Venture Capital Has A Lot To Learn From Fintech: Data-Driven, New Products, And More Access To A Broader Set Of Companies

Source: Forbes 2020-05-18

Investment in the financial technology space has skyrocketed globally over the last decade. Fintech has transformed nearly every aspect of the traditional bank. It has also gone mainstream: 75% of people have used a money transfer or fintech product. Fintech innovation has also driven broad-based access to financial products and services to the unbanked and underbanked.

Fintech’s lessons hold promise for a different, yet related industry: venture capital. The technology industry is increasingly global – with over 1 million startups around the world in over 480 startup hubs. A new playbook is required, a theme I explore in my just released book: Out-Innovate: How Global Entrepreneurs - from Delhi to Detroit - Are Rewriting the Rules of Silicon Valley (HBR Press). Fortunately, fintech shows us three important ways the VC model might adapt to this new reality.

Revisit Existing Products With New Business Models, and Create New Products

Traditionally, financial services could only be offered by large incumbent financial institutions. They were the only game in town and presented a limited menu of financial offerings. Similarly, venture capital’s origins were in whaling, wherein whaling agents (the equivalent of modern-day venture capital firms) recruited investors and put up capital to buy and equip the boats. For this, they would receive a share of the profits. The captains (our modern-day entrepreneurs) often also invested their own capital in the voyage and received a meaningful share of the proceeds. The crew was paid entirely from the proceeds of the voyage, much as modern-day stock options reward startup employees. Carried interest was once quite literal – how much could be carried off the boat.

Fintech companies have upended traditional financial services by reinventing business models and offer role-models for similar product innovation in venture capital. Robinhood, for example, demonstrates that the freemium model may yet work for trading platforms. Chime (disclosure, the fund I work at is an investor) offers free checking accounts and monetizes through debit and rebundling. M-Pesa offers low-cost payments and money transfers over feature phones. Various fintechs that offer loans have found access to capital beyond traditional bank customer deposits.

Critically, fintechs have also added entirely new product categories centered around key needs. For example, Opendoor provides cash offers for homes after making quick, competitive offers to react to a changing environment. kWh Analytics focuses specifically on the solar market, guaranteeing performance to unlock lending in the space. Zola bundles loans and mobile repayments with Pay-As-You-Go financing to unlock demand.

Venture capital will similarly evolve its own business models and product lines to cater to the growing breadth of startup companies. One inspiration I find particularly interesting is revenue share financing. Unlike the whaling industry, revenue share financing got its start in mining through royalties. In this construct, prospectors pay their investors a certain percentage off the top over time. Investors therefore share in the upsides and downsides of the business; they get paid only if the prospectors are successful, and, if things don’t go well, there are fewer payments. Novel Growth Partners, founded by Keith Harrington and Carlos Antequera, took this model and applied it to the world of venture capital in the Midwest. They purchase a portion of a firm’s revenue for a specified amount of time. Startups like Clearbanc, based in Toronto, have programmatized giving capital to startups and being repaid as a function of revenue. Others argue large-scale debt is coming to the technology industry soon to fund repeatable revenues.

The capital sources and structures may also change. Evergreen structures may better align long term growth, instead of the traditional fund, which is 10 + 2 years. Arguably, the world’s best venture investment was through an evergreen structure and relied on a long-term hold: Naspers’ $32m investment in Tencent. Nearly two decades later, Tencent’s market capitalization is more than $500 billion, and Naspers’ stake is worth more than $100 billion (over the past ten years, Naspers’ own market valuation skyrocketed from $1 billion to more than $100 billion, largely on the back of this single deal).

Automate Decision Making and Flatten Access

In fintech, the new wave of products have been focused on customer experience and helping them make decisions faster based on better (and more) data. Digital insurance, has automated underwriting based on wider data sets. In lending, companies are combining more and less frequently used metrics to evaluate decisions. As a result of this abundance of data, fintechs have been able to target people in markets regardless of location, who otherwise would have been ignored. After all, processing a digital loan is no different if you’re in San Francisco or Omaha.

Venture capital needs to start leveraging data in similar ways. There have already been some green shoots. Social Capital’s “Capital as a service” used algorithms to benchmark and predict companies’ performance objectively. If it liked what it saw, it could write a check for as much as $250,000. A number of VC firms are amplifying decisions through certain levels of automated data analysis.

This quantitative approach to dealmaking focuses on objective benchmarking. It has the added benefit of improving the diversity of a portfolio. When investing is based more strictly on data, minorities tend to benefit because the data is “blind”. (Naturally, there will be some bias in data, too, but venture capital already has a diversity issue, so any movement towards data-driven decision making will help.) Among Social Capital’s more than seventy-five CaaS investments, 80 percent of founders were nonwhite and 30 percent were women, spread across twenty countries—statistics far above traditional industry numbers

Of course, algorithms will not replace human decision making any time soon. After all, venture capital remains a long-term relationship (I remind my students that the average venture-entrepreneur relationship is longer than the average American marriage), but it is interesting to think about what the future of deal-making will look like, especially as many VCs are relegated to videoconferencing for the time being.

Target the Underserved and Focus on Impact

One of the largest segments of fintech has been the underbanked. Sixty million Americans and (depending on the data source) approximately 1.5 billion global citizens are underbanked and are typically underserved because products and services aimed at that population were not economically viable. One of the largest categories of fintech growth, then, has come from addressing this challenge. It is the size of the population and the possibility of upward mobility that makes this opportunity so appealing. In these cases, impact and successful businesses have gone hand in hand.

There is a similar gap in venture capital funding.

Venture dollars often flow to the coasts of the U.S. and not as much to middle or emerging markets. The entire Midwest accounted for a mere 0.7 percent of national venture capital investment (versus 40 percent on the West Coast). Similarly, many higher-impact segments have been left underfunded, in lieu of more alluring mainstream plays.

More and more, however, venture capital firms are realizing that there are huge growth opportunities outside of Silicon Valley. Funds are specifically being launched to target global startup ecosystems that are not the typical hubs of innovation. There are initiatives to target specific high-impact verticals like financial inclusion, education and cleantech.

This brings us back to the point that VC model is right for certain companies with typical growth trajectories in well-known markets. But with such a diverse group of entrepreneurs and business models, VC will need to find ways to open themselves to new markets. A huge, and incredibly impactful opportunity is waiting for them.

The learnings from fintech are slowly making their way to venture capital, partly because it is such a bespoke industry with high-touch deals and a reverence for “feel”. Everything cannot be automated away, surely, but disruption is coming, and VCs will find themselves with more tools and different methods for doing business in an increasingly global venture economy.

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Venture Capital Has A Lot To Learn From Fintech: Data-Driven, New Products, And More Access To A Broader Set Of Companies

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