Fintech Endgame: Rise of Supercompanies

The Evolution of Fintech and Software Convergence

Considering money as the primary commodity, a key question arises: how can fintech companies – those involved in the sale, transfer, or insurance of monetary value – develop products that maintain distinctiveness and deliver sustained value?

Furthermore, why are numerous software businesses, already possessing highly differentiated products and serving substantial markets, expanding into offering financial services integrated directly within their existing platforms?

The Rise of Hybrid Companies

A novel and compelling category of business is currently emerging where software and financial services intersect. This convergence is generating significant interest within both investment and entrepreneurial circles, as highlighted during our recent “Fintech: The Endgame” virtual conference and the associated report.

These specialized entities – sometimes software companies that also facilitate payments and manage customer funds, and at other times, financially-focused companies incorporating software-like workflows and features – effectively blend the strengths of both sectors.

They leverage software principles to create highly engaging user experiences with intuitive products that foster long-term customer retention. Simultaneously, they benefit from the financial sector’s capacity to generate revenue directly tied to customer business expansion.

Driving Market Value

This potent combination of business models is rapidly boosting value in both public and private markets. Investors are assigning premium valuations to these “super” companies.

Battery analysis indicates that these companies are valued at nearly double the median multiple of traditional, pure software businesses.

Shopify: A Prime Example

Shopify serves as a near-ideal illustration of this trend. Initially recognized for its software solutions assisting entrepreneurs in launching and managing online stores, Shopify now derives twice as much revenue from payments as it does from its core software offerings.

By enabling merchants to process credit card transactions and functioning as its own payment processor, Shopify has unlocked a significant revenue stream.

This synergy – a software solution linked to e-commerce growth coupled with a rapidly expanding and profitable payments business – has resulted in investors assigning Shopify a 31x multiple on its projected forward revenues, as per CapIQ data from May 26.

The ability to scale revenue through both software subscriptions and transaction fees positions these companies for exceptional growth and investor confidence.

Determining the Valuation of Fintech Companies

The valuation of fintech companies presents a unique challenge, sparking considerable discussion and disagreement within both private and public investment spheres. Establishing a fair market value for these hybrid entities has proven consistently difficult.

Advantages Over Traditional Software

Fintech businesses often possess distinct advantages when contrasted with conventional software companies. For instance, when selecting customer service software, a thorough comparison of features, integration capabilities, and pricing is standard practice.

However, the process of securing a loan differs significantly. A competitive offer with swift processing is often the deciding factor, regardless of other considerations.

Rapid Revenue Growth

This dynamic has empowered numerous fintechs, particularly those skilled in digital marketing and data-driven underwriting, to achieve revenue growth comparable to, or even exceeding, leading software companies.

Margin Considerations

Despite this growth, a strong case can be made for the higher valuation of pure software companies. Software businesses typically retain 60%-90% of their revenue as profit.

Conversely, financial institutions, such as lenders, must factor in expenses like interest on capital, as well as potential fraud and credit losses, impacting their margins.

Scalability Limitations

While software companies can theoretically scale to an unlimited customer base with cloud infrastructure, financial companies are inherently limited by their balance sheets and capital reserves.

Recent events, including constraints experienced by stock brokerage Robinhood during the GameStop situation, demonstrate this limitation extends beyond traditional lenders and insurers.

Growth vs. Profitability

Rapid expansion is relatively easy when dealing with financial products, but it isn't the sole determinant of value. Public markets generally link valuation to growth for software companies and to profitability for capital-intensive financial institutions.

Therefore, a key question arises: how should fintech companies, blending elements of both models, be appropriately valued?

The Synergy of Software and Finance

A key factor contributing to the elevated valuations of technology companies is their ability to access expansive markets regardless of geographical limitations. Furthermore, they often possess substantial barriers to entry, hindering competition, and can efficiently scale revenues with a relatively stable cost structure.

This leads to significant profitability and, consequently, increased value over the long term. To illustrate how this applies to various fintech businesses, we present the Battery Fintech Framework.

This framework is intended to serve as a valuable resource for fintech entrepreneurs, aiding in their understanding of business model valuation and investor perspectives.

The framework categorizes fintech companies based on their business models and then analyzes their median revenue multiples. This analysis reveals several noteworthy insights, including:

• Companies that successfully integrate a SaaS model with financial services consistently achieve the highest valuations. They benefit from both recurring subscription revenue and fees generated from financial services, which grow alongside customer activity.
• A diverse range of fintech companies occupies the middle ground. This spectrum includes payment processors that earn fees based on transaction volume – a variation of the SaaS + financial model without subscription fees – and short-term lenders, such as buy-now-pay-later (BNPL) services.
• These lenders require less balance sheet capacity compared to those offering longer-term loans.
• At the lower end of the spectrum are traditional lenders. These businesses primarily depend on interest income from loans, necessitate substantial balance sheet resources, and typically lack a consistent repeat purchase cycle.

The core takeaway is that valuations are higher when revenue streams are derived from subscriptions or transaction fees rather than interest income. Additionally, models requiring less balance sheet investment are favored.

For fintech entrepreneurs, incorporating these characteristics into their businesses can significantly enhance their value. Inspiration can be drawn from both established software companies and traditional financial institutions when constructing a sustainable and enduring business.

Establishing Control Over Your Business Operations

Software businesses have long understood a crucial principle: the deeper your integration into a client’s workflows and personnel, the more difficult it becomes for them to switch to a competitor. Examining enduring software companies, such as the leading CRM provider Salesforce, reveals a pattern.

These companies are so fundamentally woven into the fabric of an organization that, despite potential shortcomings in user experience or outdated interfaces, displacement proves remarkably challenging.

A Valuable Insight for Fintech

Fintech companies can draw a significant lesson from this observation. Traditional financial institutions, like banks and insurance providers, are often perceived by their customers simply as essential services.

However, successful fintech innovators are redefining this dynamic. They empower users to not only manage their processes – for example, monitoring accounts payable and receivable – but also to execute financial transactions, such as money transfers.

This dual capability delivers a comprehensive and highly valuable solution.

• By combining process management with financial action, fintechs create a more compelling and sticky customer relationship.
• This integrated approach positions them as more than just a utility, fostering deeper engagement and loyalty.

Ultimately, the goal is to become indispensable to the customer’s operational success, mirroring the entrenched position of established software giants.

Navigating the Regulatory Landscape

Many software firms entering the financial sector encounter difficulties due to a lack of understanding regarding the significance of regulatory compliance. This is an area where established banks and insurance providers demonstrate expertise in every facet of their operations.

The rapid innovation and iterative approach favored in software development – often summarized as “move fast and break things” – is incompatible with the stringent oversight of multiple regulatory bodies.

These agencies possess the authority to impose substantial penalties or even suspend operations until concerns are adequately addressed, a process typically conducted at a deliberate, governmental speed.

Therefore, it is crucial to either fully adhere to existing regulations or collaborate with a partner experienced in financial services to ensure compliance.

Fintech is positioned to fundamentally transform the financial services industry.

This transformation will occur through both the reimagining of established products and the emergence of novel business models as financial services become increasingly integrated into other industries.

Given the estimated $6.2 trillion valuation of the U.S. financial services sector, substantial opportunities for value creation exist.

However, remember the importance of regulatory adherence – consider it your BFF (Best Friend Forever).