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What CIOs can learn from investors when assessing fintech startups

IT leaders who are looking for innovative ideas but wary of using startups could turn to the investment community to see how they gauge which firms to back

With thousands of fintech startups being established globally, there are plenty of opportunities for investors – and also for IT leaders in financial services looking for innovation. What can IT buyers learn from the way investors assess the startups they choose to fund?

Screening startups in a constantly evolving segment is a major challenge faced by investors looking for an innovative idea that can scale and has market potential. But investment criteria go beyond that – and the technology proposition of the company is of course a crucial consideration.

German venture capital firm Alstin typically invests in Series A/B rounds where startups already have more than €1m in revenue and have established a commercial proof of concept.

Carsten Maybach, investment director at Alstin, says people, process and technology are all important.

“There is a high degree of correlation between a great team, timely and transparent reporting, orderly processes, and scalable, smoothly running IT,” he says.

Maybach says his work during the lifetime of the investment will involve ensuring technology aspects are in order, to handle the “usual chaos” seen in fast-growing companies.

“If the founding team cannot steer working processes and structure for the company when we invest – they will usually have about 20 to 50 staff at this stage – how will they be able to steer a larger company? Growth can kill a weak management so this is a crucial point.”

Working around regulations

Even though technical development of products and services is theoretically easier for fintechs due to their lean structure and application of the latest innovations, there are other tech-related hindrances that can affect their attractiveness to investors.

“If the startup’s business model is regulated, authorities will check its IT structure and processes, and if they white-label products to companies like banks, there will be a purchaser’s due diligence, too. So the fintech needs to have proper [technical] documentation to sell its products in any way,” says Maybach.

A fintech will have an agility that can't be found in traditional institutions
Camilo Telles, Antecipa

Another common challenge for startups comes in connecting to legacy systems at banks and insurers, which often have limited and inaccessible documentation, says Camilo Telles, founder of Antecipa, an exchange for prepayment of receivables.

“A fintech will have an agility that can’t be found in traditional institutions. We can start developments from scratch with no legacy anchoring us and adopting the market’s best practices, which means we can move faster and be more flexible,” he says.

According to Telles, the simplest route to overcoming technical complexity, as well as issues related to regulation, is to focus on the minimum necessary to deliver value for clients.

“Obtaining a full banking licence is not necessary for most startups – and is often extremely complicated and costly. So you have to really focus on what will be truly useful for the client while limiting exposure to regulation,” he says. 

Adapting to clients

Clients expect their innovation demands to be met, but matching that to the technical and process complexity of financial corporations isn’t easy either, says Gabriel Gross, founder at MeteoProtect, an insurance startup dedicated to weather risk management.

“It is very tricky to combine the fact that you have to follow the client’s own rules and guidelines, comply with regulations and also innovate, be faster and cheaper. These pillars are not always aligned,” he says.

Gross found that rather than adapting his systems to meet client demand, the most effective route was to configure his startup as if it was an insurance company – even though it isn’t one.

“We assembled elements of the technology seen at an insurer, as well as elements of the regulatory environment. That enabled us to provide clients with a turnkey solution that is very often not even fully connected to these systems,” he says.

“By using this approach, we create the product with a full management platform that meets their reality. Also, they do prefer to have our platform separately from their own systems, and they also prefer to delegate its management to us because it’s faster.”

Lack of investor understanding

So how can a startup operating in highly regulated, process-heavy environments and facing all manner of technical intricacies still be a good option, for both investors and IT buyers? According to Gross, the first point to keep in mind is that a company should not change its goal simply to meet investor demands.

“If you are a good business, you will attract investors without changing your core purpose and strategy,” he says. “However, the most important thing in these relationships is clarity – and if you want to express your technology strategy effectively, your overall strategy needs to be clear.”

Communication can also be an issue on both sides. There is also a perception across the startup community that many investors do not understand their business model well enough, says Gross.

MeteoProtect partnered with SAP’s Startup Focus programme, where firms build new applications on SAP’s Hana in-memory database platform. The startup uses Hana to aggregate over 80 billion weather-related data points from multiple sources to deliver climate variability analyses to clients. Thanks to publicity stemming from the SAP relationship, the startup gets approached by potential backers with varying levels of technical expertise.

“Some investors are extremely competent and have real insight into what a fintech does. But I’ve also met many so-called fintech investors who analyse a company like ours in the same way they would analyse an e-commerce company, for example. They either don’t understand or don’t take the time to understand our business model,” he says.

Read more about fintech startups

Michael Degnam is a partner at Explorer Advisory & Capital, which provides consulting to financial services companies and seed-stage capital to fintech startups. He agrees with the point made by founders that most investors that traditionally focused on retail-based markets don’t quite “get” the technical realities of the finance sector.

“Financial services is a market that requires a certain amount of institutional knowledge to fully understand the dynamics that have to be accommodated, like long innovation times and the seasonality of institutional IT cycles, changing dynamics and the impact of all of that on a startup’s business prospects,” he says.

Echoing MeteoProtect’s Gross, Degnam adds: “Most [investors] aren’t willing to adapt their own financial projections to the reality of this market, or worse, try to force-fit expectations from other industries to fintech in a way that ultimately doesn't work.”

A different investment approach

Whether they understand the inner workings of a fintech, those in charge of the money want a return on their investments – and margins for investors in fintech can be low compared to other segments such as e-commerce, media and software. This means fintechs need a large volume of business to become profitable.

However, it is possible to see these investments under a different light. To start with, investors need to consider that the dynamics of customer relationships are often different in financial services, says Degnam.

“What’s attractive about financial services is that the scale of the markets is often significantly larger – sometimes in the trillions of dollars – and the customer relationships are generally longer lived.

“Where it’s pretty easy for someone to shop at a different retailer, it’s much more difficult for a person to switch providers of their financial products, both in consumer and business markets,” he says.

“People just don’t switch banks that often, and even fluid markets like credit cards tend to have multi-year relationships with their customers. Long-term customer relationships with decent gross margins and high switching costs in massive markets are pretty attractive to the right investors.”

The regulatory voice needs to be heard and compliance needs to be a core part of product design
Michael Degnam, Explorer Advisory & Capital

Another common complaint from startups is the time pressure put on them to deliver results. Degnam reinforces this, stating that one of the main growth challenges for startups is the rate of customer acquisition.

“The point is can you find, acquire and onboard new customers fast enough to meet your growth needs? Fintech companies are no different, but have the additional challenge of naturally longer onboarding times than other digital consumer products.

“Uber will always be able to activate and onboard a new customer faster than a fintech company offering a financial product – and probably rightfully so,” he says.

While fintechs complain about not being understood, Degnam says the fatal mistake startups make is failing to understand the regulatory intricacies of the clients they are trying to serve – an important consideration for IT leaders.

“A classic and unfortunately common mistake we see with inexperienced founders is that they believe they don't need to fully understand the regulatory environment of their market,” he says.

Focusing on sector expertise

One of the ways this pitfall can be avoided is in getting the technology strategy right by focusing on sector expertise.

“From a technical perspective, the best way a founder can avoid this mistake is to have regulatory matters as a primary design point in their product management process – either by finding an advisor with regulatory expertise or having personal experience,” says Degnam.

“The regulatory voice needs to be heard and compliance needs to be a core part of their product design process.”

IT leaders with a heavy focus on the regulatory environment of their financial business would surely agree.

Read more on IT for financial services