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The Green Sheet Online Edition

March 09, 2020 • Issue 20:03:01

Oversupply applies to fintech startups

By Brandes Elitch
CrossCheck Inc.

CrossCheck is located in Sonoma County, California, also known as Wine Country. And 2019 was a nearly ideal growing season for grape growers here: just the right amount of heat early in the growing season to acclimate the grapes, a late summer with late rains, followed by warm days through September. This led to long hang times and even ripening. These wines should be outstanding. There is just one problem, but it is a big one: oversupply of premium wine.

Silicon Valley Bank just issued a 71 page report called State of the Wine Industry. The author, Rob McMillan, stated, "Today, the supply chain is stuffed. The oversupply, coupled with eroding consumer demand, can only lead to discounting of finished wine, bulk wine, and grapes. You'd have to go back to the 2000–2001 era to see the kind of things that we're going to have to do to clear up the supply chain. You'll see wines destined for $35-$55 bottles sold as a private label or in a Costco Kirkland box, but instead of more generic Sonoma cab or pinot, it will be more specific Russian River Valley pinot. If there's a silver lining, if we're going to provide great values at lower price points, that might help drive some future sales to a more interested young consumer."

Furthermore, consumer habits have changed: last year Americans' wine consumption dropped for the first time in 25 years.

Do we have a similar situation in the fintech or payments industries? Well, fintech is not so much about a financial services business as it is about venture capital, also known as private equity. I have not seen much commentary on this in the payments industry, but this is an important topic, so let's explore it in more detail.

How venture capital works

The model for a venture capitalist is to invest in a fledgling company. It could be a startup or it could be an early-stage company. A venture capitalist (VC) firm is in theory, going to lend its expertise in managing the company, but more importantly, it is also going to take a hefty management fee every year, so whether the investment ultimately fails or succeeds, the VC will get its management fees. If it has invested only other people's money, it will come out unscathed.

One thing is certain: at some point, three to five years down the road, certainly no longer than 10 years, the VC is going to have to sell its shares and return money to the investors. But the VC cannot get its money out until one of two things happens: the firm that it has backed enters the public market, or it is acquired. Neither is inevitable in all cases.

Harvard Business School professor Tom Nicholas recently published a book called V.C., An American History. He found that VCs make predominantly bad bets – about 80 percent don't pay off. Traditionally, to achieve a 20 percent return, those two in 10 winning bets must generate between 20 and 30 times the money invested in them (the power of compound interest).

Success is a 12 percent return per year, and a 10-year fund needs to return three times the fund size. And then there is the Pareto Rule: 80 percent of the returns come from 20 percent of the startups. A realistic rule is that out of a portfolio of 10 firms, five will be complete losers, three will sell for small to medium amounts, and one or two will be wildly successful. All of this should be pretty sobering to startups in the payment space that are looking for VC capital.

This is not to disparage VCs. There is another side to this. "A thriving society needs moon shots, and in the absence of a literal space race, only venture capitalists have the mandate to throw cash at an improbable success," Nichols wrote. "Venture capital has offered a path into the market for unsmooth operators and bizarre ideas."

Fintech facts

Now lets's have a brief overview of fintech, some of which have a business-to-business model, and others have a business-to-consumer model.

  • Fintech startups by region show the Americas leading with 5,779 startups, about 35 percent of the world's market share (Statista)
  • In the United States, the biggest fintech segment is digital payments, valued at $1.2 trillion (Statista)
  • The biggest fintech product is digital payments, comprising 25 percent of the ecosystem (McKinsey)
  • The U.S. consumer adoption of fintech is 46 percent (Ernst and Young)
  • The U.S. fintech market's transactional value's compound annual growth rate is 8.6 percent over the forecast period, 2019 to 2024. (Business Wire)
  • U.S. consumers have identified fintech benefits as convenience, security, simplicity, transparency and personalization. (Mordor Intelligence)
  • Through Q3 2019, there were 18 VC backed fintechs (Deloitte)
  • 1158 funding events helped 841 fintechs raise $46.6 billion through multiple rounds of financing (Deloitte)
  • U.S. fintech based investments stand at $24.2 billion (Deloitte)
  • A crucial truth

    Let's stop a minute and think about all this while considering how VCs operate. Do you really think all these startups are going to succeed in the marketplace, to the extent that they will be sold or go public at a high multiple of what the VC invested? The answer is, of course not.

    We are already seeing a slowdown in the digital wealth management field. Only one wealth tech startup launch occurred in the first nine months of 2019. The 19 players that have entered this market since 2017 represent only about half of the 34 new entrants that launched in 2016. As Shelagh Dolan put it, "The sharp downturn in market entrants suggests the competitive dynamic in the wealth tech industry is no longer conducive to new startups."

    The same thing happened in the wine industry – exuberance, overconfidence and optimistic projections, without considering exogenous variables such as shifting consumer preferences, tariffs, and oversupply of the product.

    Remember, when you plant a new vineyard, it takes at least four or five years before you have a marketable crop. Planting vines is a long-term bet. Ultimately, the wine will be sold, of course, in some capacity, and some growers will lose money. But things are different in the VC world. Not everything will be sold. The primary rule of the VC is don't lose the capital, but capital will be lost. You might want to keep this in mind the next time you hear a presentation about the Next Big Thing in fintech. end of article

    Brandes Elitch, director of partner acquisition for CrossCheck Inc., has been a cash management practitioner for several Fortune 500 companies, sold cash management services for major banks and served as a consultant to bankcard acquirers. A certified cash manager and accredited ACH professional, Brandes has a Master's in Business Administration from New York University and a Juris Doctor from Santa Clara University. He can be reached at brandese@cross-check.com.

    The Green Sheet Inc. is now a proud affiliate of Bankcard Life, a premier community that provides industry-leading training and resources for payment professionals. Click here for more information.

    Notice to readers: These are archived articles. Contact names or information may be out of date. We regret any inconvenience.

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