The failures of
"It's become way more expensive to secure capital right now," said Rudy Yang, an analyst at Pitchbook, in an interview. "A return to quality is definitely happening and a lot of fintechs have yet to demonstrate that their business models have been profitable. When you combine all these factors, it definitely makes for a very tough market, especially because fintech was one of the sectors that benefited the most coming out of the pandemic."
The shutdown of Silicon Valley Bank adds to this effect.
"SVB was an established bank for nearly 40 years," Yang said. "For a lot of these players, it was the symbol of reliability and trust, and now that has been pretty much shattered."
Venture capital firms invested $97.2 billion in fintechs in 2021 and $57.6 billion in 2022, a 40.7% year-over-year decline, according to Pitchbook.
"We had a boom in 2021," said Jim Angel, an associate professor at Georgetown University who teaches about fintech and financial markets, in an interview. "Now we have the hangover as VCs that overindulged try to deal with their headaches."
A general belt tightening among venture capital firms has been exacerbated by interest rate hikes, said Ed Zimmerman, co-founder and chair of The Tech Group at law firm Lowenstein Sandler and co-founder of accelerator VentureCrushFG, in an interview. This is true for all startups, not just those in fintech, noted Zimmerman, who is also an adjunct professor at Columbia Business School and an investor in fintechs and venture capital firms.
"The double punch of heightened interest rate with this questionable availability of the dominant venture lender in the market does mean that capital is going to be much less available for fintech startups among others than it has been," Zimmerman said.
By "dominant venture lender" he meant Silicon Valley Bank, which made about half the venture debt deals with fintechs. Startups like venture debt because it allows them to access extra funds when they need them without giving up equity in their company.
"Silicon Valley Bank had such a significant market share and so many interrelated relationships that I would actually describe it as irreplaceable in the venture debt market," Zimmerman said.
Fintechs will try to extend their runways by cutting their burn rates, he said. Some will go out of business and some will be acquired for amounts that they would have found disappointing two years ago. Of those acquisitions, some will be "acquihires," where the company is being bought just for its team, and others will be to obtain the startup's intellectual property and the team will be shed.
"A lot of those acquisitions will be private to private so that you're trading a fist full of magic beans for another fist full of magic beans," with "the illiquid shares of one venture-backed startup being traded for the illiquid shares of another venture-backed startup as they merge," Zimmerman said.
Even though the FDIC has said all Silicon Valley Bank depositors will have access to all their money, "you still could get a scenario where a lot of portfolio companies get affected," Yang said. "They could be even shorter on their runway than before. And because of that, you now have a lot of people losing faith in the VC market, and because of that, you'll have less capital deployed from limited partners to general partners. That could lead to an even slower pace in funding this year."
He expects to see fintechs make more use of cash sweep accounts that distribute customers' deposits across several banks so that they can stay covered under the deposit insurance limit of $250,000 per account per bank.
"A lot of startups are probably going to start implementing this very soon," Yang said. "In the long term that could lead to more confidence in banking overall."
Fintech outliers
Not all fintechs are struggling.
StellarFi, a startup that pays customers' bills for them, floats them money when they fall short and reports the bill payments to credit bureaus to help increase users' credit scores, is announcing a $15 million series A fund on Tuesday. The company officially launched in June.
Its customer base has been growing 86% per month since its launch at the end of June, founder and CEO Lamine Zarrad said in an interview.
"In an economic downturn or even a time of uncertainty, a product like ours occupies a big part of the mental real estate for consumers," he said. "We've done well and that translated to our ability to raise more capital paradoxically when everything is melting down."
About 210,000 customers use StellarFi for free to obtain credit bureau reports and keep an eye on their credit score, he said. Close to 40,000 customers subscribe for either $5 or $10 a month. The "overwhelming majority" of customers go for the $10 plan, he said. The $5 monthly subscription pays up to $500 worth of monthly bills, the $10 plan pays up to $25,000 a month.
This helps people avoid overdraft fees and credit card interest payments. The service also helps people increase their credit scores, Zarrad said.
The startup is not immune to the banking crisis: It was a Signature Bank customer and lost the venture debt funding it had lined up with the bank, which Zarrad thought of as a runway extension.
"This was just to have operational resources to make sure that we have as much runway as we possibly can in this economy," he said.
StellarFi had obtained term sheets from several banks; Signature Bank had the most attractive terms. It seemed like a safe choice — its exposure to the tech industry was minimal, and it served a lot of accounting firms and law firms in New York.
When the bank shut down, Zarrad assumed the venture debt deal was off.
"But then they come back to us literally within 12 hours after being shut down to tell us we have this bridge bank, it's now business as usual, you still have your debt, we're going to honor all of our obligations," he said. "A day later they came back and said, just kidding, we were bought out by Flagstar and they don't want to buy a venture debt portfolio. So we don't know what's going to happen."
Few banks offer venture debt. "Most players these days that do venture debt are usually nonbanks," Zarrad said. "There's a bunch of fintechs now that are backed by private investors, and they kind of got into the venture debt game." Hedge funds have also been offering venture debt.
He's considering his options. He would prefer a bank, because generally speaking banks have better terms than nonbanks.
Impact on banks' digital transformation
If it doesn't end soon, the current banking crisis could dampen banks' efforts at digital transformation, which generally means upgrading to modern core systems, real-time payments, real-time data and analytics and advanced mobile and online banking.
"One thing we saw 20 years ago was there was cost cutting and [research and development] went out the window," Zimmerman said. "Big companies fell further behind because R&D went out the window. They also were less interested in acquiring startups and they were less interested in doing a lot of business with startups because they were insecure about them."
In one case, Zimmerman helped a fintech incorporate in June 2000 and signed a term sheet for a venture deal on September 10, 2001 in New York.
"As startups were faring increasingly poorly, that company started getting asked to show balance sheet and financial statements more broadly to customers because customers started getting concerned about whether it made sense to do business with startups as opposed to larger, better capitalized companies," he said.
There's a fear among banks of doing business with startups because they're less stable, less likely to be there in the future, Zimmerman said.
"So why would I spend money integrating their products into my business?" he said.
Banks have said they will continue to
"I'm sure that banks will continue to do venture investing as they have," Zimmerman said. "Whether they'll do less of it or not, I can't say." Strategic investors often buy high and sit out when prices go down, he noted.
On the other hand, "if they feel like their core business is under attack and their cash reserves are dwindling, then they're not going to spend cash on making non-core investments," Zimmerman said. "I'm sure that we're going to see people cutting back in a whole bunch of ways that will disadvantage them three or four years from now."
Will fintech funding pick up?
Fintech funding, like all venture capital funding, is cyclical, Angel noted.
"Sometimes the window is open, sometimes it is closed," he said. "However, I think that the fintech industry is here to stay. Big and highly regulated financial firms find it easier to buy innovation off the shelf than build it internally."
A lot of fintechs that have raised a lot of money didn't have sound business models, Zarrad said.
"Investors are indexing business models that make sense these days, which is smart," he said. "But the problem is that most investors, and it's just human nature, like to follow other investors. You see people who made right choices and you tend to follow. So when a correction happens, it inevitably becomes an over-correction."
Startups have to be high-growth companies, Zarrad pointed out. "That's the only advantage that a startup has over an incumbent, its ability to take risk and move fast. It has to be an organization or an entity that takes more risk than anyone else and then moves fast and gets to profitability."
But it also has to have a sound business model, he noted, and at least a plan to become profitable.
"Investors are going to be expecting models that are profitable from day one, which means that they're going to be very conservative models, which means that they're not going to move fast, which may make them uncompetitive," Zarrad said.
Startups in places like Austin, Texas, and Columbus, Ohio, "will never be unicorns," he said. "They may exit one day for $10 million, they're going to make a buck and they're going to have a small team, but ultimately they're not going to influence the culture. They're not gonna change the way people interact with anything. They're not going to be disruptors. That's my fear, that we're going to kill a lot of disruptors."
But other observers have more hope that this, too, shall pass.
"Things come in cycles," said Michael Held, partner at WilmerHale. "I'm reminded of the first internet bubble – some things popped and then new things sprouted up in their wake."
In a rising interest rate environment, people are more judicious in the kinds of things they fund and the risks they're willing to take, he noted.
"I do think that there will be venture capital funds that have prepared for this kind of environment and will be willing to continue to fund and take risks," Held said. "But I think in virtually every part of the economy right now, people are being more thoughtful about where they make investments and they have to rethink their risk tolerance because we're in a place where the messages from the Fed are that they really want to get inflation under control."
Efforts to get inflation under control can slow economic growth.
"Any rational investor is keeping an eye on that to make sure they don't get caught on their back foot, depending on how fast and forceful the Fed goes with respect to fulfilling its mandate," Held said.
Startups that have brought discipline to their business plans, that have realistic objectives over the near and long term and have concrete explanations about how they're eventually going to reach profitability are more likely to receive funding, he said.
"There's probably going to be a little bit less of, trust us and just have faith in us," Held said.
