A New Framework for Fintech
I have spent the better part of the past decade looking at and thinking about opportunities in fintech. Generally speaking, people group these companies by the sector of the financial system they occupy. However, that grouping is overly simplistic, as it doesn’t appropriately reflect where the opportunity to create outsized value exists. Recently, I’ve begun to think of fintech within a new framework: financial platforms, financial product manufacturers and financial infrastructure providers. Financial platforms earn a customer’s trust by solving an immediate pain point and leveraging that position to take over more of their financial life. Financial product manufacturers create and distribute new (or traditionally offline) financial products. Financial infrastructure companies build the connective tissue of a modern financial ecosystem. Thinking about it this way actually helps shine a light on where outsized value can be created and venture returns realized.
Chasing the platform dream
Financial platforms are companies that have earned a customer’s (SMB or consumer) trust and become habitual parts of that user’s life. Platforms use technology to solve a significant and recurring pain point for the customer. But the key is that the customer develops a meaningful relationship with a service (beyond the simple transfer of funds that occurs in the background). Solving this pain gives these companies access to customer data that allows them to offer additional services that are superior to alternatives by virtue of their unique insight into the consumer. These companies generally will tend towards monetizing additional products via lending — A16z recently dubbed them Lenders in Disguise.[1]
In SMB, Square is an archetype. By building reliably better processing and point-of-sale (POS), Square secured three valuable things. First, they earned trust. Second, they accessed all the revenue flows of their customers. Third, they grabbed valuable real estate — literally becoming the dashboard for the decision maker at each SMB. The happy outcome for Square is they can offer a loan to a customer who they know has the ability to repay and not have to compete for attention in the knife fight that is CAC for SMB lenders; and because they can increase the LTV of a customer, they can afford a higher CAC then their competitors in the processing and POS. This outcome, though, is all predicated on using technology to deliver a superior experience and product for a critical pain point — in this case processing and POS. Other examples in the SMB space are: Divvy, ScaleFactor and Shopkeep.
In consumer fintech many companies are chasing the platform dream. Again, the opportunity here is to use technology to solve a specific problem and build up trust and relationship with a consumer — slowly supplanting their relationships with traditional financial institutions. That said, there is no canonical example in consumer as there is in SMB.
We’ve seen many approaches to building platform companies in consumer. Some companies come at the platform opportunity by connecting to a user’s bank account and helping to manage spending or fighting fees. These companies offer AI-enabled budgeting solutions and the ability to fight bills in order to build trust with the consumer. Once trust (and hopefully habitual use) is established, these companies leverage their unique insight into that consumer’s behavior to offer secondary products. Others offer tools to help parents and kids manage money, and again once habitual use is established, they begin to offer secondary products. These secondary products can be third party products integrated tightly into the application by modern APIs or can be fully formed new products.
One area that I’m particularly excited about is using these product wedges to acquire and solve problems for populations that have traditionally been poorly served by the traditional financial system and retail distribution model.
The bottom line is that there is an opportunity here to build a company that plays many banking functions without actually building a bank (and all that would entail regulatorily and technically). And it’s really quite simply going to be based on using technology to solve real pain points for a customer and earning trust.
Financial product manufacturers: All financial product wedges are not created equal
Companies in this category start by bringing a financial product online. In most cases these products are very similar to what exists in the market today but are poorly distributed. In the past decade we have seen a number of mono-line startups get to great scale.[2]However, these mono-line companies have seen significant contractions as they have entered the public markets. In general, simply being a producer of a new financial product does not generate tech multiples.
Where the opportunity does lie for these financial product companies is in leveraging their position with the customer to become a platform (also known as cross-sell) or infrastructure company. Ideally the strong unit margins of your core product allow you to scale a user base cost effectively and give you enough runway to figure out what additional product lines you can sell to your customers. Growth solves many problems! SoFi is one of the most recognizable examples of this strategy. They started with the great insight for an arbitrage opportunity in the student loan market and quickly expanded to other services. This is a similar road being traveled by overdraft protection lenders like Dave and Brigit who have found incredible product market fit by offering a subscription service to avoid overdraft fees.
The challenge that these companies face is the leap to becoming a platform company. By no means is it a fait accompli because a user chooses you for one financial service that they will want an ancillary product from you. This is particularly true when an initial wedge product is around an unmet need in the market and the secondary product may have a good enough substitute in the market. Ultimately, simply being a product manufacturer is a challenging path, and crossing the chasm to become a platform is difficult.
Infrastructure that turbocharges platform building
Much of the opportunity to build financial platforms is driven by innovation in the underlying technological foundations of financials services. The quality of data, and more importantly the ability to pass it back and forth has been historically terrible in financial services — just think FTP sites, flat files, PDFs, etc. But this has changed dramatically in the past decade. Plaid’s APIs make it easy for developers to access and analyze financials from any financial institution. EVEN Financial’s APIs make it simple to refer a potential customer from one platform to another. Companies like Bond and SynapseFi make it much easier to add new debit or credit products to an existing application.
The upshot of these advancements is two-fold. First — new product creation and distribution has become much easier. This allows the financial platforms referenced above to exist and monetize. Second — there is an opportunity for anyone who aggregates a large, high-trust audience to easily begin to monetize this audience via financial products. This is an opportunity that did not exist five years ago and will bring about huge shifts in distribution of financial products. My colleague Michael Gilroy likes to say that eventually all big brands will become fintechs. If you have consumer trust and access to interesting underlying data then financial products offer a way to improve your customer’s (Apple and Apple Card holders) or supplier’s (Uber and drivers) life while also being a great way to expand the LTV of a customer.
That said, huge gaps remain in the underlying infrastructure. While there are leaders in data aggregation and distribution, customer distribution and banking product distribution — large swaths of the market remain unserved, including in trading, clearing, servicing, insurance.
Identity management remains a nightmare — and particularly interesting. Everything in insurance is about ten years behind the rest of fintech — a topic for another post. And everything in insurance is uniquely its own beast given the power of incumbents and state regulators (rather than federal ones).
At Canaan we remain bullish about the continued pace of innovation in fintech. The past ten years since we led LendingClub’s Series A has brought a huge windfall to consumers and SMBs in financial services. The next ten years will usher in a wave of platform and infrastructures — and we are more excited than ever about the companies and founders that will emerge to build that future.
Note: Canaan investments mentioned in this post are: Bond, Brigit, EVEN Financial, ScaleFactor, Shopkeep.
[1]A quick aside about lending: finance is a heavily regulated space with very clear rules about what you can and can’t do. It is hard to legally underwrite better than incumbents can (though not impossible). Incumbents have lower costs of capital (via deposits — often fed by branch networks that many people love to deride but serve a valuable purpose) — mapping the cost of the branch network to a cost to acquire deposits would a great piece of work some enterprising person to follow up with! And consumers are generally rational actors (preferring lower cost products). Thus the best way to compete in lending is to get access to proprietary data to underwrite with or develop a proprietary channel to access the borrower.
[2]It can’t be ignored that many of these companies came into existence in the wake of the financial crisis. The banks had all pulled back dramatically from many of these markets and stayed out them for years (all of the executives had just lived through Armageddon).
