Failing fintechs: survival of the fittest?

20 Dec 2019

Hundreds of fintechs have arrived on the Open Banking scene in recent years, but history hasn’t been kind to fintechs, with the vast majority destined to fail – how do they handle the challenges, asks Jennifer Turton.

Any start-up company has to find the right balance between short-term priorities and long-term strategy. Fintech start-ups are no different.

Those in the business say the current climate is all about longevity of funding. Put simply, those who have great ideas and backers with deep pockets will be the most likely to succeed.

While this may seem self-explanatory, the demands of private equity backers can create a conflict between achieving short-term milestones and executing long-term product strategies.

Michael James, head of technical architecture at financial services software business Altus, likens this to BBC TV programme Dragons’ Den.

“Fintech companies often look to the outside world for funding in exactly this way, albeit not on camera,” he says.

“They will likely meet potential investors on a one-to-one basis hoping to secure the funding they need to deliver their world-beating idea and make everyone rich. Unfortunately, most corporate investors will have standard due diligence hurdles for any significant investors which many start-ups will fail to clear – policies, contracts, clients, commercials can all trip up business founders who have been entirely focused on the proposition they want to build rather than the mechanics of the business.”

James argues that for that reason, the most popular method of funding start-ups is for the founder to invest their own money.

“For the serial entrepreneur this may have come from the sale of a previous business or, if it’s their first attempt, perhaps from a redundancy package, having worked for one of the larger financial services firms for many years,” he says.

“This kind of boot-strapping may be enough to get the business off the ground but often not to reach profitability – the cost of customer acquisition can be punishingly high in financial services.”

This is where private equity or venture capital firms come in: businesses with cash to invest, looking to improve the prospects of a struggling firm with a great idea.

James cites Nutmeg as one high-profile example that has gone through multiple rounds of funding, but is yet to make a profit.

“It is tempting to assume that the expert asset managers who have injected cash on more than one occasion see a long-term trend which amateur investors have missed but there may be another explanation,” he says.

“A colleague recently told me of an investor friend who will make five investments on the basis three will fail, one will remain on life support for the foreseeable future but the fifth will make them a fortune. If corporate investors operate on this basis, then Nutmeg (and many more fintechs like them) could simply be a casualty of statistics.”


Venturing beyond

Oliver Charlton, a consultant at Tori Global, explains that fintech has received the most investment over the past five years of all start-up sectors, with the source of funding primarily venture capital firms.

However, he suggests a growing percentage of investment is coming from the crowdfunding community and argues that this has several benefits over the traditional venture capital route.

“Firstly, before even launching a product, a firm can build a community of investors who (hopefully) will evangelise the product and act as a sounding board during product development,” he says. “Secondly, it grants the firm raising capital a degree of autonomy that they might not get with a venture capital firm. Venture capitalists often require positions on the boards of their portfolio firms, so crowdfunding can be a better option for the more free-spirited founders.”

Charlton adds that, while investment in fintechs has been rising, this pattern fits the wider trend of increased investment in start-ups across the board.

“This is partly due to historically low interest rates, which translates to cheap money and growing interest in alternative investment strategies. [It] has resulted in a swelling of the number of venture capital funds, as well as an increase in the size of funds, in terms of assets under management,” he says.

There is a degree of variation in the type of investors in fintechs depending on what stage the company is at, but also the manner in which it is invested (either directly or indirectly).

In what is increasingly seen as a status symbol, Charlton argues, angel investors and seed-funding are often supplied directly by high net worth individuals.

“As the company gets off the ground, the likes of family offices and incubators start to take an interest, and this can be done through a combination of direct and indirect channels,” he says, adding that this was demonstrated by Y-Combinators’ £113m investment in Monzo.

However, what makes a challenger stand out from the crowd, particularly when it comes to seeking investment, differs depending on the stage they are at.

Charlton explains: “At angel and seed level, the emphasis is less on financial analysis, although this becomes increasingly important as the company seeks to raise more substantial levels of capital.

For fledgling companies, the analysis really focuses on the leadership team, the idea itself and the addressable market.

“Quite simply, the lack of data makes it harder to crunch the numbers of early-stage challengers, so more heuristic methods are employed. Ten is often the magic number when it comes to choosing a successful challenger: if the product or service is 10 times better than its competitors, then it could be a winner.

“Additionally, the rule-of-thumb for venture capitalists is that an exit event for a portfolio company must deliver roughly 10 times the amount invested in order for the fund to be profitable.”


Funding winners

The Business Competition Remedies scheme has also recently assisted in funding a handful of fintech firms. In Pool D of the £775m scheme, where the focus has shifted to the commercialisation of fintech, Codat, Fluidly, Form3, Funding Options and Swoop Finance were all given £5m.

Daniel Meere, UK managing director of global financial services consultancy firm Axis Corporate, says: “This is a clear message for all fintechs which applied to continue with their expansion plans, building capabilities and development of their product roadmaps. The commercialisation of fintech is not going away and Pool A and B winners are already scanning the market for fintech partnerships to help them serve the SME market through their funding awards or future expansion plans.”

Turning to those securing funding from Pool D, Meere explains that they continue the approach set out by ClearBank in the Pool A announcements, aimed at connecting providers and providing elements of utility banking offering.

He says: “Fluidly, for example, aims to unlock financial data for SMEs and transform how businesses manage their finances, while bringing together the wider banking and fintech ecosystems. This is welcome to the sector overall and is a positive step in enabling and commercialising innovative technology for use by banks in the delivery of their services to SMEs.

“Codat capitalises on the need for integration and the challenges faced by banks in linking the new applications that they need with the legacy technology that they are saddled with. Specifically targeting the accounting packages, and the need for SMEs to connect these to their banking applications to enable more accurate credit scoring, better flow of information and more seamless business management, its solution has been welcomed by many banks as a core offering already.”

Succeeding, however, is made up of more than just investment. The nature of the financial services industry means timely legal advice about strategy can be the difference between success and failure.

David Gardner, partner at UK law firm TLT, explains: “Early stage fintechs commonly need to establish relationships with multiple parties and consider the application of complex regulations at the outset of their growth journey.

“For start-ups, limited time, resources and finance mean it is important to be able to separate the wood from the trees and focus on key issues. Launching a successful fintech business involves navigating an alphabet soup of regulation and compliance requirements – PSD2, SMCR, GDPR, EBA requirements on outsourcing and Cloud, and so on. If it doesn’t apply to you, it probably will apply to your customers, suppliers or partners.”

He says these firms need to navigate legal, commercial and regulatory issues that are often unique to this sector.

“A fintech that is set up from the outset with a clear and credible position on these issues will be far better prepared for due diligence from would-be investors or acquirers.”