Preparing for the Fintech Revolution: What to Expect in 2021

Bill Harris, the former PayPal CEO and veteran entrepreneur, took the stage in Las Vegas in late October to announce his latest startup. He said that the company would help Americans improve their relationship with their finances.

Harris told CNBC that people often struggle to manage their money effectively. He said that his company is working to bring money into the digital age and redesign the experience so that people can have better control over their finances.

But less than a month after the launch of Nirvana Money, which combined a digital bank account with a credit card, Harris abruptly shuttered the Miami-based company and laid off dozens of workers. Harris said that surging interest rates and a "recessionary environment" were to blame for the shutdown.

This reversal is a sign that more financial damage is on the way for the fintech industry.

Many fintech companies will be forced to shut down or sell themselves next year as startups run out of funding, according to investors, founders and investment bankers. Others will accept funding at steep valuation haircuts or onerous terms, which extends the runway but comes with its own risks, they said.

According to Point72 Ventures partner Pete Casella, top-tier startups that have three to four years of funding can ride out the storm. Other private companies with a reasonable path to profitability will typically get funding from existing investors. The rest will begin to run out of money in 2023, he said.

Casella warned that companies can get caught in a "death spiral" if they can't get funding and their best employees start leaving because their equity is underwater.

After the 2008 financial crisis, thousands of startups were created as investors poured billions of dollars into private companies. With interest rates low, investors were looking for ways to get higher returns than they could get from public companies, and traditional venture capitalists began to face competition from new players like hedge funds, sovereign wealth funds, and family offices.

The fintech sector has seen explosive growth in recent years, driven by the pandemic and the resulting shift to digital channels. This has led to a surge in investment, with fintech companies raising more than $130 billion in 2021 and minting more than 100 new unicorns. This frenzy is showing no signs of slowing down, as investors continue to pour money into the sector in search of the next big thing.

"VC investment in fintech is growing rapidly," said Stuart Sopp, founder and CEO of digital bank Current. "You can't put that much capital behind something in such a short time without crazy stuff happening."

The influx of money led to the creation of copycat companies whenever a successful niche was identified. These companies would get funded regardless of whether or not they had a solid business model. This led to a lot of speculation and risky investment, as companies relied on metrics like user growth to justify their sky-high valuations. Investors who hesitated on a startup’s round risked missing out as companies doubled and tripled in value within months.

The thinking behind this approach is that you can reel users in with a marketing blitz and then figure out how to make money from them later. This can be a effective way to grow your user base, but you need to be careful not to over-promise and under-deliver on your product or service.

"There's no question that we've overfunded fintech," said one founder-turned-VC who asked not to be named. "We don't need 150 different neobanks or 10 different banking-as-a-service providers. And I've invested in both of those categories," he said.

The first cracks began to appear in September 2021, when the shares of PayPal, Block and other public fintechs began a long decline. At their peak, the two companies were worth more than the vast majority of financial incumbents. PayPal’s market capitalization was second only to that of JPMorgan Chase. The specter of higher interest rates and the end of a decade-plus long era of cheap money was enough to deflate their stocks.

Many private companies created in recent years have been based on the assumption of low interest rates forever. However, this assumption has been challenged by the Federal Reserve's aggressive rate-hiking cycle in recent years. This has created difficulties for many companies that have been relying on low interest rates to stay afloat.

Many fintech startups have been unprofitable for their entire existence, but they continue to attract investors with the promise of eventually becoming profitable. However, many of these startups will never actually become profitable, due to faulty assumptions on which they were founded.

According to Greene, even companies that have previously raised large amounts of money are struggling now if they are deemed unlikely to become profitable.

Greene said that he saw a company that raised $20 million but couldn't get a $300,000 bridge loan because their investors told them they were no longer investing. He found this unbelievable.

According to investors, the market has reset lower by at least 30% to 50% at every stage of the private company life-cycle, from embryonic startups to pre-IPO companies. This follows the decline in public company shares and a few notable private examples, like the 85% discount that Swedish fintech lender Klarna took in a July fundraising.

Now that the investment community is exhibiting more discipline and "tourist" investors have been flushed out, the emphasis is on companies that can demonstrate a clear path toward profitability. In addition to previous requirements like high growth in a large addressable market and software-like gross margins, companies now need to show that they can be profitable, according to veteran fintech investment banker Tommaso Zanobini of Moelis.

Zanobini stated that the real test for a company is whether their cash flow needs are shrinking, which can be determined in six to nine months. He emphasized that it is not enough for a company to simply say that they will be successful in a year.

As a result of the current economic climate, startups are laying off workers and cutting back on marketing expenses. Many founders are hoping that the funding environment will improve next year, although that seems increasingly unlikely.

As the economy slows further into an expected recession, companies that lend to consumers and small businesses will suffer significantly higher losses for the first time. Even profitable legacy players like Goldman Sachs couldn’t stomach the losses required to create a scaled digital player, pulling back on its fintech ambitions. This will likely lead to consolidation in the industry as smaller players are forced to exit the market.

"If loss ratios are increasing in a rate increasing environment on the industry side, it can be dangerous for loan economics," said Justin Overdorff of Lightspeed Venture Partners.

Now, investors and founders are trying to determine who will survive the coming downturn. Direct-to-consumer fintechs are generally in the weakest position, several venture investors said. This is because they have high customer acquisition costs and are reliant on capital markets.

According to Point72's Casella, there is a strong correlation between companies with poor unit economics and consumer businesses that become very large and well-known.

Many of the country's neobanks are not likely to survive, according to Pegah Ebrahimi, managing partner of FPV Ventures and former Morgan Stanley executive. "Everyone thought of them as new banks that would have tech multiples, but they are still banks at the end of the day," she said.

Oded Zehavi, CEO of Mesh Payments, believes that most companies that raised money in 2020 and 2021 at high valuations of 20 to 50 times revenue are in a difficult situation. Even if a company like that doubles its revenue from its last round, it will likely have to raise new funds at a significantly lower price, which can be very damaging for a startup.

"The recent boom in the economy has led to some really surreal investments with valuations that cannot be justified," Zehavi said. "All of these companies across the world are going to struggle, and they will need to be acquired or shut down in 2023."

There is always opportunity during tough times. The stronger players will snap up the weaker ones through acquisition and emerge from the downturn in a stronger position. They will enjoy less competition and lower costs for talent and expenses, including marketing.

"The competitive landscape is always changing, but it tends to shift the most during periods of fear, uncertainty and doubt," said Kelly Rodriques, CEO of Forge, a trading venue for private company stock. "This is when the bold and the well capitalized will gain."

As the year has progressed, sellers of private shares have become more willing to accept discounts on their valuations. However, the bid-ask spread remains too wide, with many buyers holding out for lower prices, according to Rodriques. He believes the impasse could be broken next year as sellers become more realistic about pricing.

In time, both incumbent firms and well-funded startups will reap the rewards, either through purchasing fintechs outright to jumpstart their own development, or by poached talented startup employees who return to banks and asset managers.

In an October interview, Harris agreed that the cycle was turning on fintech companies, though he didn't let on that Nirvana Money would soon be among those to shutter.

Harris is confident that the best startups will not only survive, but thrive. He believes that there are huge opportunities to disrupt traditional businesses, and that these opportunities should not be ignored.

Harris stated that the best products always come out on top, regardless of the circumstances. He believes that the existing solutions that are the best will only get stronger, and new products that are even better will also be successful.