Fintech companies: Behind the hype, a tough industry & high investment risks

In one of his latest blog, Early Metrics’s CEO Antoine Baschiera details why fintech startups are hyped but not the best rated startups, why, and what does it mean for an investor:

I’d be interested to have the Fintech Genome community’s thoughts.

Fintech start-ups are hot and have been for the past few years. Global investment in the industry reached a whooping $20bn in 2015, from $12bn in 2014. Despite a drop in VC-backed investment in the sector at the end of last year, fintech start-ups benefited from $4.9bn in Q1 this year. But take a closer look at the industry, and you might want to start questioning the state of affairs. While 2014/2015 brought its number of IPO, prices of fintech start-ups shares have actually systematically gone down, and performances of listed companies have gone awry.

The hyped-up fintech industry is becoming very crowded, and the high volume of actors hides the lack of genuine innovation. A look at the 12 fintech unicorns identified by CBInsights’ Unicorn Tracker shows that none are fundamentally shattering the financial services, even though they brought lower costs of operations and/or better customer experience. Blockchain, perhaps the most disruptive technology yet developed, has currently no broad applicability.

In such a situation, decision-makers looking to make smart investments need better ways to assess potential opportunities. But how to measure a fintech start-up’s actual worth when the venture is early stage?

Financial criteria are not sufficient enough to value fintech start-ups

The financial approach traditionally adopted to value a fintech start-up has its limitations:

Credit risks assessments are usually irrelevant for start-ups, who lack credit history or management accounts. Some early stage ventures seeking seed funding might not even have banking facilities and may not be able to provide banking references.

The lack of facts to back growth rate indicators or revenue generation forecasts also makes these projections hard to evaluate. If a market exists, the potential of capturing shares is highly dependent on the ability of the team to operate and deploy strategically, rather than on the existence of said market.

Initial investment and high valuations do not validate a business model. Investors should look at traction and other business related KPIs. which depend on the state of the market, marketing plans, ability to partner with relevant actors etc. Visa Europe’s decision last year to reduce its stake in Monitise but keep engaged through a procurement relationship provides a good case example of an stakeholder focusing on building a start-up’s growth rather than betting on forecasted valuation.

Non-financial assessment as a first step will soon become the norm

Financial due diligence should not be disregarded as it can reveal skeletons in the closet. However, it does not help to fully assess or support investment decision-making. As a first step of due diligence, investors are more and more turning to a less-financial centric approach:

First, evaluating the team is becoming an essential part of the investment decision-making process, in particular the founders’ understanding of the marketplace and skillset. Philippe Collombel, Managing Partner at Partech Ventures, also looks for complementarity, which is increasingly present in fintech, with more and more bank executives teaming up with entrepreneurs. Assessing a team’s ability to deploy a strategy is also important. The difference between TransferWise and Remitly’s success lied in that the former has a clear scale-up strategy and executed it systematically.

Second, assessing the product allows decision-makers to understand whether is possesses a strong differentiating factor. As any technology-driven product, fintech start-ups need a high level of capital to get kickstarted. It is therefore important that the product assessment shows whether the technology has true innovative aspects that can be integrated within financial operations, and not yet another replica of existing technology.

Finally, the market opportunity should be sizable and should indicate the potential for a start-up to scale. Evaluating if the business approach is sound, and how the entrepreneurs will manage to generate revenues realistically will help support the investment decision.

Turning to non-financial metrics brings an additional level of understanding of early stage ventures. But the assessment needs to be done in a systematic and scientific way rather than solely on gut feeling. Non-financial due diligence - performed in a methodological manner the way Early Metrics does -, will help de-risk investment. It will also facilitate engagement further down the line, as entrepreneurs and investors will know a start-up’ strengths and weaknesses and will work together to improve and scale the business. As assessments are by nature static, performing follow-up assessments will allow to track the evolution of a fintech company.