An old story tells us that the seven fat cows tend to be followed by that many lean ones, and so it seems that it would be wise for those of with funds at stake in FinTech to heed this sage advice.
The early madness that surrounded FinTech valuations has of late begun to grow a bit threadbare, with former high fliers such as Lending Club finding themselves in trouble, and the entire robo-advisor segment coming under question because of its inability to defend its space against incumbents. Even the better-managed early stars, such as SoFi, reportedly find themselves hard-pressed to unload their paper and are forced to resort to setting up captive hedge funds to take it off their hands. The payment space is vastly overcrowded, with profits for many of the more recent entrants being as scarce as unicorns once were. Because many of the players are still sitting on large cash hoards, the shakeout - that otherwise would by now have manifested - has instead become a slow-motion defenestration, but a defenestration no less real for its glacial velocity. In the valley of no profits, these cash hoards can postpone the inevitable for those players who have bad business models, and they may well disappear all the more quickly as these companies succumb to the twin temptations of buying market share and their equally ill-starred competitors. This state of affairs is enough to give sleepless nights to investors holding the once so exciting FinTech portfolios.
I am advancing the following 10 principles to help you strategize your way through the coming mini-Armageddon. In this post I will explore the first five. Part 2 will discuss the balance and the implications for planning your portfolio.
A good place to start would be to take a look at how well the company had hit the milestones that matter - not total visitors, or users, likes or stories, but real progress toward profitability, like paying customers, expanding margins and conversions. You would do well to see how the company is spending money: can they account for how their spending contributes directly to revenue or cost management? If you see proliferating VPs of this and Chiefs of that, material sums spent on culture and staff perks and parties, if they are racing to compete for the hottest and most expensive engineers who then turn over at a faster than expected rate, then you may well ask yourself if this management is capable of going the distance. If you see that competition for the company's key customer's share of wallet (not just for exact same service!) is growing and its realized market share is not keeping pace, then you might want to start thinking hard about its business model.
Assuming that the management team and business model survive your close review, the next step would be to take a page out of the Fed playbook and run a stress test on the business: how would it fare in a localized recession? Industry downturn? A general recession? There is probably little need to think about extreme scenarios, but a small to medium-sized slowdown within the next two years is a likely possibility.
Is the non-tech business really worth saving? If after your gimlet-eyed assessment you still believe so, then it may be tempting to set up a new division or even just a sales force to sell tech products within the overall company umbrella. This temptation, however, is best resisted, because few management teams can muster enough focus to run two very different businesses successfully at the same time, and certainly not on the sub-$1B scale, and their temptation to favor the sexier side of the house over the the less fun one might prove difficult to manage. If, on the other hand, technology is the only thing worth saving, then being brutal in forcing a hard pivot may be your best option: shutting down all other business without delay and seriously considering replacing the company's top management with people who understand the enterprise tech business may then be your best way forward.
If your investment is indeed succeeding in making a real dent in its chosen market, then congratulations - you found a real unicorn indeed. If, on the other hand, capturing big market share and real profitability have been elusive, then no matter what scale this company achieved, it may be time to ready a backup strategy, such as, for example, selling products based on its secret sauce to those same old-economy incumbents who proved so difficult to displace. One thing that FinTech companies, especially the consumer-facing ones, have done well is smoothing the customer-business interaction. This is a valuable good that can be rather difficult for financial institutions, to name one example, to emulate well, and selling them on digitally interacting with their clients ought not be like climbing Everest. Selling enterprise tech is not such a glamorous thing to do anymore, and valuations will reflect the lack of glamor, but real profits may well be the one factor that distinguishes the finishers from drop-outs when the band is ready to stop playing.
The early madness that surrounded FinTech valuations has of late begun to grow a bit threadbare, with former high fliers such as Lending Club finding themselves in trouble, and the entire robo-advisor segment coming under question because of its inability to defend its space against incumbents. Even the better-managed early stars, such as SoFi, reportedly find themselves hard-pressed to unload their paper and are forced to resort to setting up captive hedge funds to take it off their hands. The payment space is vastly overcrowded, with profits for many of the more recent entrants being as scarce as unicorns once were. Because many of the players are still sitting on large cash hoards, the shakeout - that otherwise would by now have manifested - has instead become a slow-motion defenestration, but a defenestration no less real for its glacial velocity. In the valley of no profits, these cash hoards can postpone the inevitable for those players who have bad business models, and they may well disappear all the more quickly as these companies succumb to the twin temptations of buying market share and their equally ill-starred competitors. This state of affairs is enough to give sleepless nights to investors holding the once so exciting FinTech portfolios.
I am advancing the following 10 principles to help you strategize your way through the coming mini-Armageddon. In this post I will explore the first five. Part 2 will discuss the balance and the implications for planning your portfolio.
1. Understand where you stand
The first step is to get above the daily grind and take a hard look at whether your company is really positioned to survive the downturn and thrive through the recovery. It may be tempting to ignore early signs of trouble, just because this business is your baby in which you have invested funds and reputation. However, no matter how much you might have sunk into it, if the business model is not working out then it will only drain your focus from those investments that have a better chance of driving your returns.A good place to start would be to take a look at how well the company had hit the milestones that matter - not total visitors, or users, likes or stories, but real progress toward profitability, like paying customers, expanding margins and conversions. You would do well to see how the company is spending money: can they account for how their spending contributes directly to revenue or cost management? If you see proliferating VPs of this and Chiefs of that, material sums spent on culture and staff perks and parties, if they are racing to compete for the hottest and most expensive engineers who then turn over at a faster than expected rate, then you may well ask yourself if this management is capable of going the distance. If you see that competition for the company's key customer's share of wallet (not just for exact same service!) is growing and its realized market share is not keeping pace, then you might want to start thinking hard about its business model.
Assuming that the management team and business model survive your close review, the next step would be to take a page out of the Fed playbook and run a stress test on the business: how would it fare in a localized recession? Industry downturn? A general recession? There is probably little need to think about extreme scenarios, but a small to medium-sized slowdown within the next two years is a likely possibility.
2. Business does not live by technology alone
It has been fashionable of late for every company to be a "startup" ($1B+ value unicorns!), "disruptive" (even if they are disrupting nothing) and "Silicon Valley tech" (that make cars, run taxi services or simply just lend money). The tech buzz has been good for raising F, G and H rounds, but all too often it has lead investors and the managers to forget what business they are really engaged in. Being a tech company is not a strategy. I have seen more than once an example of company that swallows whole the concept of being a tech company to such extent that of all its resources wind up in engineering, while its real revenue-producing business is left to wither on the vine - not to mention any names, but a certain high-profile enterprise has been a poster child for just this manner of a train wreck.
More to the point about your portfolio: it would be good for you know whether the company is fish or fowl, or, in other words, is it truly a tech company that sells technology and tech products, or is it really a pseudo-bank or brokerage or payment expediter, and such like. If your answer is that it is both, then you may find yourself falling between two stools when pushes come to shoves. Your next question may well be be about what is most valuable about its assets: is it a technology, or client base, or business process, or network of suppliers? If the company is, say, in the lending business and its operations are not taking off enough to propel it to leading market share and profitability, then maybe the technology can be spun off to be marketed to competition. Helping incumbents compete against each other through technology - rather than seeking to displace them - might be a way forward, especially in industries where regulation favors pre-existing business, such as in mortgage or real estate brokerage.
Is the non-tech business really worth saving? If after your gimlet-eyed assessment you still believe so, then it may be tempting to set up a new division or even just a sales force to sell tech products within the overall company umbrella. This temptation, however, is best resisted, because few management teams can muster enough focus to run two very different businesses successfully at the same time, and certainly not on the sub-$1B scale, and their temptation to favor the sexier side of the house over the the less fun one might prove difficult to manage. If, on the other hand, technology is the only thing worth saving, then being brutal in forcing a hard pivot may be your best option: shutting down all other business without delay and seriously considering replacing the company's top management with people who understand the enterprise tech business may then be your best way forward.
3. Who has the deepest moat? It may well be the old-economy incumbent
As you are making your assessment of the business, the key question you might consider asking is just how much disruption the industry is going to tolerate. You might want to take a hard look at the incumbent competition: how much market share has it really shed because of the "disruption"? If it is negligible after several years of active sales and if the entire market has not been expanded by your company, then it may well be that your investment has topped out on its growth. Another question you might be asking is how much influence do incumbents has over regulation? I recall some dismal failures to disrupt the real estate brokerage industry, for example, because brokers just happen to dominate their state regulatory agencies. Marketplace lenders and mortgage startups may well be finding themselves in the same boat.
4. Beware racing to the bottom
Is your investment by any chance a payment company or a personal finance iPhone app? Don't look now, but the sheet size of competition - most at about similar market penetration - is a warning sign that it will either shake out to at best a couple players, or worse. I you see a largely similar service is becoming a loss leader for incumbents, that it likely may commodify, and I don't need to tell you what it would mean for valuations.
A few investors will have seen the commodification trap approaching, but fewer of us are smarter than the market most of the time. How best to think about playing the situation? Chances are that your competitors are all looking at the same options, so trying to set up a tech business out of the ashes of the consumer service may not be all that attractive in this instance. However, an incumbent might be found who is willing to acquire your investment with a view to getting parity with their own competition. With luck, at least the better-managed commodity-trapped companies will all get a chance to exit in this manner.
How to tell whether commoditization looms for your investment? It depends on whether it can build itself a moat, AKA sustainable competitive advantage. It is important to have no illusions about what constitutes this moat: defensibly patented software and process might help, regulatory protections for its market space are wonderful, a large lead on the competition in adoption will give you runway, and branding is an old standby. Can your company honestly say that they have a defensible position?
A few investors will have seen the commodification trap approaching, but fewer of us are smarter than the market most of the time. How best to think about playing the situation? Chances are that your competitors are all looking at the same options, so trying to set up a tech business out of the ashes of the consumer service may not be all that attractive in this instance. However, an incumbent might be found who is willing to acquire your investment with a view to getting parity with their own competition. With luck, at least the better-managed commodity-trapped companies will all get a chance to exit in this manner.
How to tell whether commoditization looms for your investment? It depends on whether it can build itself a moat, AKA sustainable competitive advantage. It is important to have no illusions about what constitutes this moat: defensibly patented software and process might help, regulatory protections for its market space are wonderful, a large lead on the competition in adoption will give you runway, and branding is an old standby. Can your company honestly say that they have a defensible position?
5. Scale is worthless absent a clear road to profits
Despite the madness that has surrounded rapid-scaling enterprises so far, few of the new giants have been showing a propensity to convert their users into profitable customers. Of course scale can be a defense of sorts against new entrants, but in the area of finance, it is incumbents who have the most certain scale advantage. For FinTech companies, scale alone is not a moat. An incumbent can at any time acquire your competitor and swamp the relatively small Silicon Valley entrant with its existing client base. High valuations have been keeping these transactions to relatively few in number, but as the shakeout develops, valuations are quite likely to sink much lower.
Surviving the downturn against the pressure from incumbents will require more than a large cash cushion - it will require operational profitability. Unless your investment is on track to reach profitability given a recession scenario in the next two years, then quite likely it may become a casualty, and you may want to begin thinking of an early exit.
Tune in to this blog in the coming weeks for Part II, in which I will set out the remaining 5 principles and their implications for defending your FinTech portfolio investments.
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