Navigating Early Stage FinTech - A framework
Hi,
One of the few things I’ve been up to for the last ~2Y was early-stage (Pre-Seed to Pre-Series A) investments, primarily in FinTech and SaaS, being trusted to be a sector investment lead for a Micro VC fund has its benefits.
After evaluating close to 250+ deals in the space, looking at startups across lending, payments, investing and wealth-tech, among others and making several mistakes.
Here are my learnings and mental framework have helped me understand and make sense of this wonderful industry.
Let’s Begin
Why looking at a FinTech’s Revenue is the worst place to start
The first and most common mistake I’ve seen VCs, myself included, make when they first look into the sector is approaching it with the lens of a) Consumer (B2C) or b) SaaS (b2b)
The thing is, Fintech revenue doesn’t work that way
Consumer revenue as you can see grows in the most “linear” fashion out of the three, which is also why alot of people find it easy to understand as well as we can value it using basic revenue multiple since the flow typically is revenue > operating leverage kicks in basis unit economics, covers fixed cost > at “X” point, it’d become profitable
SaaS, however, grows in a relatively more “exponential” manner, initially slower but eventually growing faster. Logic? As the company grows and its product offering widens (cross-sells + price increase), reaching more people while the older players expand their contracts.
The nature of the above is also why, at least partially, the “rule of 40” works after seed / Pre-Series A for SaaS funds, allowing for an easy heuristic metric to understand if the SaaS company is doing well basis growth and margins.
FinTech, however, isn’t like that, and that’s because its revenue isn’t a simple price*qty equation, and the adoption and growth rate of FinTech is rear-ended, not front-ended.
Before I dive deeper, let’s first see the data used to make the above chart.
Consumer revenue is basic to understand: Price * Qty > over time, there are minor price rises as the company can demand more basis new product additions, brand, etc. , Qty on the other hand rises quickly initially due to low base but eventually slows down as penetration slows down after capturing initial whitespace + needing capex to drive newer distribution channels + competition entering the whitespace, moreover consumer overall while big, the whitespaces that do exist are often sub ~INR 500 Cr. and hence the growth slows down after a point to whatever the segment is growing after a certain scale - btw 20% y-o-y growth is no joke, just slows down is my point
If we look at SaaS > the intial client acquistion in % terms is high but in actual terms is lower, however given the B2B nature, there are only so many people who’d buy from you intially, eventually growth does slow down > it’s also then that SaaS companies often start focusing on cross-sells, new product lines, etc. to increase their ACV and target a wider base > moreover while growing, as they add more features, their ACV increases too over time as their product becomes better > however even here, it’s a simple price qty, i.e ACV Clients
In FinTech however, that’s not the case - I’ve used transaction value to explain here (which could be in payments or lending, for investing/wealth-tech, this becomes a bit more complex, but more on that later) - in fintech, the revenue is a result of price qty my share (take rate) which is super small
Given the trust nature + network effect required in the business, the initial days for a fintech don’t have high volume growth, and the people using it also often use it for lower value of transactions; given the low business, you can’t demand high take rates either since your value-add is lower.
However, the opposite is also true: when they grow, all three of the above grow together and exponentially, leading to a J-Curve like revenue, especially after adoption.
For investing / wealth tech business, the transaction volume and value would be replaced with AUM (existing which grows as the AUM grows basis wallet share acquired + returns generated > which is an exponential thing) + new AUM (which is basis employee + capex + brand value leading to higher net worth / more money) > hence having similar 2-3 pillars growing exponentially
to make it simpler look at it this way
if you’ve 2 drivers for revenue (price qty) and in most cases only one has hyper growth, your overall growth while fast, would be diminishing, leading to eventually slower returns (think 1.2 1.1 per year) vs. if you’ve 3 drivers all of which fire at the same time, grow exponentially together (1.2 1.2 1.2 per year).
This is one of the reasons why FinTechs are hard to understand and require a different lens to understand and value as well as why most investors miss out on early-stage FinTechs due to “low traction” that doesn’t justify their valuation.
Further, given the market size most fintechs operate in, the exponential rise is easier than say consumer, aided by the aspect that since fintechs are mostly “enablers” of other businesses and the fees earned are “hidden” from consumers who are the most finicky to pay and without the fintechs, the normal course of business would be hard to continue (imagine a consumer brand that doesn’t accept digital payments?)
So if not revenue, what do we look at, Aryan?
Well, what drives that revenue
Transaction value / AUM
Volumes
Repeat rates
Quality of product (failure rates in payments, NPAs in lending, NPS of the product)
Need of the product and workflow
Solving the puzzle: why do early rounds of fintech happen at even crazier valuations?
Now, we finance folks (we can argue how much VC is finance some other day)LOVE thinking we can forecast the future and then, based on our view of how that’d look like and the expected return we want to make, figure out how much we want to pay for it today; the art of “DCF”
Yes, you can say we do have a certain level of god complex.
Now, how’s that relevant to the puzzle - why do fintechs have larger valuations in early stage rounds vs. other sectors?
It boils down to mainly three simple things
The way revenue shapes up, as discussed above, given while revenue today might be much lower than startups in other sectors, it can grow in a way that can quickly surpass it the moment it gets it triggers > this is where the entire forecasting part comes into picture alongside point no. 2
“Operating Leverage” - fintechs while making less per transaction on absolute terms, actually have potential for pretty high-profit margins otherwise since majority of their expenses are fixed post they make their take rate so once they hit that “inflection” point, every transaction could quickly start contributing heavily to the bottom line and eventually cashflow (especially since working capital here is lower due to no inventory), for the uninitiated, I’ve explained operating leverage before. - Link
Lastly, and an equally important reason; Fintechs simply need more capital; unlike consumer or SaaS businesses where a) setup costs are lower b) you can start with 1 SKU or a simple product and add more complex features over time; that isn’t the case in Fintech, operating in the “trust” business and in what is a heavily regulated industry with even minor offences being punishable, you simply can’t afford to have incomplete products or products that still need iterations as well as need more folks who bring in expertise such as regulations / compliance and high level connects, and if that’s not enough, most licenses required for being an NBFC (lending) , PA (Payments) or even RIA (investment advisor) have net worth requirements including a certain amount of cash reserves > you simply need more capital and since early stage valuations is basically = Amount needed divided by stake diluted > ofcourse the valuations are high
The market size paradox - seemingly large markets but small profits yet high valuations in early stage?
In the first bit of this post, I mentioned how there’s a large bet on future revenue + profits that makes the seemingly high valuation turn out to be okay in the long run.
But if the markets are that huge, why do only a few manage to actually reach that scale and make profits, isn’t that paradoxical?
After all, we all need payments, loans and more, no?
Well, the trick to that lies in how FinTechs make money, Let’s look at the “SME Credit gap” according to a report by Avendus back in the day, $530Bn. i.e $530 Billion - That’s huge, isn’t it? Afterall, it’s also one of the “larger” fintech segments which VCs have and continue to put a large amount of money in.
Well, yes and no.
Firstly, let’s just see how much of the overall demand is simply unaddressable before we arrived at the addressable market of $819Bn. and the $530Bn. gap that has to be met - that shows how while the total market is often large in Fintech, addressing it is another thing.
Further, even the $530Bn. that’s an overall number, not all of it can be tapped by the same workflow, app and strategy (i.e same firm) since different loan sizes are usually for different needs and require a different form of underwriting > so let’s further see the credit gap for loans sized less <INR 1Mn (i.e INR 10L) > about $120 Bn.
See how quickly that came down? now let’s look at the potential revenue pile that can be added (since this is the number that is yet to be serviced, not the total market)
Usually the spread for Micro-Finance firms recently has been 10-12% (i’m taking into account based on the size of the loans, and this is being generous) - so the revenue share tbh here is closer to say $10Bn. - still a large market, but no where close to the number we began with.
Now this is ofcourse a riskier segment with 2-3% NPAs, so assuming those always happen, the actual revenue realised is probaly even lesser at about $7-8Bn; although technically NPA would come under cost or revenue not earned, but this is to understand that how in FinTech big intial numbers often boil down to small numbers quickly.
And if you’d guess the profit margins here, you’d be shocked, they are usually between single digits to low teens, i.e the untapped profit pool is probably closer to <2bn. (assuming $10Bn revenue without including the impact of NPA and 10-20% margins which include the impact of NPA)
Now by no means is an additonal $2Bn profit pool is small, it’s just that, it’s not as big as one thinks, and that’s crucial.
Two criticisms you might have here are
a) most fintechs are often lead gens for capital providers or do FLDG so would be different in economics > well yes but their economics / take rates would be worse since they are part of this value chain and not beyond it > and all of them do want to eventually have their lending book, the thing i’d agree with is they might have higher profit pools given they’d be lighter in operations so you can probably add another 5-7% given i’ve already taken the higher end of the profit margin pool.
b) does that mean fintech is not a big space or one shouldn’t invest? and if yes, why did you justify the valuations before?
This is the paradox, while fintechs in early stage would and can command higher valuation multiples for the reasons above, including that j-curve revenue in pre-seed / seed, the premium multiple would drop drastically as they scale eventually because once they reach the industry levels of size of transactions, volumes, margins, the play becomes commoditized
Let’s look at our early fintech revenue and try to visualize this paradox to make it more clear
If you see, investing in Year 1 (first row) - you’d probably look 9 years down the line, and as companies mature, you’d look at a shorter time in the future + would want a lower required return as the risk wears off.
Now the valuation multiple in the future (at exit) - remains the same, a lowly 1x revenue (now, yes fintech would and could have a different valuation multiple basis book, or some other metric however for simplicity sake, let’s go with this) - 1x revenue is not that high compared to other industries late stage multiples.
But given how low the early revenue in fintech is > you’d see an insane high revenue multiple - although it makes sense now that we look at it this way, even as the actual multiple in future is lower > the issue and reason is the slow start of revenue, not the large end goal or high exit multiples
See how that solves the paradox on why it’s okay to have high absoulute valuation/valuation multiples way early in life of a fintech startup (not to add, that early on, most fintechs are operating only partially in the value chain) even though they are in markets that are not as large as one thinks and have commoditized multiples as they grow.
Importance of trust in a commoditised business model - if most firms are price takers, where’s the MOAT?
Okay, high initial valuations, eventually a commodity play, so like any 1st year VC analyst asks every founder ever “where’s the MOAT?”
“Execution”
Aura points aside, execution is the primary differentiator here, nothing else.
How strong is your distribution, the trust people have in your application, your customer service, your underwriting capabilities, your success rate in transactions, processing claims
Are you a star in what you do, the “go-to” solution, where nothing comes close? if yes, that’s your right to win.
Take any big FinTech or financial services player today, they are going to be the most reliable player in their field, even if not the fanciest. That’s what the aim should be - to be so good that you’re irreplaceable or at least a pain to replace, that’s the only kevlar
HDFC, the largest private bank of the country doesn’t have the fanciest app but still grew at 20% for the longest time, why? execution
Bajaj finance - a lucky cost of financing combined with probably the best distribution when it came to consumer durable loans > but end of the day - execution
Razorpay, phonepe, juspay, perifos, aavas > pure execution after a point
Unregulated entities in the regulated industry - Challenges?
“Well, then, anything else I should know?” Yes, that you are still bound to regulations, even if you’re not a bank!
The most stupid thing one can do is not care about regulations, cause it’s not something you can always get out of with a fine
Further, the more in trouble with the regulator you get, the faster you lose trust, the slower you move, and the more you lose, any short-term advantages gained from “gaming” the system would be lost, losing out on a strong foundation to build a long term business on.
The regulations in India seem stingy but are pretty much always incorporating new things, yes it’s annoying at times, yes my startup dreams were partially crushed due to ever-so-changing regulations, but that doesn’t mean they aren’t forward looking or they do not invite folks to comment on it.
Now, I’m not saying just always put your head down and listen to authority, but compliance while advocating for a better future with a regulator that listens is such a better way than to not comply at all; and this is where hypergrowth pressure often leads to issues as well.
Compliance with regulations is also one of those few parts that are often overlooked while evaluating fintechs. Sure nobody can comply from day 1, especially without capital due to the requirements, but it’s paramount to always partner up with folks who care about complying.
After all, Financial institutions take time and trust to build.
And on that note, Until next time, keep Manifesting Wealth.
This post was orginally writen for my newsletter which can be accessed here
Disclaimer 1: All above views are purely for educational purposes and are not to be taken as investment advice. Investment or trades taken of any kind based on this are solely the person’s risk and I bear no liability. Please consult a financial advisor before making any investments. All investments are subject to market risks.
Disclaimer 2: The views presented above are mine and not of any organization(s) I work(ed) with / am employed at.