FinTech CEOs need to know their potential investors very well and select the best ones in terms of capital, business growth opportunities, and long-term exit opportunities.
Crowdfunding
Crowdfunding is a way for individuals to collectively invest in a business in return for a potential profit or reward by responding to a pitch posted on a crowdfunding website. Crowdfunding can be very exciting for new investors, because they can back young, exciting start-ups and help them raise the money they need to grow. Often multiple banks will have rejected these early start-ups for loans, so these investments can be quite risky.Several types of crowdfunding exist:
- Loan-based: Peer-to-peer (P2P) lending is provided in return for a set interest rate (such as Lending Club and Funding Circle).
- Reward-based: Money is invested in return for nonmonetary returns, typically samples of the product developed. This is the type of crowdfunding on sites like Kickstarter and Indiegogo.
- Investment-based: This entails receiving shares in return for your investment.
Investment-based crowdfunding is more the norm in Europe (particularly in the United Kingdom with companies such as Crowdcube and Seedrs) and more recently Asia. Reward-based investment is more popular in the United States due to regulations around investor requirements, although the JOBS Act (May 2016) extended online equity crowdfunding opportunities in the United States.
The very nature of crowdfunding lends itself to B2C-type investments because individuals can relate more to a consumer-focused application (see the earlier section “Understanding the Players” for more information). The product being developed may be something they’d use themselves. Hence, companies may raise a relatively small amount of money from hundreds or even thousands of investors, which in total gives them a decent funding round.Crowdfunding platforms will give you a choice of many companies that need money to grow. The most popular sites make it fun and enjoyable to browse these exciting companies and their products, therefore making it easy for you to part with your money. However, you should never invest money you can’t afford to lose because you may not get it back, and you should invest only in what you completely understand.
The amount of due diligence retail investors do is relatively light, given the funds invested. However, firms on such platforms have increased the amount of information they provide, giving a certain standardization around the type of investor presentations produced. The platforms also have an obligation to undertake a due diligence process before allowing companies to list on their sites. The crowdsourcing model is so new that good data isn’t yet available to understand how the majority of the firms on such platforms perform from a return on investment (ROI) perspective.Fewer B2B companies are available for investment on crowdfunding sites, particularly FinTech companies, because B2B technologies aren’t as immediately appealing to casual investors. A revolutionary new electronic gadget is just more “fun” to invest in than technology required for workflow processes within a financial institution. And that’s why we need angel investors! Read on.
Angel investors
An angel investor is an accredited investor who provides financial backing, networking, business expertise, and other support to a small start-up in return for an equity share. Angel investors are typically sophisticated, experienced investors with high net worth and lots of readily available capital.Angel investors are more likely to invest in businesses that are pre-revenue and seeking seed capital, because they tend to invest in businesses where they feel that they can add value through their domain expertise and network/contacts in that area. Therefore, angel investors generally take more risks than venture capital firms covered in the next section (including investing their own money) and invest more per company than individual crowdfunding investors.
However, angels aren’t just guardians. The majority are seasoned professionals who regularly take positions as nonexecutive directors within the firms that they invest in or provide advice and networking to further the firms’ opportunities. In addition, many angels invest collectively as a group or syndicate, either within a given theme, such as FinTech, or within random groups coming together under the guidance of one angel who acts as the lead investor.
Europe’s first angel network focused on FinTech was established in 2014 by the FINTECH Circle, where the best FinTech start-ups apply to pitch to experienced FinTech angel investors. The application process is very competitive and normally starts with an online application form, from which the best companies are selected and invited to Selection Days where they present in front of FinTech expert investors. The top seven companies are selected to present at the final FINTECH Circle Angel Network.
In some European countries, particularly the United Kingdom, both crowd and angel investors receive income tax rebates/reliefs from their investments in start-up firms. This acts as an incentive for some investors to become more active in this space and improves the risk-reward ratio for such investors. In other countries, for example the United States, it’s more common for the start-up companies themselves to receive tax rebates for their research and development investments.
Research which tax benefits you’ll get as an investor and/or as an entrepreneur early on. This could make your investments much more attractive/cost effective.
Venture capital
Venture capital firms do what angel investors do, but they do it on a corporate basis. Instead of investing their own money, venture capitalists (VCs) are paid to invest other people’s money.Managers of the venture funds, known as general partners (GPs), are typically investors who have years of experience investing in and taking minority stakes in early stage firms. That’s what they do for a living, unlike investors in crowdfunding sites or angel investors. GPs are either good at investing or lose their jobs.
Venture capitalists receive money from high net worth individuals, family offices, and corporations, all of which become limited partners (LPs) in the fund. Each of the LPs is looking for a diversified but higher return than what they can achieve from less risky investments, ordinarily for a fixed period of up to ten years. The GPs receive management fees (typically 2 percent of funds under management) to scout and invest in the right types of investments, conduct due diligence, and manage the resulting portfolio.
GPs and their firms typically take a carry fee (for example, 20 percent) of the performance of the fund (this management fee and performance fee are commonly referred to as “2 and 20”). The remainder of the profit (for example, 80 percent) is distributed to LPs. However, many funds have to achieve a hurdle rate — a return rate that investors must receive before the fund managers can receive their carry fee. For example, a fund’s agreement may specify that the LPs must be paid back their invested capital, in addition to an agreed annual percentage yield, prior to the GP receiving their return.
To reduce the number of LPs that a fund services, a substantial minimum investment is typically required, putting such funds outside of the scope of most regular investors. To invest in VCs, you must either be very rich or indirectly invest via a fund that serves as one of the LPs; this is called a “fund of funds” structure.Because they’re investing with other people’s money, VCs tend to invest in businesses that are relatively established, with a given level of annual or monthly recurring revenue, at the Series A level of fundraising or later. Series A is generally the first funding round by VCs; Series B is the second funding round; Series C the third funding round; and so on. Crowdfunding and angel investors are normally investing in seed or post-seed rounds that come before Series A.
Some VC firms are lately shifting their focus to later stage investments (called scale-up funding), because the ROI for many funds have been lower than anticipated. Generally, VC investors should anticipate that about four out of ten firms will fail, and another four out of ten firms may return the monies invested. The remaining two firms would therefore need to have returns of 10 times or more to achieve the type of returns expected. The very successful firms are called unicorns, a term that refers to start-up companies that achieve a $1 billion dollar market valuation.To protect their interests, VC firms are more likely to demand preference shares for their investment and receive veto or minority investor rights that aren’t available to other investors. They also tend to act as the lead investor in a funding round, thereby dictating the valuation, total monies raised, and the terms of the investment. Those terms may include the pre-money valuation of the firm, prior to investment, and the post-money valuation, which includes the funds raised added to the pre-money valuation. For example, a firm raising $1 million at a pre-money valuation of $10 million will have a post-money valuation of $11 million.
Corporate venture capital
As the name suggests, corporate venture capital (CVC) firms are like regular VC firms, but they invest on behalf of a given company. Their initial motive is therefore to invest in companies that will give some form of strategic benefit to the company, either immediately or in the future. As such, they tend to be focused on later stage firms that can bring immediate revenue and/or profitability. Some CVCs also take outside money, where LPs invest alongside them. However, such funds may be split in focus between providing a good ROI to all investors and delivering a strategic benefit to the parent company.For example, suppose that your bank has a corporate venture fund. It could decide to invest in a FinTech company before it rolls out its FinTech app to millions of consumers globally. The bank must decide whether it will immediately separate the funds made available as CVC or whether it will draw down funds from the bank’s balance sheet to support the investment. Draw down refers to collecting funds when an investment occurs, based on an agreement that such funds will be available when the CVC requests them.
This decision can have a significant impact on the commitment to the investment, or at least the perception of commitment. The employees who manage the CVC aren’t necessarily rewarded in the same way that a commercial VC would be, with respect to management and performance fees. Therefore, the incentives, and hence the commitment, can be questioned.
Good VC investors should make lots of money, because they share the performance fee. However, the manager running a CVC won’t get such unlimited payments. Therefore, if someone is driven by money, he’d probably want to run his own VC fund. Having said that, in principle, CVCs should be better venture partners to FinTech firms than regular VCs, because they have a competitive advantage due to their domain expertise, knowledge of markets, client networks, and technologies. In addition, their stronger balance sheet makes them a more patient investor. They aren’t looking only for mutual growth but also more strategic benefits, such as direct synergies with their company’s business that further drives additional revenue growth and valuation.
However, not all CVCs leverage these benefits. Internal stakeholders can question the start-up’s ability to deliver or suggest that they can build the same thing themselves internally. Those that do succeed follow the mantra that “rip and replace” isn’t the solution to managing old legacy systems and that “core and satellite” is a better strategy.Of course, FinTech firms need to consider whether a CVC minority investment gives them the necessary short-term capital injection to meet their scale-up aspirations in conjunction with the corporate “mother ship.” They may find that aligning closely with one large corporate infrastructure reduces their ability to scale into other competing corporate infrastructures due to a paranoia around access to confidential data. In addition, the obvious exit may be full integration into the CVC’s company, which may not give the same return as selling the product on the open market.
Private equity
Historically, private equity (PE) funds have been viewed as more similar to the traditional asset managers of private investment. They tend to invest in much later stage companies that already have substantial revenue and are therefore less risky investments. (Blackstone buying a majority stake in Refinitiv is a recent example). Not many FinTech firms are sufficiently large to qualify in that regard, so PE activity is more often found in other commercial sectors.PEs have a similar structure to VCs, in that they involve GPs and LPs. However, the pools of capital raised for such funds tend to be much larger, as the company valuations of invested firms are much higher, given the firms’ maturity, revenue, and profitability. PE funds typically have a fixed investment period, typically ranging from seven to ten years. There are similar management and performance fees (2 percent and 20 percent, respectively), although when institutional and ultra-high net worth individuals invest substantial funds, fees are often negotiable.
PE funds can also support investments such as leveraged buyouts, management buyouts, and company restructuring, whereby they regularly take majority or outright stakes in a company and use debt to finance large transactions, with the resulting burden of servicing that debt left with the company. They may then appoint management to make the company more profitable and valuable, which may include selling off pieces of the business in a “sum of the parts being greater than the whole” strategy. Alternatively, they may exit the investment through a trade sale to a strategic buyer (for example, Blackstone subsequently selling their stake in Refinitiv to the London Stock Exchange) or to another PE firm, or they may list the company on a stock exchange via an initial public offering (IPO).
The world of investors and investing is changing as a result of the FinTech revolution; this area of FinTech applied to the global investment management sector is called WealthTech. For more information, check out The WealthTech Book by Susanne Chishti and Thomas Puschmann (published by Wiley).