The recent travails of Lending Club have shone a not-so-flattering light on FinTech startups. On the surface, the finance industry replete with large slow-to-innovate institutions appears ripe for disruption. However, the performance of the recently public FinTech companies shows that finance make not be as easy a target for disruption as FinTech companies have made out.
What is FinTech?
FinTech startups attempt to take a single business line in the finance industry and apply new technology and business practices. In general there are four primary business lines startups have focused on:
- Wealth Management (Betterment, Wealthfront)
- Transfers (Transferwise)
- Payments (Square, Stripe)
- Lending (Lending Club, OnDeck)
In this article I will focus on the the lending space which has seen the most turmoil in recent months. 2015 saw the debut of two lending companies on the public markets — namely Lending Club and OnDeck. Lending Club is a marketplace for personal small loans whereby the loans are on-sold to investors. OnDeck, by contrast, focuses on small businesses and utilizes its own balance sheet to fund the loans (although it also runs a small marketplace) and so more closely resembles a traditional bank.
The core proposition by the lending startups is that banks, who typically prefer loans under $15k to be done via credit card debt, have served the small loans market poorly. Furthermore, risk analysis can be done more efficiently and accurately using algorithms.
The IPOs for both Lending Club and OnDeck have proved disastrous with both Lending Club and OnDeck’s stock down by 80% and so slammed shut the door for FinTech IPOs in the short to medium term. Several categories of risk specific to FinTech startups have become apparent:
FinTech lending companies are heavily dependent on consistent and stable sources of funding to back their loans (marketplaces such as Lending Club require investors to purchase the loans whereas on-balance sheet lenders like OnDeck require banks to finance their lending). The market turmoil of 2015 and 2016 has clearly demonstrated that these sources of funds are highly unpredictable — Lending Club is now having to warehouse loans on its balance sheet as it is unable to find counterparties willing to purchase them. Likewise, OnDeck which had previously planned to offload 40% of its loans was only able to offload 15%.
Thus, despite efforts to broaden their funding base, both OnDeck and Lending Club are having to rely on traditional institutional (mainly bank) funding to fund their loans, the withdrawal of these lines of credit could pose an existential risk for the companies.
Tech startups often endure several public setbacks such as security breaches or privacy violations. These are often swiftly overcome and forgotten and the company progresses. Not so for finance companies where infractions can lead to a loss of confidence and a withdrawal of funding. Lending Club’s changing of the dates of $3m of loans (out of a total of ~$3bn loans originated) as well as the CEO’s undisclosed shareholding in a related party have proved so serious that the firm has not only removed the CEO but cannot provide earnings guidance as there is so much uncertainty regarding the fallout.
FinTech companies are currently more lightly regulated than the banks who they are competing with. This is likely to change as regulators turn their attention to ‘shadow banking’ and in loan marketplaces where individual investors are investing in loans (note that FinTech lenders are targeting individual investors as more stable source of funding)
FinTech lending companies trumpet the sophistication of their risk analysis technology, however, this is essentially a black box and it is impossible for investors to evaluate until the company has gone through a complete credit cycle as credit risk assessment can be flattered by an overall macro environment strong credit (as is the case in 2016, demonstrated by the below chart).
Traditional Startup Metrics
All this naturally leads to how should FinTech companies be valued. There’s been considerable debate on the subject of FinTech company valuation — should they be valued as typical finance companies or tech companies? The issue has a massive impact on valuations since tech companies tend to be valued on a multiple of revenue (typically around 4x for Saas companies), whereas finance companies tend to be valued using a multiple of their net assets which usually gives a far lower valuation.
Needless to say FinTech companies argue vociferously that they are tech companies and should be valued as such. Yet the core reasons tech companies are valued on multiples of revenues don’t apply to FinTech companies:
- Tech company revenues are relatively stable (it is usually the level of growth which causes uncertainty). This is because there is usually some degree of lock-in for tech companies’ customers — with social media companies it is the network of friends/colleagues, for Saas companies it is the customer’s investment in time to adapt to using the product and the difficultly in migrating to a rival product. None of this applies to FinTech lending companies whose customers can easily move to alternative platforms.
- Tech company margins tend to be predictable and manageable. The costs of delivering a tech product or service do not swing wildly and so gross margins can be forecast and managed. Not so for FinTech lending companies who are at the mercy of the vicissitudes of the economy which determines interest rates, demand for loans and default rates all of which have a direct impact on gross margins.
Despite all of this, the market is still focused on revenue as the primary driver of valuation although this is likely to change as the companies mature and the market’s approach to valuing tech companies evolves.