Why venture capitalists love fintechs

Fintechs are getting a large infusion of venture capital.

In 2018, U.S. fintechs raised almost $12 billion from VC firms, a surge of 120% from 2017. Leading the trend are a handful of startups that have managed to attract millions.

As a result, there's an increase too in the number of private equity firms, including those operating on the behalf of large banks, seeking to fund fintechs.

But the biggest banks also continue to prefer working in-house on tech rather than seeking partnerships. One reason may be compliance concerns — fintechs will increasingly be under pressure to comply with banklike regulations.

Following is a summary of fintech milestones and potential future moves for the industry, according to CB Insights' 2019 Fintech Trends to Watch Report:

FintechFund
Funding soars

Fintech funding reaches new heights

Venture capital funds are drawn to fintechs. Funding for U.S. startups in 2018 hit a five-year high, totaling $11.89 billion.

There were 10 megarounds in the fourth quarter of 2018 alone, transforming companies like the data aggregator Plaid into unicorns (companies valued at more than $1 billion).

"We have well-funded companies that exhibit strong growth metrics with strong customer acquisition and customer strength," said Ryan Gilbert, a partner at Propel Venture Partners, the investment arm of BBVA.

One drawback to the surge is that though VC firms are pumping up valuations, investors have yet to participate in the growth cycle of these startups.

"Where are the exits?" Gilbert asked. "From an early-stage perspective, you put a lot of thought into what pre-money valuation is and to what extent that somehow caps the pre-money valuation."
AB - Investors
Fintech investors increased by almost 18% in 2018

Fintech investors increased by almost 18% in 2018

Financial services firms are investing in new software, especially in payments and compliance, said CB Insights senior intelligence analyst Lindsay Davis, who also wrote the report.

“I expect 2019 to be another solid year for fintech,” said Mark Goldberg, partner at Index Ventures in San Francisco. “We're in a massive secular transformation from an offline to digital economy, so the the tailwinds for innovation are strong despite whatever macro headwinds develop.”

Some investors are seeing more activity from generalist funds.

“A large part of the focus is being driven by the results shown and sheer number of unicorns,” Gilbert of Propel said. “There’s also an increased amount of interest from entrepreneurs. Investors follow entrepreneurs. When capable talent is pursuing this sector, more of them will do the same. It’s an element of pattern recognition among the better investors.”

Many new fintech investors likely don’t understand financial services or bank integration, said Michael Gilroy, partner at Canaan Partners. “It’s OK, though, because they have a nose for consumer products,” he said.
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Banks will continue to build in-house
Christopher Dilts/Bloomberg

Banks are continuing to build in-house

The top 40 financial institutions still feel a need to build technology in-house — perhaps to their detriment, Gilbert said.

“Banks need to focus on what they are best at: being fiduciaries and maintaining compliance elements,” Gilbert said. “Banks should ask, can they attract and retain the best technology startups out there?”

Banks should be seeking out opportunities to acquire software companies that already have attractive interfaces, Gilroy of Canaan Partners said.

“I’m not one to bash banks,” Gilroy said. “However, I think banks are better at cross-selling, compliance and regulations.”
Robinhood
Startups will refocus on compliance
Andrew Harrer/Bloomberg

Startups will refocus on compliance

In December, the company behind the popular trading app Robinhood announced it would launch a checking and savings account insured by the Securities Investor Protection Corp.

But the stock brokerage application ran afoul of regulators when the head of the SIPC said it had not reviewed or approved the product.

With increased emphasis on compliance, investors are seeing their portfolio companies add lawyers to their teams as early as a year before product launch, Gilroy said.

“We are at a stage where noncompliance won’t be forgiven,” Gilbert said. “Startups won’t be expected to move fast and break things.”

Some challenger banks in Europe have gone so far to create “reg relations” teams that build inroads with regulators in new markets, Davis of CB Insights said.
Early-stage
Early stage deals taking up less of the pie

Smaller slices of early-stage funding

First-wave fintech innovators have reached significant scale and begun cross-selling new products to customers, Goldberg of Index Ventures said.

So as the fintech industry matures, early-stage companies grab less of the spotlight.

Typically, early-stage deals take up a larger percentage of the annual deal portion, Davis of CB Insights said. With more perceived winners in various niche markets, there are more deals happening in other startup stages.

“On the other hand, new developer tools, like Plaid, have lowered the hurdle to building and created an explosion of new consumer finance applications,” Goldberg said.

“So, paradoxically, while investors are seeing more early-stage opportunities than ever, they're focusing on fewer deals in companies that have true breakout potential and unique value propositions.”
Trading floor
Mega-rounds are hot, IPOs are not
ANDREW HARRER/BLOOMBERG NEWS

Megarounds are hot, IPOs are not

Startups have less incentive to go public with easier access to private capital, Gilbert said.

Though there were 52 financing deals worth over $100 million apiece in 2018, CB Insights predicts that the number of initial public offerings will continue to shrink in 2019. After the Tax Cuts and Jobs Act of 2017 was amended to increase the investor threshold, there’s less of an obligation for startups to go public.

“Their decision to go public will be more based on agreements with larger later-stage investors than any other factor,” Gilbert said.

Seeing public markets be unfavorable to alternative lenders may also be causing fintech startups to be cautious about the move, Davis said.
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