What drives the value of a FinTech business?

PwC's Cheryl Amin weighs in on fintech valuations.

As the FinTech landscape evolves, some niche players have entered the market, all competing for customers (to grow the loan book) and capital (to fund that growth). The sector continues to attract interest from PE and VC investors. VC investment in European FinTech companies has been over €8 billion since 2013, with a record of €2.7 billion in 2017 alone¹. FinTech investors have therefore been asking for advice on how to value these businesses. Despite the diversity in business models, similar factors drive value for FinTech platforms at different stages in their life cycle. We have used these stages to articulate the ‘value journey’ as a series of milestones.

Value drivers change throughout the evolution of the business, but ultimately, FinTechs cannot thrive without addressing all of these, no matter how niche their business model is. We have taken the example of alternative finance (AltFi) providers to demonstrate how the value drivers of a FinTech business change depending on the stage of development of the business.

1) Technology development

At the very early stages of development, Altfi platforms often rely on technology as their unique selling point using innovative techniques to optimise lending or transaction activity. In some cases, platforms differentiate themselves based on a quick loan application process or enhanced credit underwriting process through the use of credit algorithms or machine learning. Although the business is still developing its customer base, it is still attractive to investors. Investors would typically value such platforms based on a cost to replace approach or an acqui-hire method. However, investors may pay a higher implied multiple at this point with the expectation that a sustainable business will evolve from the unique technology.

Even the most innovative platforms can only remain at this stage for a finite time period.

2) Proving the business model

During this stage, PE / Venture capitalists invest on the basis that management will be able to execute their strategy and deliver rapid growth. Profitability may be compressed by funding costs as high as 10 per cent². The business might start out with a great idea, but start-ups need to show that there is sufficient demand for their product to support sustainable execution and growth. Altfi’s may find that they are unable to cope with the volume of projected activity without compromising on quality of service. This is when start-ups often adapt and refine their business model in order to develop products and services that have the potential to be scalable and don’t simply rely on key individuals or founders. Some start-ups that manage this transition properly are able to build investor confidence and generate significant value in their business in a short space of time. By developing a track record of growing volumes, attracting new customers, managing credit risk, while maintaining robust financial records and efficient internal processes the Altfi provider can demonstrate that their business is scalable. In our experience, at this stage, investors typically value platforms on a milestone approach, which is more qualitative and takes into account major developmental achievements such as launching the platform, the point at which profitability is expected or securing key contracts.

3) Borrower pipeline, investor appetite

Assuming that the technology is working and the market is buying into the business model, an Altfi business then needs to start building out a pipeline of borrowers to show that there is the potential for sustainable interest in the product/service. What is the distribution model for the business? Having other players tie up with the start-ups to refer borrowers can give the valuation a significant boost where the lender is able to achieve year-on-year growth percentages in their loan book in the high hundreds. BNP Paribas Asset Management’s alliance with Caple has allowed it to access the SME lending space, minimising its customer acquisition costs and providing a stable pipeline, which enables it to negotiate funding costs and boost its valuation.

4) Building scale and branding

Partnerships are a significant driver of value for Altfi businesses. With distribution and funding agreements in place, the Altfi provider will start to gain profile in the market. A widely recognised brand provides the basis for delivering the high growth and scale promised in the business plan, especially where it relies on high volumes. However, the brand doesn’t necessarily need to be its own. Altfi businesses have partnered with other recognised brands either through referral arrangements, plug-ins or website links. At this point, investors and entrepreneurs may consider adopting an income approach to look at the value of the partnering relationship and understand how sensitive the business value is to the relationship. Investors will however still apply caution when considering new income streams, factoring these in by probability weighting the newer sources of income.

5) Moving into the ‘black’ / profitability

Having high volumes can drive a high multiple, but only if the business is generating positive cash flow and is heading towards profitability. At this point, Altfi businesses may look to boost their valuation and appeal to investors by reducing their cost of capital with a view to improving margins. For example, Zopa is one of many FinTech’s that is in the process of transitioning to a challenger bank style model by gaining a banking licence and taking deposits. This will enable it to reduce its cost of funds closer to that of a traditional bank, which can be as low as 50 bps.²

As the business moves to profitability and volumes increase, the uncertainty haircut applied to the business begins to fall and the ability to forecast improves. This means that the income approach can become a more reliable tool for estimating the value of the business. Year-on-year growth rates in the loan book are likely to fall down to double digits at this point as the business approaches reasonable scale.

6) Trust and resilience

This final value driver is the hardest to develop, and is particularly important in the Altfi space. Operating in a digital environment where they manage their customers’ exposure to financial risk, Altfi firms are particularly susceptible to reputational damage. If the fundamentals discussed above are in place, then an experienced management team will be able to maximise growth opportunities while building a reputation for the quality of its products and services. Developing trust with customers allows Altfi businesses to expand their product range, retain customers and reduce the cost of customer acquisition. This has a positive impact on value by giving investors confidence that management can deal with adverse scenarios such as macro-economic downturn or other situations that can be difficult to predict. The Altfi provider will ultimately reach a point at which it is able to maintain the size of its loan book as a mature business.

To maximise value, Altfi businesses need to leverage each of these value drivers at different points in their life cycle. They need to understand how to manage their development so that the achievement of each milestone has a positive impact on value and minimises any drag on their valuation.

Reference:

1 https://pitchbook.com/news/articles/rise-or-fall-the-evolution-of-the-european-fintech-industry

2 https://hbr.org/2017/04/how-banks-can-compete-against-an-army-of-fintech-startups