Investors have poured an additional $510 million into Varo Bank, the bank unit of Varo Money that opened last year. The announcement, made Thursday, raises a fundamental question: Is the money vital growth capital for an ambitious, new kind of bank — or is it a lifeline for a struggling de novo?
Critics of the all-digital bank say its financial problems — including steep losses and reductions in capital — are serious when it's judged by the standards typically applied to traditional banks. Fintech investors and analysts, on the other hand, say it should be viewed more as a tech company experiencing the normal ups and downs of its startup phase, when heavy investments are made to fuel rapid expansion and profits aren't expected until farther down the line.
The latest funding round came from a collection of investors. They include new backers such as Lone Pine Capital, Declaration Partners, Berkshire Partners and funds and accounts managed by BlackRock. Existing investors that also participated included Warburg Pincus, The Rise Fund, Gallatin Point Capital and HarbourVest Partners.
Varo, based in Draper, Utah, says the new money will be used to accelerate customer growth and invest in product and technology innovation. In the 13 months since the $248 million-asset Varo was granted a bank charter, its number of customers has doubled to 4 million. It has introduced a short-term line of credit and cash-back rewards and plans to offer a credit-building credit card program.
Since its inception Varo Bank also has burned through capital and reported a combined net loss of $169.2 million, according to Federal Deposit Insurance Corp. data. Total bank equity capital fell to nearly $67 million at June 30, down from $122.6 million on Sept. 30 — a 45% decline. Quarterly noninterest expenses more than doubled to $74.6 million during the same period as it ramped up hiring and technology spending.
To be sure, Varo has more capital than a typical bank. Its Tier 1 risk-based capital ratio was 21.35% at midyear, which far exceeded the industry average of 8.61%. And it had a total equity capital ratio of 27.01%, nearly triple the industry average of 10.13%
Community bankers have argued that regulators and investors are allowing challenger banks, even Varo though it holds a bank charter, to grow at a pace that jeopardizes safety and soundness — something traditional banks say they couldn't get away with. Yet fintech investors look at the situation through a different lens. They emphasize metrics such as customer growth, profitability per customer and the potential for new income streams in the future.
How should the performance of a neobank or other consumer-facing fintech be measured? What follows are two different sets of answers to that question, offered by bankers, tech experts and other observers.
Banking industry's critique
In a
He acknowledged that Varo has grown quickly, attracted millions of customers and seen noninterest income expand to $21.3 million in the second quarter from $11.5 million six months earlier. But he noted that Varo’s noninterest expenses grew at faster pace during the same period, too.
“This ratio of revenue to expense has negatively impacted Varo Bank’s bottom line where the bank’s losses in just the first half of 2021 total $103.9 million,” Williston wrote. “That’s more money than Varo Bank has remaining in capital and a cash burn rate of more than $575,000 per day in 2021. What’s more, the losses accelerated from Q1 to Q2, with Varo’s Q2 cash burn rate increasing to more than $645,000 per day."
Varo officials declined to be interviewed for this story, but the company issued a statement defending itself from some such criticism.
"We are on the road to profitability," the statement said. "We are well capitalized and have the confidence of both investors and regulators."
In a subsequent interview, Williston said he got interested in Varo’s numbers because it is the first of the neobanks to be subject to full regulatory reporting.
“They are the only available sample of the real data,” he said. “I don’t have a vested interest in the success or failure of Varo. I certainly wish them the best. I just dug into the data on that bank because it’s what was available. But doing so opened up a bevy of questions of whether Varo is being treated differently than other banks and if the traditional valuation models that venture capitalists use are really applicable to neobanks.”
Williston says that challenger banks and community banks should be judged by the same standards.
“Until or unless there is some regulatory pronouncement that challenger banks will be treated differently, they ought to be treated like any other bank,” he said. “And if that pronouncement comes, there ought to be a really good explanation as to why challenger banks are being treated differently.”
Williston acknowledged the valuations placed on some challenger banks are based on traditional valuation models used by venture firms.
“I question if those valuation models are appropriate for a bank,” he said. “I think some investors will have disappointing outcomes by buying in at these valuations, but that’s always a risk you take when investing.”
The investor mindset
Several venture capital firms that have invested in Varo declined to comment for this story.
Hans Morris, managing partner at NYCA Partners, a New York venture capital firm, is not a Varo investor. But when he looks at neobanks and other fintech startups, he doesn’t focus on their cash burn rate or expense-to-income ratio.
“What you want to have complete clarity on is that the unit economics are working, so that their profitability per account is clear and the incremental expenses are either adding some sort of new product, which therefore could add more revenue per user, or it's cost for customer acquisition, which is in itself profitable,” he said. “On top of that, you have regulatory capital requirements, which are another lens.”
Morris noted that to get regulatory approval, banks have to put together a plan, and then they are held to whatever is promised on that plan. If all goes according to plan, they are — often — allowed to proceed in peace.
Investors have similar expectations, Morris said: They want to see companies do what they say they will do during their fundraising rounds.
“What you'd want to know is not necessarily how much cash is the company burning through, but how much did they project they were going to burn through and are they doing better or worse than that?” Morris said.
Morris also said that in fintechs, he would look at profitability before marketing and customer-acquisition expenses. He would look at cost of customer acquisition, operating expense per account, how much interchange revenue the challenger bank is getting and if customers are linking direct deposit to its account.
One question he would ask of challenger banks is if they have any revenue sources besides interchange. For instance, he'd want to know if they can make loans or sell cryptocurrency.
When Robert Le, fintech analyst at Pitchbook, analyzes challenger banks, he looks at all of those same metrics. But in Varo’s case, he also considers more conventional bank performance measures.
“Varo is in a unique position because they are a licensed, regulated bank,” Le said. “So I think applying some of the traditional metrics does make sense. But what they do have that most traditional banks do not have is venture capital dollars backing those losses.” It’s not uncommon for venture capital firms to back tech companies for several years, he said.
“Then, once they reach scale, they turn around and become profitable,” Le said. “That's how I see Varo.”
Varo’s investors also understood upfront that it would be expensive for the company to acquire a bank license, and they signed up for that.
“I talked to [Varo CEO] Colin Walsh about a month before Varo got its [national bank] charter,” Le said. “And when he went to raise its Series C, he told investors this money is to go get a bank license. They spent that whole round, that $100 million, to go through the process of getting a bank license. Varo’s investors saw that there's a huge benefit to having a bank license, and they knew it was going to be a very long process.” It took about three and a half years,
Like Morris, Le expects Varo to start offering lending products.
“When that happens, they will increase their revenues and profitability,” he said.
