships with retail outlets like Walmart.

Harris at Bain says that strategy has been one of his major investment theses. “In every vertical market, there are software companies that are offering these solutions with embedded payments and taking share from these vanilla payments companies,” he explained. These vertical offerings provide more adapted features for their markets, while also driving higher margins and lower CAC costs.

Finally, as these startups continue to grow, they are flexibly taking advantage of their existing customers to direct them to new financial products. Anthony Noto of SoFi, which raised $500 million in May, stopped by TechCrunch recently to talk about how the company is now offering fractional stock share purchases. While SoFi’s core business is student loan refinancing, it now offers a suite of products to retain, engage, and build profits around its customers. An existing customer is free to acquire essentially.

And so whether it is embedding new products into an existing app, embedding a product into other services, or offering an API to embed in other processes, the modern fintech startup is taking advantage of these strategies to lower the cost of acquisition while driving higher volumes and margins.

An IPO wave to come?

There was a time when software-as-a-service was completely foreign to public market investors. It took a series of outperforming IPOs and serious educational outreach for Wall Street analysts to understand these companies, price them correctly, and start to popularize them. The result of all of those efforts though has been profound: today, there are dozens of publicly-traded SaaS companies, and new ones like Zoom and Slack seem to be joining that rarefied club all the time.

Fintech is most definitely behind the SaaS world owing to its slower adoption cycle, but it is catching up quickly. The mega-rounds we have been seeing the past few months all but guarantee that we are going to see a wave of fintech IPOs in the next 2-3 years as these companies mature and reach deeper into the capital markets for growth.

But unlike the last mini-wave, where companies like Lending Club dropped precipitously post-IPO due to high costs and low revenue growth, this new batch of fintech companies is built on much stronger foundations that should improve with time. Founders, executives, and investors have finally gotten the model right around fintech by focusing on embedded finance, and adoption among customers will lead to serious adoption in the public markets soon.