Fintech doesn't show signs of stopping. No chance this bubble is popping. The startups are ready to go, let it grow, raise some dough, let's IPO! When these companies were young and uncertain there were three basic risks their investors were underwriting:
- Product (micro) risk
- Regulatory risk
- Cyclical (macro) risk
Product
Unlike many deep tech investments, there is little question about whether the entrepreneur's vision of a potential solution can be created. The risk that the early stage fintech investors are taking is often proving out that a market for a product even exists and then figuring out that product market fit. These are microeconomic questions. What is the pain point in the customer's life, how much would they pay to solve it, and how much does it cost you to get your solution to them?
Regulatory
On the other end of the spectrum are the cyclical, or macroeconomic risks. After the Great Financial Crisis, investors were justifiably wary. Many fintechs, particularly those in the lending space, who rely on access to cheap and liquid capital markets, but also those who connect to banks and other financial institutions have valuations that can swing wildly with the overall stock market performance. In corporate finance, this is known as beta. Money center banks, (traditional large international financial institutions), after all, have the highest market correlation of any sector. Then pile on the idiosyncratic startup risk, and you begin to understand why investors ask for so many protections.
Cyclical
Third, and most interesting, in my opinion is regulatory risk. This is one reason you saw VC's backing foreign fintechs for so long. Sending American money abroad to find a regulatory arbitrage in the U.K., Germany, or Brazil, only to have these companies wash up on American shores, taking on the entrenched big banks who had prevented homegrown startups from impinging on their turf. Finally, U.S. based regulators have begun to loosen binds, and as my friend Kaushik pointed out, "Everybody is a bank nowadays" (or at least they're trying to be). Recently, I was invited to the 7th Annual Digital Financial Services Summit at Columbia University. There I saw one of the most powerful financial regulators, the New York State Department of Financial Services Superintendent speak:
New Sheriff in Town
The message was clear. If you do your part to listen to customers, care about their problems, and make a good faith effort to improve their lives, we are not here to stop you. In fact, they can't stop the innovation in financial services that customers demand! This is why regulators from state and local to Federal, are slowly opening the flood gates. So what regulatory risk is left? Well three big ones, that could get you fined millions of dollars, or worse revoke your charter:
- Know your customer/anti money laundering (KYC/AML)
- Predatory pricing and aggressive sales tactics
- Cybersecurity
While investors still have dollar signs in their eyes, they are wary to these three big regulatory risks. Product risk is inscrutable, and market cycles are impossible to predict, but regulatory risk is completely within a startup's own control. Any investor or entrepreneur who doesn't derisk where they can, is playing with fire.