Amid the IPO gold rush, how should we value fintech startups?

My colleague, Tess Munsie and I, originally published this piece in TechCrunch here.

If there has ever been a golden age for fintech, it surely must be now. As of Q1 2021, the number of fintech startups in the U.S. crossed 10,000 for the first time ever — well more than double that if you include EMEA and APAC. There are now three fintech companies worth more than $100 billion (Paypal, Square and Shopify) with another three in the $50 billion-$100 billion club (Stripe, Adyen and Coinbase).

Yet, as fintech companies have begun to go public, there has been a fair amount of uncertainty as to how these companies will be valued on the public markets. This is a result of fintechs being relatively new to the IPO scene compared to their consumer internet or enterprise software counterparts. In addition, fintechs employ a wide variety of business models: Some are transactional, others are recurring or have hybrid business models.

In addition, fintechs now have a multitude of options in terms of how they choose to go public. They can take the traditional IPO route, pursue a direct listing or merge with a SPAC. Given the multitude of variables at play, valuing these companies and then predicting public market performance is anything but straightforward.

The fintech gold rush has arrived

For much of the past two decades, fintech as a category has been very quiet on the public markets. But that began to change considerably by the mid-2010s. Fintech had clearly arrived by 2015, with both Square and Shopify going public that year. Last year was a record one with eight fintech IPOs, and there has been no slowdown in 2021 — the first four months have already produced seven IPOs. By our estimates, there are more than 15 additional fintech companies that could IPO this year. The current record will almost certainly be shattered well before the end of the year.

Not all fintech is created equal

It is important to note that fintech is a complex category with many different types of players, and not all fintech is created equal. Nor will all fintech public valuations live up to the hype. To understand this more deeply, we need to examine the various business models that fintechs employ today and the revenue multiples these models can command on the public markets.

Broadly speaking, we can divide most fintech IPOs into four buckets: (1) Lending 1.0 (e.g., LendingClub), (2) Payments (e.g., Square), (3) fintech SaaS (e.g., Avalara), and (4) BNPL (e.g., Affirm). Just three years ago, all but Lending 1.0 coalesced at ~10x forward revenue, but the forward multiples (and valuations) of these companies have evolved substantially since — particularly in the year since COVID struck.

Lending 1.0

The first wave of lending companies has remained the lowest valued throughout this period at ~2x-3x forward revenue. This is despite recent favorable public market conditions for most tech companies. This low multiple is a reflection of overall deteriorating business characteristics (e.g., negative growth rates, high losses and challenged unit economics). Many of the Lending 1.0 players also served end customers like subprime consumers or brick-and-mortar SMBs that were heavily impacted by COVID.

We expect these Lending 1.0 companies to continue to trade at low, single-digit revenue multiples (likely around 3x). We have seen some consolidation in this space as well (OnDeck was acquired by Enova last year, for example), and suspect that there will be more M&A in the years ahead.

Payments

Payments has been the most consistently valued group of the four categories, rising modestly to ~12x during this three-year period (despite some fluctuations). This group includes scaled businesses like Square and Paypal generating billions of dollars in revenue at decent gross margins (40s-50s) and still growing at around 40%-50% year over year. As they mature and reach scale, many of these companies have diversified their product offerings and looked to inorganic channels for further growth.

We predict that this category will see slight valuation uplift in the coming years to ~13x-15x. This will mostly be a result of younger companies like Stripe and Toast entering the IPO pipeline in the next few years. With strong growth rates, these new entrants will receive higher multiples and raise the average multiple for the payments category.

Fintech SaaS

Like much of enterprise software, fintech SaaS was a very clear winner over the past 12 months, doubling forward multiples to ~20x. This was a result of positive COVID tailwinds, recurring revenue models, high gross margins (70%-80%+) and general business reliance on core financial software systems. Many of these companies also have very high net-dollar retention (in many cases >120%), perhaps the most important metric aside from growth.

That said, there is some potential that this category has experienced the most multiple inflation of the four categories. As we move into a post-COVID era, 20x revenue multiples may not be sustainable. We expect fintech SaaS companies to reset to a new “steady state” well above 10x, but likely in the 15x-20x range.

Buy-now-pay-later (BNPL)

BNPL is the newest and most fascinating basket of the bunch. Pre-COVID, this group quickly expanded up to trade at ~15x due to 100%+ growth rates, hyper network effects, enormous markets and consumer virality. At the start of COVID, these companies saw their multiples briefly dip almost down to Lending 1.0 levels before the market priced in the strength of these models and their enabling of e-commerce merchants (many of which were COVID-accelerated), all while seeing no material impact to loss ratios. While average multiples in this category briefly exploded to 30x+, with Affirm’s debut, we have seen them fall back to earth a bit.

Still, this category currently commands the highest multiples in all fintech at ~25x. Given we are still in the very early innings of e-commerce globally, we expect the near-term steady state for BNPL multiples to be somewhere in the 20x-25x range. We look forward to Klarna’s reception on the public markets later this year.

But what about insurtech and crypto?

Importantly, there are two additional categories (not pictured above) that have begun to emerge within fintech: insurtech (Root and Lemonade) and crypto (Coinbase). While the data is still limited in terms of number of IPOs and time on the public markets, we will eventually add these as their own categories to the chart above. As of the end of April, Root was trading at 6.6x, Lemonade was trading at 46.7x, and Coinbase was trading at 12.5x.

The return of the SPAC

One big caveat to our discussion on valuation and multiples is, of course, the return of the SPAC. In 2020, SPACs burst back onto the scene and have rapidly made an impact on the IPO landscape. Metromile was the first fintech to be taken public via SPAC this year, but there is a wave of additional SPAC IPOs on the horizon (e.g., SOFI, Hippo, Payoneer and MoneyLion) and plenty of demand from investors for SPAC IPOs — there are currently over 150 fintech or financial-oriented SPACs seeking targets.

SPACs represent the Wild West for fintech public valuations. SPACs targeting fintechs is a relatively new phenomenon, and many of these blank check companies are taking fintech targets public earlier than they otherwise would via a traditional IPO. How SPACs perform on the public markets and the impact they have on the fintech valuation story is perhaps the most interesting question for 2021.

That said, whether it be via SPAC, direct listing or traditional IPO, we are likely to see at least 10 to 15 fintechs go public this year — possibly more. That is nothing short of astounding. The spotlight will be bright this year on fintech IPOs as the gold rush continues.

***

You can access the data (including the underlying raw data) for the graphs above by clicking the link here.

Anchoring Oak’s efforts out West

**This post was originally published on the Oak HC/FT website here**

Last month, I joined Oak HC/FT’s San Francisco team. I could not be more excited to help identify and partner with the next generation of entrepreneurs in FinTech, building on Oak HC/FT’s strong legacy of investors and operators who have built enduring companies for decades.

Over the course of the last ten years, FinTech has really begun to hit its stride. There are now nearly 40 FinTech unicorns globally (more than any other vertical) worth an aggregate value of nearly $150B. Not bad for a sector that didn’t have a ton of buzz when Oak first started investing in the space in 2002.

FinTech_CBInsights — Source: CB Insights

And this is just the beginning, there will be much more to come in the next 10 years. As I look to the next decade to come, I’m first and foremost eager to learn from the founders and entrepreneurs building at the fore-front of our industry. That said here are a few themes I have been thinking about deeply in recent months and am particularly excited about:

Vertical payments: We have already seen a few successful versions of this playbook including: Toast (restaurants), Flywire (travel & education) and PayIt (government.) But many more verticals could benefit from a bespoke, vertical-specific payments solution including pharma, logistics, manufacturing and more.

Next-generation commerce: Innovation in commerce in recent years has largely come in the form of new payments options (like Square, Affirm and Afterpay.) The next wave of innovation will enhance in-store commerce, logistics/ delivery/ returns, international commerce and buying via new mediums like voice, computer vision and mixed reality.

Intersection of FinTech + AI: Machine learning is already being used in financial services. Our portfolio company, Feedzai, uses machine learning to help banks and merchants fight fraud. In the years to come machine learning will stretch beyond risk and into underwriting, product discovery, predictive intelligence and a number of other use cases.

Middleware tools for developers: Stripe and Plaid have shown us that developers are the next big consumers of financial data and they require tools to access and use that data: be it payments meta-data, account information or piping infrastructure to connect with other financial institutions. As microservices and APIs continue to proliferate, developers will require more tooling to serve end customers.

Banking Applications: Many financial services incumbents suffer from manual-heavy tasks for workflows that have struggled to make the transition to digital. Our portfolio companies Kryon (robotic process automation) and Ocrolus (digitizing financial documents) are two examples of the new wave of companies focused on automation, software-enabled workflows and refined banking applications.

Back-office application software for SMBs: The software stack for most functions (e.g. marketing, sales, customer support, etc.) within an SMB certainly looks a lot better than it did 5 years ago when Oak first invested in Freshbooks. But the finance and accounting functions remain underserved. As SMBs demand better software for their back offices, new entrants will rise to the occasion, providing these businesses with a better way to close their books, pay their vendors and manage payroll.

Financial services for the underserved: Banking services have improved for many of us but there remain many demographics that are underserved. Oak has a history of investing in this category, dating back to NetSpend, which went public in 2010. I’m excited to see founders focus more on low-income Americans, immigrants, freelancers/1099s, older (and younger) generations, those with large sums of student debt, etc.

Future of real estate: Almost everything about commercial and residential real estate stands to be improved for both buyers and sellers. Moreover, the ecosystem players around them (e.g. brokers, agents, lenders, inspectors, etc.) are still mid-transition to cloud-based tools. New entrants in real estate will find ways to improve workflows for these ecosystem players or generate more economic value for buyers and sellers.

If any of this resonates with you, let’s get in touch. I’m focused on opportunities on the west coast (and that certainly includes more than just the Bay Area!) But even if you are outside the west coast, I still want to hear from you. Looking forward to finding ways to collaborate!

Matrix FinTech Index: 2018 Edition

The full overview of the Matrix FinTech Index 2018 edition is available on TechCrunch here.

At the end of 2017 we published the Matrix FinTech Index for the very first time. In what we hope will become an annual tradition, we are excited today to publish an updated index and set of supporting data.

There is no doubt that this has been another stellar year for fintech. In last year’s version of the Matrix FinTech Index, we predicted the crypto enthusiasm would be short lived and that the fintechs would be the more relevant disruptors in 2018. By most metrics this seems to have turned out to be true. A comparison of search interest in “fintech” vs. “crypto” is one clear indicator of this:

Definition: Matrix Partners considers “fintechs” to be venture-backed organizations that are (a) technology-first companies that leverage software to compete with traditional financial services institutions (e.g. banks, credit card networks, insurers, etc.) in the delivery of traditional financial services (e.g. lending, payments, investing, etc.) or (b) software tools that better enable traditional finance functions (e.g. accounting, point-of-sales systems, etc.)

Methodology & Results

As a refresher, the Matrix FinTech Index is a market-cap weighted index that tracks the progress of a portfolio of the 10 leading U.S. public fintech companies over the course of the last two years (beginning in December of 2016). For comparison, we have also included another portfolio of 10 large financial services incumbents (companies like JP Morgan, Visa and American Express) as well as the S&P 500 index.

With two years of data now in, the results are pretty clear — the fintechs continue to outperform both the incumbents and the S&P 500. 2 year-returns for the fintechs were 133% compared to 34% for the incumbents and 24% for the S&P 500.

Updated Data Now Available

As we did last year, we are releasing an updated data package that anyone can download here and which has a range of other helpful information on both the U.S. fintechs and the incumbents. The updated package has much of what we had last year plus a few newer elements:

Market cap and stock price data for the fintechs and incumbents
Comp sheets with financial metrics
Data on the 20 fintech unicorns
Information on the fintech “Brink list” — companies that have raised over $100M in equity financing
M&A & IPO activity in fintech this past year

As always we appreciate your feedback and thoughts on the process and methodology. And we look forward to sharing our thoughts again in 2019!

Enterprise Payments: The next frontier for payments innovation

Towards the end of 2017, we discussed the rise of the FinTechs and briefly alluded to payments as being a key area for further innovation. The payments ecosystem is an ever-evolving space froth with opportunity and plenty of buyers with deep pockets (see Paypal’s announcement a few weeks back). Furthermore, it is a deeply intricate ecosystem with challenging technical problems, shifting regulatory components and a variety of consumer and enterprise use cases. For all these reasons, it is worth a “double click” to explore further.

We have already seen huge amounts of innovation in payments over the last few decades. In the U.S., this innovation was enabled by a few important advances. The establishment (and operation) of ACH by the Federal Reserve Banks and EPN created a much needed electronic network for financial transactions. NFC technology and POS hardware enabled mobile payments. More recently, pay-out APIs and fraud management systems have allowed developers and those working in risk to manage feature build-out while also keeping an eye out for bad actors. And we are just beginning to see some applications of crypto in the payments space — such as this.

Despite these advances, most of the innovation has been focused on two areas: consumer-to-consumer payments (e.g. Venmo), business-to-consumer payments (e.g. Square) or new entrants that facilitate one of the two (e.g. Stripe). A third category, business-to-business payments, has not benefited from innovation to the same degree as the other two categories. This is particularly interesting given that the market size of B2B payments is 5–10x that of C2C or B2C payments. And yet, technology has been slower to transform the B2B payments world. Case in point, B2B payments made by the good ol’ check, as a share of overall transactions, leveled off around 2013 at a point significantly higher than C2C and have actually gone up slightly to ~51%.

Existing Challenges

In the early days of C2C and B2C payments, there were many intricacies from a technical and regulatory perspective that had to be navigated very carefully. After all, real consumer money was at play so the stakes were high. The same is true in the B2B world, with a few additional challenges that make things even more hairy:

Transaction values are significantly higher: While the volume of B2B payments is much lower (some say in the 9:1 range compared to B2B + C2C), the value of these payments per transaction is much larger. This makes enterprise transactions prime targets for hackers, front-runners and a host of others with bad intentions. Beyond the actual financial risk, enterprises also risk having the banking information of their suppliers and customers exposed.
There is greater complexity: In the enterprise payments context there is significantly more complexity. Let’s take the simple example of someone in procurement trying to pay a supplier. Post RFP, legal review, etc., the buyer will need to first work with the various business units and other internal stakeholder to issue a purchase order. The supplier must do the same in order to provide an invoice to the buyer. The buyer must then send a request to the card issuing bank (via p-card or some other mechanism.) The buyer’s bank must then handle settlement with the supplier’s bank. This may happen via check, credit, debit, ACH or even cash. Post-settlement, the buyer and seller must ensure that both their internal financial systems and/or ERP systems are accurately updated. Imagine the complexity involved when doing this hundreds or thousands of times per day across many different payment types (one-off, recurring, up-for renewal, etc.)
Many people are involved with any given transaction: As a result of the greater complexity, many heads are involved on both sides of the transaction. Procurement, legal, finance and the BU may all be involved at various stages. B2B payments affect the workflows of a much broader set of people than C2C or B2C payments.
The life cycle of a payment is longer: As a result of the added complexity and multiple stakeholders, the duration of the payment is longer than in the C2C and B2C contexts. C2C payments in today’s world can clear in a matter of minutes. On the enterprise side, the payment life-cycle can have a duration of 60, 90 or even 180 days.
The life cycle of a payment is longer: As a result of the added complexity and multiple stakeholders, the duration of the payment is longer than in the C2C and B2C contexts. C2C payments in today’s world can clear in a matter of minutes. On the enterprise side, the payment life-cycle can have a duration of 60, 90 or even 180 days.
The U.S. is not well structured for top-down fixes to B2B payments: When Europe moved to the Euro, all the participating countries did a significant overhaul of their banking systems allowing them to make significant upgrades to the tech stack. In the process, they solved a number of the pain points above (including significant reduction/ elimination of checks). But in the U.S., the Fed does not have the authority to mandate unified standards. Lack of standardization is particularly tough in the U.S. as we have many more banks than Europe (including regional and community players) — creating a major interoperability problem with few bank-agnostic solutions. Meanwhile, the U.S. banks themselves have made little attempt to create a common solution to fix the antiquated system.

Key Opportunities

While these challenges are daunting (they most certainly are not for the faint of heart!), the good news for new entrants is that the banks and other FIs are unlikely to be the ones to fix enterprise payments. We believe FinTech startups are best positioned to make progress here, bottoms-up. More specifically, there is an enormous opportunity to capture value in enterprise payments($2.1T in payment revenue by 2026) across 5 specific subcategories: (1) capital markets, (2) procurement, (3) treasury management, (4) payment dev-tools and (5) blockchain.

Capital Markets: Many parts of capital markets (e.g. HFT, commercial lending, etc.) send/receive very large transactions each day. Most of the time these payments are slow, expensive and require manual reviews to ensure they are valid. In the HFT world, for example, every minute matters when making a trade and fees add up. Payments solutions that focus on speed and automation, without sacrificing security will do well here.
Procurement: In procurement, enterprises and their suppliers face the problem of trying to integrate procurement software tools, with ERP systems and antiquated payment processes. This problem is particularly challenging with services and in the “long-tail” spend, where some enterprises have to pay tens of thousands of suppliers each year. Solutions that integrate with existing software solutions, simplify the enterprise’s workflow and get the money to the supplier faster (e.g. lower DSO) will have the most success here.
Treasury Management: Initiating and managing ACH payments to other businesses, auditing those payments and then closing the books at the end of the month is still not straightforward. Software tools that provide solutions for both the finance and the tech team to navigate this process have a shot at building a must-have for anyone trying to get a grip on treasury management. Particularly for SMBs who don’t have the luxury of simply throwing more people at the problem.
Payment Dev Tools: Companies like Stripe and Plaid have created great APIs and financial plumbing tools. But they are largely focused on C2C and B2C payments. B2B developer tools / APIs that work for the IT and risk departments of enterprises and address the complexity therein will do well. Certainly a hairy problem to figure out but there is a lot of spend here for the right solution.
Blockchain: In the short run, blockchains have enough technical issues (e.g. scaling, interoperability, etc.) to work through. But in the long-run distributed ledger technology can provide a single database of truth between two enterprises, eliminating the need for ledgers on both sides and making verification/ security a bit more manageable. The real question from a B2B payments perspective is not “if” but “when.”

At Matrix Partners we are deeply interested in backing the next generation of enterprise payments companies. We focus primarily on Seed/ Series A investing here in the U.S. Please let us know if you are building something interesting here — would be great to meet up and learn more!

FinTech: We’re just getting started

Global FinTech investment in 2017 was unprecedented with $16.6B of capital (+20% compared to 2016) deployed across 1,128 deals. Despite this, some have argued that FinTech’s days are numbered and that it is less clear how much opportunity still remains for future innovation. Proponents of this line of thought argue that most traditional financial services have already been unbundled and that large startups that dominate areas like payments, lending, and investing have even begun to re-bundle services. Moreover, despite the uptick in investment into the sector, the early-stage portion of overall financing dropped to a 5-year low which has further supported the belief that most of the innovation in FinTech has already happened.

At Matrix, we believe that we are still in the early innings of the financial services disruption. While FinTech startups have done very well in the last decade, there is still room for more great companies to be built. As a follow-up to our previous article where we introduced the Matrix FinTech Index, we have put together a corollary to that piece where we specify 7 tailwinds that have powered FinTech innovation for the last 10 years, discuss key drivers for future innovation, and identify the subcategories we believe are most promising.

Review of 7 important tailwinds for innovation in FinTech the last 10 years

Mobile has been leveraged as an enabler: Companies like Squareleveraged mobile as a way to reduce the cost of doing business for merchants by allowing for new features like secure payments via mobile applications.
The financial crisis created unmet demand: Incumbent’s unwillingness to lend to credit poor individuals and high-risk SMBs created a window of opportunity for companies like Lending Club and OnDeck to fulfill this unmet demand.
The payments infrastructure opened up to developers: APIs and developer tools made available by companies like Braintree and Stripeallowed developers to integrate payment processing into their websites without the need to maintain a merchant account.
Online banking penetration unlocked important customer data: Deeper penetration of online banking has made it possible for companies like Yodlee to allow users to see all their banking information on one screen and others like Credit Karma to provide credit monitoring services.
Core financial services have been unbundled: Many sub-segments traditionally handled solely by the banks have been unbundled. For example, SoFi is helping with borrowing, Xoom with money transfers and Mint with financial management.
The cloud provided a new distribution channel to serve SMBs: Companies like Kabbage, which provides loans to SMBs, can now justify serving lower life time value customers like SMBs due to the lower customer acquisition costs associated with the cloud.
Digital disintermediation provided greater value to consumers: Companies like Wealthfront, Betterment and Robinhood all reduce the fees charged by brokerages and traditional investment managers providing greater alpha to retail investors.

Key drivers for innovation in the next 10 years

Many of these 7 trends will continue to play a role in FinTech innovation moving forward. But we have identified 3 additional drivers for innovation in FinTech going forward.

1. Incumbent failures are really coming into focus.

Traditional financial institutions are anachronistic. They serve their customers with antiquated products and are often slow to innovate due to both their size and regulatory burdens. Moreover, financial products have historically not been customer-centric, as banks devote most of their resources to optimizing their data and analysis and boosting their bottom line. Consequently, incumbents in financial services have largely failed to meet the needs of consumers, and the emergence of FinTech has put their shortcomings under the spotlight.

While financial services as an industry has been notorious for low consumer trust levels, consumer trust has plunged even further in the wake of fraud, scandals, and data breaches (e.g. Wells Fargo and Equifax). Additionally, poor customer experience has left consumers with limited loyalty to their financial services providers.

2. Millennials are emerging as the new source of spending power.

Millennials are the largest generation in American history consisting of over 70 million people born between 1980 and 2000. Millennials are digital-first users who grew up distrustful of banks and are generally more inclined to try FinTech applications. Furthermore, while traditional financial services has focused on large pools of wealth characteristic of older generations, FinTech innovation is making financial services and products much more accessible to younger generations.

3. Due to the transition of profit pools, incumbents are going to become a lot more acquisitive in the coming months.

Incumbents have begun to acquire FinTech companies as a means to compete against innovative startups and other acquisitive incumbents. Many of the acquisitions so far have been centered around automation of basic tasks. In the last 5 years, 18 FinTech startups have been acquired by banks, with 8 acquisitions occurring since the beginning of 2017. We believe that there is much more opportunity and incentive to acquire — especially for technologies that go beyond automation.

5 subcategories we are most excited about

Ultimately we believe the incumbents will continue to lose ground to the FinTechs and that there is plenty of opportunity for entrepreneurs to build enduring companies in the sector. Great companies will certainly be built across the entire financial services industry, but here are a few sub-categories within FinTech that we think are particularly exciting:

Payments: Even with all the innovation to date in payments, there continue to be pain points throughout the category and many customer demographics remain underserved. In order to be successful in this category, new entrants will need to build on-top of existing payment rails, serve large TAMs and go after new use cases.
Investing / wealth management: Despite recent innovation by players like Wealthfront, Betterment, Robinhood and others, wealth management remains dominated by the incumbents. This reality makes the category a ripe one for entrepreneurs as there are large TAMs, poor customer experiences and a new generation (i.e. millennials) that have unmet needs. Success here will require intuitive design, low fees and efficient customer acquisition.
Infrastructure Apps: Financial institutions suffer from bloated cost structures in the middle and back office for tasks like fraud/ risk management, collections, invoice management and customer support. There’s an opportunity for entrepreneurs to provide software tools that reduce costs and allow for more efficient work flows if they can manage the lengthy sales cycles and procurement processes.
SMB tools: Companies like Gusto and Namely, have begun to serve SMBs in areas like payroll and benefits administration. Even so, SMBs remain largely underserved compared to larger enterprises. FinTech companies that can acquire SMBs efficiently and provide enterprise-level experiences will be able to generate enough value to their customers to create large outcomes.
B2B Lending tools: On the consumer side, lending has become pretty crowded with some of the winners already declared. But on the enterprise side, the category is very ripe. The opportunity for entrepreneurs is in leveraging data at cloud scale combined with advances in machine learning to allow enterprises to better assess borrower risk and drive higher yield.

The author would like to thank Sreyas Misra for his contributions to this piece.

Revolutionizing wealth management with Jon Stein, Founder & CEO of Betterment

In this fourth episode of Focus on the Founder, Jon Stein, Co-founder & CEO of Betterment joins us to discuss his career journey, experience starting Betterment while in business school and thoughts on wealth management and investing more broadly.

Achieving Personalization At-Scale

Betterment is a robo-advisor platform that provides investment advice and wealth management at a low price point. The wealth management space is fiercely competitive. Startups like Betterment, Wealthfront, and Robinhood as well as incumbents like Vanguard and Schwab have all entered the space, competing to provide personalized, low-cost advice to consumers.

Since Betterment launched in 2010, their assets under management have grown rapidly, reaching almost $12 billion earlier this month. During this conversation, Jon discusses his experiences growing Betterment, and how Betterment has succeeded in such a competitive environment through truly putting the customer first. As always, you can find the full podcast episode on SoundCloud, iTunes, and Google Play.

Key Thoughts from Jon on…

The reasons behind founding Betterment:

While working for the First Manhattan Consulting Group, Jon advised some of the world’s largest banks and brokerages. In the process, Jon gained an insider’s perspective on how banks operate and serve their customers. His product-development engagements with banks typically involved working on the key aspects of their products such as default rates and internal transfer pricing. Notably, these larger players paid almost no attention to their customers during the product-development process, as they focused much more on optimizing their data and existing flows, which Jon found perplexing. While working in Australia, Jon encountered user-centric financial products not available in the US at the time, such as the mortgage-offset account which combines a traditional mortgage and deposit account.

These experiences helped frame the problem that Betterment aims to solve — that “the old way of managing money is broken.” Investment management should be held to a higher standard — one which focuses far more on consumers.

Building a team:

Jon committed to starting Betterment before starting his MBA at Columbia Business School. In the early days, building Betterment was a two-fold challenge — building the actual product and navigating the regulatory challenges of being an investment advisor.

Sean Owen, Jon’s roommate at the time, provided much of the early engineering expertise. Sean was a software engineer at Google who studied computer science at Harvard, and built the back-end of Betterment while Jon worked on the front-end. Jon eventually met Eli Broverman during a weekly poker game. Eli, who was then a securities attorney, provided the legal expertise and helped Jon navigate through complex regulatory landscape. Sean and Eli’s skillsets were diverse and congruent with the early challenges that Jon needed to solve.

The fundraising journey:

Betterment launched at TechCrunch Disrupt in 2010, where they competed against 500+ entrants, many of which had already raised some amount of funding. Betterment went on to win the competition, giving him crucial exposure to customers and investors. Immediately following the competition, Betterment signed up 400 new customers, who helped drive Betterment’s initial organic growth by way of referrals. The boost in credibility from the event made it easier to hire new employees, and helped Betterment rapidly grow from what was at the time a four-person team.

Just as important, preparing for the Disrupt presentation helped Jon and his team internalize their story and understand how to best pitch the idea. A month following the TechCrunch competition, Jon was able to raise $3 million from Bessemer Venture Partners.

How Betterment puts customers first:

Since the initial investment from Bessemer, Betterment has secured $275 million in funding and has grown significantly in employee count and AUM. In this period of growth, Jon doubled down on the theme of bringing the voice of the customer into every interaction. This focus has helped Betterment withstand the test of time and compete effectively against a host of startups and incumbents offering similar services.

Private Robo-Advisors in the Wealth-Technology Category

Betterment puts the customer first by:

1. Personalizing advice

Betterment’s vision is to provide excellent financial guidance that is easy to understand and available to everyone. Betterment is unique in that it offers a spectrum of interaction-types: customers who prefer human interaction can receive hybrid-robo solutions through Betterment’s unlimited text messaging and premium telephone access services. By prioritizing the education of their end-user, Betterment offers a suite of solutions to improve consumer-access to financial markets.

2. Building trust

Financial services as an industry has historically had a low NPS. Betterment strives to build trust with its customers as both an ethical obligation and a means of differentiation. In addition to investment advice, Betterment publishes scores of articles helping consumers understand their personal finances, navigate through tax reform, and manage their expenses. Betterment also has no holdings of their own; thus, they eliminate many of the conflicts of interest present in most banks.

3. Combining responsibility with wealth creation

Betterment offers a way for consumers to hold well-diversified portfolios that are also socially responsible through their socially responsible investing (SRI) portfolio. Social responsibility doesn’t just afford Betterment an additional dimension of personalization; it also reflects well on their brand as an ethical investment advisor.

The future of investment management:

In this bull market, massive amounts of capital have been pushed into indices and ETFs, which represent a little over 10% of the global equity market capitalization. In fact, these indices and ETFs, spearheaded by firms like BlackRock and Vanguard, have outperformed an overwhelming majority of hedge funds.

Net flows into U.S.-based passively managed funds and out of active funds in the first half of each year

Jon explains that Betterment is here to stay even in increasingly likely bear market scenarios, as the same principles of minimizing cost and managing tax burdens that currently power Betterment’s platform still apply during downturns. Through careful risk-management, alternative investment strategies, and optimizing customer behavior to prevent market panic, Betterment aims not only to protect its customers in bear markets but also provide them competitive returns.

Money 2020: 12 lessons from this year’s conference

Earlier this week I attended Money2020 in Las Vegas. In just over 5 years, Money2020 has become the leading industry conference for everything to do with FinTech. It’s a jam-packed but valuable 4 days of expert panels, startup pitches, networking events and keynotes from industry leaders. I was there for just under 24 hours, which meant the experience was even more of a blur. This post is my attempt to capture twelve of the biggest learnings from the conference.

Lesson 1: Money is still the #1 biggest stressor for most Americans, understandably so. Dan Wernikoff from Intuit was one of the keynote speakers Tuesday morning and some of the data points he surfaced on consumer behaviors around money are sobering:

44% of Americans cannot come up with $400 for an emergency.
49% of Mint users spend more than they make.
Intuit customers on average paid $1,700 a year in interest.

Lesson 2: Most financial institutions are not adequately meeting the needs of their customers. Despite the potential opportunity created by the high stress around money, banks and other financial institutions really struggle to provide the experience their customers need. This is in part because most financial institutions are product centric not customer centric. The result has been notoriously low NPS scores and a disenchanted end user. Even more alarmingly, most customers of the leading banking brands distrust their banks:

Capture

Lesson 3: Among an already pretty unhappy customer base, millennials are the most disenfranchised of all. As Philippe Dintrans, Chief Digital Officer at Cognizant put it, most financial institutions are totally missing the mark with millennials. That is in part because millennials exhibit fundamentally different behaviors than earlier generations around things like savings. 63% of millennials are focused on saving towards desired life goals (e.g. getting out of student debt, purchasing a home, etc.) as compared to 45% of gen Xers and baby boomers. 55% of gen Xers and baby boomers are focused on developing savings towards retirement, where only 37% of millennials are planning for retirement

Lesson 4: FinTech startups have capitalized on the failures of incumbents by addressing specific pain-points with carefully designed products. The examples are smattered across financial services but a few examples that stand-out:

Wealth management was traditionally a confusing and fee-heavy landscape to navigate. Betterment created a beautiful and educational product that reduced fees and enabled a better user experience.
Peer-to-peer money transfers traditionally required a manual process that took days and trips to the bank. Venmo made it simple, quick and fun to do P2P payments.
SMBs used to have to use clunky check-out payment methods that locked them into a set location and required back-end processing to reconcile the books. Stripe enabled any merchant anywhere to accept payments with ease using an iPad.
Applying for, managing and refinancing loans was historically a painful process for most students. SoFi provided students with an easy way to apply for and refinance their loans all with the promise of a lower interest rate.

Lesson 5: Barriers to entry have never been lower to starting a FinTech business. It’s not just that the cost of starting a business in tech has been dramatically reduced (which has been well documented). In FinTech, there are also important industry-specific enablers allowing startups to enter and compete with the incumbents:

Insurgents don’t need a large balance sheet to open business. For example, marketplaces like LendingClub and Prosper connect borrowers and lenders without underwriting any of the loans.
Regulatory hurdles, for almost every sub-category within FinTech (with the exception of Blockchain / crypto assets), have been removed thanks to early pioneers like PayPal.
Platforms and developer tools like Stripe and Shopify have reduced development costs and time-to-market dramatically enabling SMB merchants to sell with the same ease as larger enterprises.

Lesson 6: Large and enduring companies have been and will continue to be built in FinTech. In two decades, PayPal, the “original” FinTech startup has reached a market cap of $84B. By comparison AMEX, which was founded a 167 years ago, has a market cap of $82B. Many more enduring companies will be built in FinTech in the years to come.

Capture 2

Lesson 7: There is no shortage of venture money. As of today there are 36 FinTech unicorns globally – that number represents 17% of the total share of unicorns. The venture market has realized the breadth of opportunity in FinTech and more money has poured into FinTech than ever before. In 2008, the number of FinTech companies funded was just over 200. In 2016, the number of FinTech companies receiving venture capital exceeded 5,000. In the same time period, venture funding from a dollar perspective climbed from <$1B to close to $60B.

Lesson 8: Great companies are being built across categories. With this increase in FinTech funding, great new companies are being built and entire sub-categories, from payments to insurance, are being served in new ways. Some of the really big winners of today either didn’t exist or were in their infancy 10 years ago. A few examples include publicly traded companies (LendingClub, Square, etc.), unicorns (Stripe, Sofi, GreenSky, CreditKarma, AvidXchange, Gusto, etc,) and several others that are well on their way (Betterment, Affirm, Plaid, etc.)

Lesson 9: Many think that the big area of opportunity for FinTech is in Blockchain/ crypto assets but that may not necessarily be true. Blockchain/ crypto assets are certainly getting all the attention right now but there are plenty of other areas that are just as interesting on both the B2C and B2B sides of the table. Some areas that are particularly exciting include:

Consumer: (1) personal financial management, (2) insurance, (3) real estate and (4) investing / wealth management
Enterprise: (1) institutional investing, (2) infrastructure apps, (3) SMB tools, (4) commercial insurance and (5) security & fraud detection

Lesson 10: Blockchain – lots of noise but few clear signals. Bitcoin today is trading at $5,500+ per coin and the total market cap of all cryptocurrencies is $170B. ICOs meanwhile have raised $8B in 2017 to-date. In the midst of this some things are clearer than others. What is clear today is that crypto assets have a definite use case as a store of value. What’s less clear is how we get from there to the end goal of software with no central operator, which is the big promise behind blockchain. The big advantage to blockchain, as Adam Ludwin from Chain put it, is “censorship resistance” (access is unfettered and transactions are unstoppable) but we have yet to see killer applications that can cannibalize existing practices.

Lesson 11: It’s not all about the U.S. ~1/3 of today’s FinTech unicorns are outside the U.S. (Asia + Europe). U.S. FinTech companies can likely learn a bit from their peers in other geographies. Behavioral and cultural differences certainly exist but there are a few clear examples of this that came up during one of the payment-focused panels. For example, in China, WeChat is using messaging capability to allow social payments. Stan Chudnovsky, the Head of Product for Facebook’s Messenger, revealed during one of the payments sessions that Facebook is developing this and expects it to be a key use case in the next 18-24 months. But in this space we are certainly followers not leaders.

Lesson 12: The FinTech community grows more vibrant and robust each year. Money 2020 was founded 5 years ago and since its launch then has grown into the leading FinTech conference globally. There are now 11,000+ attendees, more than 1,700 CEOs & Presidents and 85 countries represented. Still a lot of opportunity ahead but the numbers speak clearly to the vibrancy and enthusiasm in the community. Many thanks to the founders of Money2020 Anil Aggarwal, Simran Aggarwal and Jonathan Weiner for another great conference. Looking forward to next year!

P2P Lending: The Early Regulatory Environment & Today’s Emerging Landscape

Over the course of the last century government has always found a way to influence the course of business through regulation. Traditionally, however, the government has tended to focus regulatory efforts on large enterprises. The vast majority of startups often fly under the radar as they are too small to really create concerns for regulators. The select few that do balloon into bigger companies through super-sonic growth, i.e. the Ubers and AirBnBs of the world, often do encounter regulatory hurdles as they grow into large enterprises. The reality, however, is that government regulation, in certain industries, can be game changing even at the earliest of stages. We need look no further than peer-to-peer (P2P) lending as an example.

Going back a decade to the mid-2000s, P2P lending was a nascent industry that had begun to shape into a two-horse race between Prosper (founded in 2005) and Lending Club (founded a year later in 2006). At the time, U.S. consumers had about $880 billion in credit outstanding and the virtual marketplaces for P2P lending were thought to reach $300 billion in loan origination per year by 2025. It was (and still is) a huge and growing market with lots of potential. As the first mover in the space, Prosper had jumped out in front by the end of 2007, facilitating 10x the number of loan originations as Lending Club. But 7 years later, Lending Club went on to IPO in December of 2014 and now has an enterprise value of $9.6B. Prosper has fallen to a distant 2^nd and has struggled to find demand for an IPO—withdrawing its filing process on numerous occasions. So what happened?

The answer is government regulation, which provided Lending Club with a huge competitive advantage over Prosper in the early days of P2P lending. The critical issue that came up in 2008-2009 was over whether the SEC would view the loan transactions Prosper and Lending Club were facilitating as promissory notes, without any filing requirements, or securities, which (at the time) had extensive and very expensive filing requirements.

Prosper took a more passive “wait and see” approach to this regulatory issue—hoping that regulators would simply view the underlying assets as promissory notes and leave them alone. Lending Club, however, had the foresight early on to see the danger with this approach. If the industry was forced to file with the SEC, everyone would have to shut down for 6 months and submit to the long and expensive registration process. As such, Lending Club chose to take a proactive approach in being the first movers to file. Moreover, they actually helped the SEC shape much of the regulation in P2P lending which provided them with a huge short-term advantage over the competition.

As soon as Lending Club finished their filing process, the SEC then ruled that every other P2P lending marketplace would have to do the same. This meant that they came out of the process right when everyone else had to temporarily shut down for 6-9 months. So for ~9 months (time it took Prosper to emerge from the process) they were effectively the only player in P2P lending, right as the market took off courtesy of the tailwinds provided by the financial crisis.

Many of the other early players essentially shut down due to the heavy costs of filing and the lost time. Prosper managed to hobble out of the process but by then the damage had been done. With 9 months of green field, Lending Club had built out both sides of the two-sided marketplace, enhanced their network effects and customer captivity and emerged as the #1 player in P2P lending. The last 5 years Prosper has been playing catch-up as best it can. So government regulation was game-changing early on in P2P lending.

However, the story doesn’t really end there. While Prosper and Lending Club continue to do pretty well, the challenge for both of them is that they don’t have much by way of long term competitive advantages. The image below shows their respective competitive advantages at 2 different points in time.

We’ve already discussed the early days of P2P lending, so let’s shift our focus on what is happening now in 4 cores areas: (1) government regulation, (2) scale, (3) customer captivity and (4) cost.

Government Regulation: Having cleared the SEC regulatory filing process, Prosper emerged wounded but alive. The problem with regulation now, however, is that in many ways Propser and Lending Club cleared the way for everyone else. The SEC filing process is now much faster and less costly. So there no longer exists a true competitive advantage for either from a regulatory perspective.

Economies of Scale: Neither Prosper nor Lending Club ever had an advantage in terms of fixed costs. These are software marketplace business that are not capital intensive; that basic principle remains true today. What has changed is the strength of the network effects.
- Since dropping the auction-style borrower/lender matching process and migrating to the Lending Club method of assessing credit risk (through FICO scores and other metrics), the number of credit-worthy borrowers and therefore lenders willing to lend has increased tremendously on Prosper’s platform. The result has been a strengthening of Prosper’s network effects. They have now done $2B in total loan origination, which is a third of the $6B Lending Club had done.
- The challenge though for both Lending Club and Prosper, however, is that the networks effects are not unique to their platforms. Lenders are simply in search of credit-worthy individuals in this low interest rate environment. As lenders on these platforms continue to move away from individuals and towards institutions, they will be increasingly more willing to multi-home across multiple platforms in search of the most credit-worthy borrowers and the highest yields. Borrowers will also multi-home in an effort to find the lowest interest rates as well as the most personalized / specific marketplace—hence the rise of P2P lending in specific verticals (more on this below).

Customer Captivity: Admittedly, I don’t have much by way of evidence but my belief is that as network effects begin to dwindle on both Prosper and Lending Club, so too will customer captivity. This will be most notable in terms of customer acquisition costs. Around 2010/2011 it cost Lending Club ~$40-$60 to acquire each borrower and ~$20 to acquire each lender. I am positive that this is higher than CAC in 2009-2010 when Lending Club barreled its way out of the SEC filing process as the only player and lower than what they will have to spend in years to come to acquire customers. Expect to see marketing and sales spends as a % of revenue to increase as well as higher churn and a lowered ARPU/CAC ratio.

(Supply) Cost: Early on, Lending Club and Prosper may have had a slight supply advantage in terms of proprietary knowledge and/or special resources. Their algorithms matching borrowers and lenders as well as probability of default may have provided them with a slight edge—particularly given the larger amounts of data they had as a result of being in business longer than others. Unfortunately, this too is not a sustainable competitive advantage. The technology in P2P lending over time has become increasingly commoditized—there are only so many ways you can assess credit-worthiness and, given enough brain-power and time, the technology can be easily replicated.

So the overall affect for both Prosper and Lending Club has been a weakening of their competitive advantages vis a vis the rest of the P2P lending market. This has resulted in a whole slew of new entrants fighting for share and cutting into the once high (as high as 40% for Lending Club) margins. Here’s a look at how the competitive landscape is shaping up today:

In particular, the last few years have given rise to vertically focused P2P lending marketplaces. These vertical P2P lending marketplaces focus on specific verticals like student lending (SoFi, CommonBond, etc.) or SMB lending (OnDeck, CAN Capital, etc.) Because they offer a specific focus or thematic lending opportunity, the network effects and customer captivity of these offerings tends to be high. While still mostly small and narrowly-focused, these vertical P2P lenders have broadened the P2P lending marketplace into more than just a 2-horse race.