Five Fintech Predictions for 2022

2021 was such a roller coaster that making predictions for 2022 feels somewhat daunting. But as venture capitalists our jobs is to make bets on the future, so here it goes. Key predictions for 2022:

#1 Unit economics come back into fashion: 2021 saw frenzied deal volume and unprecedented valuations. A lot of this was driven by changes that took place so rapidly (sky rocketing e-commerce adoption, remote working, etc.) that many funds went into full FOMO. Our prediction is that 2022 will see investors sharpening their pencils on valuations, and hence we are unlikely to see the meteoric growth in valuations we saw in 2021.

The best case outcome for valuations is that any adjustment happens gradually, and in the context of sustainable economic models. No matter what happens, it is as important as ever for founders to keep in mind that the best immunity to market volatility is gained by the vaccine of solid unit economics.

#2 Embedded fintech in reverse: In 2021 we saw lots of non-fintech players using embedded finance to monetize their customer bases. A classic example of this would be a non-fintech company, such as a marketplace, using embedded finance to create lending or buy-now-pay-later solutions. Another example is a company like Shopify making a lot of its revenue from payments, etc.

A new trend we are expecting to see more of in 2022 is the reverse of this – companies going fintech first, and then building non-fintech businesses on top of this. One such example would be a company using fintech tools to initially attract customers, and then building marketplaces (or other non-fintech business models) on top of those customers.

It is also worth noting that these trends in many cases can intertwine in many cycles. So in the first cycle, a company can start with some legal tech to attract a customer base. Then, in the second cycle, the company can enrich their customer proposition and monetization by adding embedded finance such as payments, currency exchange, or mortgages. This then deepens customer engagement and attracts new customers that value these tools. And finally, in the third cycle, having achieved stronger customer acquisition momentum and higher monetization, the company can develop a marketplace proposition, where the customers start trading with each other, creating a strong competitive moat in the process.

#3 War for talent heats up: Many of the top startups and growth companies are now flush with cash after having gone through a landmark year, and they need to deliver results. Expect the war for talent to turn into a battle royale!

Being able to attract top talent was the key differentiating advantage in 2021, and this trend will only get amplified in 2022. There are of course a lot of implications for this. For example, many companies will increasingly start looking across international borders, and companies that provide the infrastructure for such remote hiring and remote working will continue to benefit. Another beneficiary will be companies whose culture is better adapted to the ways of working that are quickly emerging. So expect to see a lot of continued innovation in work cultures and the “future of work”.

#4 More regulation and polarization in crypto: The crypto world will start to increasingly bifurcate, with some countries and regulators becoming increasingly more crypto friendly, and some increasing their level of regulation. Expect lots of continued debate within developed economies on how crypto should be treated and what exactly is and is not permissible.

#5 Big brother steps in: While developed countries will look to regulate crypto more on the one hand, we will also see Western central banks more openly committing to creating their own digital currencies. UK, Sweden, the ECB and many others are working on this frantically as Covid accelerated the disappearance of cash, and central banks need a currency they can control directly.

As those of you familiar with the banking system know, central banks basically control the money supply indirectly via the banks that they regulate with all the monetary policy tools they have, while controlling it directly via the actual money they print. Even before Covid struck, cash was increasingly disappearing from developed economies (especially in places like Sweden), and hence that one part of the money supply that central banks used to control directly was becoming less and less relevant as a policy transmission tool.

As a result, central bankers will want to have a digital currency they have total control over, and we can expect lots of new announcements around this in 2022. This will make lots of new monetary policy innovations possible – for example when stimulus is needed it will be much easier for central banks to create more money supply by simply transferring new digital currency into the accounts of all eligible citizens.

Interestingly, this will also make things like highly negative interest rates and very strong consumption incentives much more easier. One example that has been talked about is that central banks would be able to hand out a digital currency that “expires” if not spent within a certain timeframe, thus creating a very strong stimulus for demand.

Undoubtedly, 2022 will continue seeing us living in interesting times. No matter what the future has in store for us, I wish a healthy and peaceful new year to everybody.

2021: A Cyber Space Odyssey

It has been fifty-three years since Stanley Kubrick’s landmark film “2001: A Space Odyssey” was first released, and exactly two decades since that particular year went from being fiction to history. While talking AIs in the form of Alexa, Siri and others have now become part of human history as well, we can all feel ever so slightly relieved that the antics of HAL 9000 still belong in the realm of fiction.

Having said that, traveling recently on a London tube carriage with my daughter, she pointed out to me that every single passenger bar none was sitting, head bent at a forty-five degree angle, face fixated on the cool glow from their smart phones, totally lost to the outside world as the aforementioned AIs were busy stimulating the dopamine receptors in their respective brains. So while HAL 9000 may not have become reality, perhaps William Gibson’s dystopian vision from the Neuromancer trilogy very much has.

In any case, turning back to the history and fiction of fintech, 2021 was a landmark year in many regards, and those of us who lived through it are left feeling dizzy, excited, and exhilarated. While it is hard to summarize a year in a few words, here are some of the key trends of this year.

Valuations went sky high. 2021 was a year of record valuations, and records were being broken at such a rapid pace, that it was difficult to keep track of what a “market valuation” for a start up should really be. Many of us in the fintech community found themselves going back and forth between the extremes of struggling with the valuations of new deals, to celebrating the successes and progress of our portfolio companies as a result.

Invisible fintech becomes real. Embedded finance is now mainstream, and we now see more and more non-fintech businesses using embedded finance and fintech as their monetization routes. Your core business may not be fintech, but fintech increasingly became the route by which companies were looking to monetize their user bases. And we started seeing more and more proof that even the big tech giants will increasingly turn to fintech for monetization.

A tale of two cities. In the rapidly evolving world of e-commerce, it was the best of times and it was the worst of times. While demand for e-commerce went through the roof, the supply side got so disrupted, it was simultaneously the best time and the worst time to be an e-commerce player. Fintechs that were funding and enabling payments for e-commerce merchants went through a similar roller coaster, and the best of them were able to capitalise on the volatility and turn it into a huge opportunity.

Everybody is now invited to the fintech party, and hedge funds were no exception. This was the year of the likes of Tiger Global and Coatue coming out in force, and becoming king makers and game changers, acting fast, decisively, and with big bazookas. Very few funding rounds went by where the stance of the big hedge funds turned growth investors were not a big topic of discussion.

Crypto goes boom. While crypto has always been a big part of fintech, this was the year where investments into crypto changed by an order of magnitude. Oh, and a sovereign country adapted bitcoin as legal tender. There was in fact a quantitative shift in the amount of money that flowed into crypto related start ups, and

Web 3.0 and Metaverse were big trends in the tech world, and their reflection in the fintech universe were NFTs that went right to the heart of this question: What does it mean to own something that only exists in the digital world? In the art world, Beeple was at the forefront of tackling this question, and profited handsomely, becoming multimillionaire overnight. In a world where so much content only exists digitally, the fintech world started tackling the questions of ownership and value attribution in earnest. One can only hope that this will continue to benefit the digital artists and creators out there.

Hiring is the ultimate competitive advantage: Forget proprietary tech or other moats around your business. Those that managed to hire top talent in this market had an edge nobody else could match. This was perhaps not surprising, since after record funding rounds, all these start ups and growth companies had to deliver on their ambitious plans, and AI or not, it turns out we all still very much need fellow humans.

So looking back at all these trends, 2021 was in many ways a year of extremes and contradictions, and this was very much reflected in our world of fintech as well.

Next up will be predictions for 2022, so stay tuned, stay healthy, and keep your seat belts fastened!

Trusting the “Fin” versus the “Tech” in Fintech

The question of whether or not people trust Fintech has recently came up in the media.

This is indeed an interesting question to consider.

For the moment, let’s put aside the difficulty of defining what exactly is and is not fintech. Arguably printed fiat money is a relatively early yet very successful example of a financial technology and trust in that particular innovation has certainly ebbed and flowed over the years depending on the political and economic circumstances. So one could easily argue that “everything in finance will one day become fintech” but for our purposes here let us only refer to the new batch of tech driven startups that have been making the headlines over the last decade or so.

In this context, one interesting thought that comes to mind is that it is very different to trust the “fin” versus the “tech” in fintech.

We can think of the fin part of fintech as all things relating to money, regulation, capital ratios, etc. and the tech part of it as relating to all things that have to do with mobile apps, APIs, data sharing – in other words all the things that have to do with the processing and sharing of information.

What becomes clear with this framework is that different kinds of people may trust one side of this equation but not the other.

A particular person may feel very comfortable opening up a mobile bank account, but may not entrust their whole paycheck to that new bank account, instead choosing their old and trusted bank for all major transactions. On the other hand, somebody else may trust the new bank as it is fully regulated by the PRA and their deposits are insured, but they may feel uncomfortable conducting transactions on a mobile app as it doesn’t feel natural to not be able to actually see and touch the money.

So what are the implications of this for the founders and leaders in today’s fintechs?

Most importantly, they must realize that they need to live up to the dual challenge of having both their fin and their tech trusted by their users. While building up the trust in tech requires things like transparent information sharing, intuitive user experiences, and an app that hopefully doesn’t crash when it is most needed, the building of trust in the fin sphere of things requires very different attributes.

To gain users’ trust in the fin sphere, the product proposition must be fair, non exploitative, and transparent with regards to fees and charges. The company must also be solidly funded and exude the kind of fin trust that consumers have craved over the ages. It is no coincidence that bank buildings looked so secure and imposing while the bank managers had a dress code that radiated an aura of dependability. If people are to trust somebody with their financial decisions, they have certain conscious and subconscious expectations that have to be met.

It is very interesting to consider what the 21st century equivalent of a solid bank building with security guards is for today’s digitally native financial service providers. Surveying the landscape here a few commonalities stand out. For example the number (usually measured in millions) of users that already use the service in question is usually advertised prominently, and so is the various quality certifications and memberships in respected industry bodies.

Surely, this space will continue to evolve, and as today’s fintechs become more and more mainstream, we will see how they continue to build the trust of the consumers in both the realms of fin and tech.

In the end, all trust is underpinned by delivering on the brand and service promise day after day, and while building up trust can take years, if not careful, it can be torn down in an instant. Hence, the best advice for the operators out there is to be conscious about building trust and delivering on your promise, and only break that promise at your own peril.

Good Growth and Bad Growth

If there is one metric the VC community seems obsessed about, it is probably growth. In fact, at times it seems that everything is measured with the famous “X” – 2x growth, 5x conversion, or the much coveted 10x, which is simply referred to as an “order of magnitude.”

This is, of course, very much understandable. When you start a business with a small team and a big idea, competing against incumbents that have 100x (there we go again) your resources, it is only natural that you want to catch up as fast as possible. After all, we can think of incumbents and fintech startups as being in a race: startups are trying to get to get to scale before the incumbents figure out how to deliver digitally native, intuitive, and seamless user experiences.

But one thing that sometimes gets forgotten in this quest growth is that not all of it is created equal – there is such a thing as sustainable and unsustainable growth. In fact, nature offers us a lot of interesting parallels here given that most living things are in a life and death race for existence, and all things being equal, natural organisms, much like startups, are trying their best to grow exponentially at the early stages of their existence.

Consider for example early embryonic development. Once a zygote is formed, an eight week long embryonic development process starts, with the cells in the zygote doubling (that’s exponential growth for you), until a fetus is formed eight weeks later. If all goes well, this process then continues with the fetus developing further, until a baby human is born around 40 weeks after the zygote is first formed! The cell division that underpins this process is of course very much sustainable, according to a grand plan, and one that all of us have experienced though we certainly cannot remember it.

Now consider a much less pleasant topic, and hopefully one that nobody reading this will ever have to experience – malign growth of tumors. In the early stages of tumor growth, cells also divide exponentially, creating two daughter cells each time. This, however, is very much an unsustainable form of growth, which if left untreated leads to the collapse and breakdown of its host environment, the human body.

The analogy for startups is that you certainly want to make sure that your growth is of the sustainable kind, and one which will result in a fully developed and independent organism at the end of the journey, and not one that is at odds with the environment in which you exist.

The key to achieving this is complex, and involves several aspects, from human resources to finance, and from product to technology. We will touch upon two particularly crucial ones here, sustainable unit economics and the right human resource infrastructure.

First, let us consider the business model and finance side. If your growth is not underpinned by solid unit economics, you can grow, but will forever be at the mercy of what can be very fickle capital markets. Yes, funds may want to come and invest in you in one round after the other as long as you are delivering your “X”s, but if you cannot manage to solve the simple equation of “revenues minus costs is greater than zero” eventually, you will never be able to control your own destiny.

In fact, back in the early days of scaling Capital One, we used to say one sometimes has to “go slow to go fast.” This referred to the fact that we would conduct tests on certain segments of the population, and then wait for as long as twelve to eighteen months for that data vintage to mature so we could get an accurate read of the risk characteristics of that segment. However, once a particular segment was proven, we would go from a test on two thousand customers to a full roll out on millions of customers overnight. That was going slow so that we could later go fast, and it was all about having a plan and about sustainability.

In fact, many of our UK investments have also utilized this very framework: ClearScore spent its very early days perfecting its model and assumptions, and once the team saw the path to sustainable unit economics, they scaled from a standing start to ten million customers in little over a couple of years. Similarly, Capitalise who is positioned as the super platform in the SME space, first fine-tuned its unit economic model, which then enabled it to not only survive the shock and dislocation of Covid in the SME space, but in fact come out of it stronger, with more customers and exponential growth in revenues.

The second and equally important element of sustainable growth is on the human resource side of the equation. Setting up the infrastructure for hiring the right kind of people is of paramount importance, and never as easy as it looks from the outside. To use one last saying from the early Capital One days, we were “not in the consumer finance business, but in the people hiring business.” The whole organization at Capital One, from the first year analyst to the division VP, all spent a very significant part of their time recruiting, scouring college campuses for talent.

And hiring is not just an exercise in throwing bodies at a new opportunity – it has to be done in a very deliberate and thoughtful manner, making sure the right people get allocated the right roles. Diversity is of paramount importance here, and as I touched upon in a prior blog, more diverse organizations also make for more resilient organizations. Sometimes surviving an unexpected but existential crisis is even more important than growth, and the kinds of organizations that have been able to cultivate an environment where people from very different backgrounds can flourish are much more likely to demonstrate such resilience.

Growth is essential, but it has to be balanced with a solid master plan and a sustainable model for it to fulfill its true purpose: creating new businesses and industries that exist in balance with their environment.

Digitization, Automation, and the Hierarchy of Human Needs

Real estate is one of those unique asset classes that has various forms of appeal to almost everybody. When you get right down to it, real estate appeals to our deepest rooted instincts of shelter, security and community. In an evolutionary sense, it even transcends our mammalian roots and gets deep down into our reptilian brain.

It is no coincidence that Abraham Harold Maslow (20th century American psychologist famous for framing a hierarchy of needs for psychological health predicated on fulfilling innate human desires) put shelter right at the bottom of his pyramid, right above fundamental physiological needs such as breathing, water, food and sex.

*Abraham Harold Maslow, 1908–1970, American psychologist best known for modeling a hierarchy of human needs*

While real estate has such fundamental appeal to humans, real estate investing takes this desire for safety and builds on it with complicated terms like gross yield, net yield, return on investment, and leverage to name just a bit of the jargon that usually goes along with real estate investing. So yes, as we start investing in real estate we transcend the reptilian brain, and start engaging our frontal lobe with cash flow projections and predictions around which country or which city will see rental incomes rise.

In this context, it is no surprise that real estate is the single biggest asset class in the world. Just to take the UK as an example (otherwise the numbers simply get too big!) UK residential real estate is an asset class of GBP 7.4 trillion. Buy to let investing (where landlords buy property for renting, also knows as BTL) equates to a “small” subset of GBP 1.4 trillion. Just to put this in context, the FTSE all-share index (in effect the value of all publicly traded companies in UK, many of which are international and operate globally) is GBP 2.4 trillion and the value of all loans outstanding to UK SMEs (Small and Medium Sized Enterprises) is about GBP 0.18 trillion, or 180 billion.

But while real estate is big, and appeals to both our analytic and primal instincts, it is one of the least liquid asset classes out there. One can trade shares on the FTSE in a a matter of milliseconds, exchanging ownership in AstraZeneca with ownership in Unilever in an instant. Business loans can be traded in a matter of hours. However, trading real estate can take months in the UK. So ironically, the biggest asset class is also the one that is least liquid.

This is exactly where GetGround and companies like them operating at the intersection of Fintech and Proptech come into the picture. There is no intrinsic reason why trading real estate should take months – in fact, many of the constraints that slow down this process, which at times can be outright frustrating, can be solved with technology. And this is exactly what GetGround does: turning the currently slow and arduous process of owning and investing in real estate into one that is smooth, simple, and secure.

At its core, GetGround enables its customers to buy, incorporate, bank, fund, and manage their property with just a few clicks of their mouse. Let’s now examine each of these five steps in more detail, and why each one is so important.

First and foremost, the process of buying property involves tons of documents, legal agreements, searches, negotiations, etc. We will examine what GetGround does in more detail on the buying side in a future blog, but suffice it to say that the process just asks for standardization, and with its technology driven approach GetGround can standardize all these documents giving confidence to all parties that are involved in the transaction. More importantly, as GetGround is positioned in the centre of the ecosystem, there are tons of so called network effects where GetGround can leverage its central position to help its customers buy their desired property.

*Buildings may change, but the human desire for real estate and shelter does not*

Secondly, and this is one of the platform’s core features, GetGround helps landlords incorporate a company that holds their property. Many of us take companies for granted as something that has always been part of human life, but as Yuval Noah Harari states so elegantly in his book Sapiens, companies are nothing more than a shared fiction that humans all subscribe to. But while companies may be nothing more than a creation of our collective imagination, they have very real financial benefits in real life. When applied to properties, these benefits include more efficient tax structures, better inheritance planning, better governance, and more standardized and easily exchangeable ownership structures to name just a few. Hence, GetGround has built a product (including direct API connections to the UK Companies House) that enables their customers to incorporate a company with a few clicks, and put their property into this company, all with automatically generated, customized, and standardized legal documents.

The third benefit follows logically from the first two: Once a landlord has bought a property and put it inside their newly incorporated company, it only makes sense to open a bank or e-money account dedicated to that company and property for collecting all the rental income into one dedicated place. This makes it very easy for the landlord to track all their rental payments affiliated with one company in one place, which in turn makes things like tax filing and expense tracking much easier.

Funding the property is then the fourth area where GetGround helps, and it does so by connecting its landlords to all the various banks and lenders that are looking to deploy their balance sheets to fund these properties with specialized BTL mortgages. BTL mortgages are one of the fastest growing segments in the UK mortgage market, and GetGround creates the ideal platform where lenders and landlords can meet. From the landlord’s perspective, they have just acquired a property and they appreciate the introduction to lenders, whereas from the bank’s perspective, the standardized documents and e-money account GetGround provides makes everything more standardized and secure, all accessible in one centralized platform.

Finally, in terms of managing the property, there are tons of needs ranging from furniture removal to renovation that need to take place, along with financial management needs such as tax filing. GetGround is in an ideal position to connect its customers to the experts that are needed in each different situation.

When all is said and done, step by step and click by click, GetGround is digitizing and simplifying the process of owning property, taking us all closer to that utopia where we can buy and sell property in a matter of minutes and hours instead of weeks and months. This is the power of technology and data connectivity applied to one of the oldest and most primal industries known to humans, and it is a real privilege to be part of this epic transformation.

Your money on autopilot

Being very much a child of the eighties, I am fortunate enough to have witnessed many of our science fiction fantasies from that period become real. There are countless examples here, but one striking example is self driving, talking cars – and, yes, you guessed it – I am talking about Knight Rider here. While the Teslas of today do not leap into the air quite the way KITT used to, and talking to Alexa or Siri one does not get the same kind of relationship and life advice like that was generously doled out by the legendary black Pontiac Trans Am, let’s face it, we are pretty much almost there.

The concept of the self driving, intelligent machine understandably holds a deep fascination for many – and in the fintech community the corollary vision is very much being able to put your money on autopilot. There are different interpretations here, but we can imagine getting a scolding look (or perhaps deep vibration) from our handheld devices as we reach for that extra pair of shoes we know we don’t really need in the first place.

Not surprisingly, tech companies big and small are working on various aspects of this vision, and while there is certainly plenty of opportunity here to create the first truly intelligent money assistant in the consumer space (we have some strong contenders in the QED portfolio such as Albert), there is also an equally great, if not greater, need for this in the world of businesses and large corporations.

In your typical company, there is that trusted individual called the CFO, that is entrusted with the proverbial strings to the purse, and sits there overseeing the ebbs and flows of money coming in and leaving the company’s bank accounts. It is their responsibility that the bills get paid on time, that the employees of the company have the financial tools and resources needed to conduct their day to day activities of making and selling goods & services, and that the financial infrastructure of the company runs seamlessly.

A well functioning CFO organization can be the differentiator between success and failure for fast growing companies. This is even more important for innovative companies that are growing fast, and looking to scale across several geographies. These growing organizations need a finance function and back office support that is as innovative as the core product they are creating to continue fueling the rocket ship.

At QED, we believe that this vast set of activities that CFOs manage, with everything from expense management, KPI tracking, bill paying, and all those other financial back office activities is an area that is ripe for more and more automation over time. And observing our investments as well as the market over time, we have noticed that the sheer number of big companies created in the SME and corporate back office automation space is truly impressive.

Your money on autopilot: The dream is coming true after all these years.

To this end, we are very happy to announce our investment into Payhawk today – a company that we believe meet all three criteria for success in this space, and is positioned to grow into the preferred choice of CFOs across the globe as they look to put their back office on autopilot and supercharge their operations. These three criteria are having product and tech in their core DNA, being regulation agnostic, and being able to scale very fast across international borders. Some more thoughts on these characteristics is unpacked below.

Firstly, the best players in this space need to be very much product and tech led. In the end, it is a crowded marketplace, and there are lots of generic technologies out there that can be put to good use to automate many back office tasks. But as with any good tech product, the devil is always in the detail, and we find that the best companies are the ones that really obsess about the customer journey and the best technology to deliver it obsessively. Automation is simple – automation that offers a transformative experience for its users is hard.

Secondly, we find that in the business of back office automation, it is very important to be regulation agnostic if one wants to be able to scale like a true tech company. This means that it is preferable not to cross the dual boundaries of bank accounts and local accounting regulation. Banks are made to keep your money safe, and there is not reason to try to challenge them on that front. Similarly, local accounting rules can be complex, so it best to do the automation up to the pre-accounting level, and then leave the exact accounting treatment to local players that know that better. Now this does not mean that there is anything wrong with being a neobank or a tech driven accounting software, but if you want to scale rapidly, it best to stick to the back office automation only.

Thirdly, and as a direct result of the point above, we see that the best companies can also scale very rapidly across national borders. Again, this is a direct consequence of choosing to tread a path of not touching banking and local accounting, but in addition to that, it also requires affirming and choosing international scalability as a true north star. After all, strategy is very much about what one says no to, and affirming publicly and loudly what one stands for. A lot of product design choices then flow from this, and the end result is the company that fit this criteria end up becoming ideal choices for any company with international operations.

So in a nutshell, this is the story of our investment into leading Payhawk’s A round. And before Tesla figures out how to get their cars to jump (to be fair I recall seeing a photo of one is space) I promise to write an update to let you know how the journey is progressing.

Cascading Failures and the Importance of Diversity

A cascading failure is a process in a system of interconnected parts where the failure of one or a few parts can trigger the failure of other parts in a chain reaction that leads to the system shutting down or collapsing.

The first step in a cascading failure is typically an unexpected breakdown in one component of the system – this can be due to chance, human oversight, a black swan event, or any number of random reasons. Once this happens, other parts of the system must then compensate for the failed component. This in turn overloads these nodes, causing them to fail as well, prompting additional nodes to fail one after another. This is the textbook definition of a cascading failure.

While such failures can occur in nature, they are most often associated with manmade structures such as power transmission networks, computer networks, the world of international finance, and transportation systems to name a few well known and well publicized examples.

The reason that cascading failures are less common in naturally occurring systems is usually attributed to one overriding factor: Nature, in its literally infinite wisdom provides a seemingly redundant amount of richness and biodiversity embedded into its creations. In a normal evolutionary environment there’s enough diversity to cushion the system when something catastrophic happens. There is an abundance of compensatory pathways that can step in to rebalance the system.

Manmade systems, on the other hand, are different. In book two of the science fiction series The Expanse by James S. A. Corey, the scientist Praxideke Meng who is trying to create a farming ecosystem on Jupiter’s moon Ganymede says, “Nothing we can build has the depth of a natural ecosystem. It’s a simple complex system. Because it is simple, it is prone to cascades. Because it is complex, you can’t predict what’s going to fail. Or how.”

There are tons of implications of this, especially in today’s world where humans are willingly and knowingly destroying significant parts of the biodiversity that nature has generously given us over billions of years of evolution.

There are also very interesting parallels and insights for founders building an organization from scratch in the start-up world. Like building a farming ecosystem on a Jovian moon, creating a new company with a new product in new market is not easy. It is complex. But because of the limited resources the entrepreneur has available to them it also by definition has to be simple: You may want five different go to market strategies and dozens of sales partnerships, but in reality, you may be stuck with only a few. You may not want people to know it, but eighty percent of your revenue may be riding on one successful salesperson or one amazing sales partnership you managed to sign up.

Matt Damon made growing potatoes on Mars look easy in The Martian – starting a new business in a new industry can be just as hard

The key implication of all this for entrepreneurs is this: In a world where a diversity of sales channels and an abundance of resources are already scarce it is even more important to cherish and promote diversity wherever you may find it.

And the most important place to promote diversity is among the people of an organization and their way of thinking. After all, if the cascade starts happening, you will only have the people you have surrounded yourself with to help you stop it.

So at every chance possible, founders should try to promote a diverse culture with a richness of backgrounds and skills. When the time comes, it may be this richness and diversity that is the only thing standing between you and the cascade.

21st Century Lending

The earliest known records of lending date back about 4,000 years to Mesopotamia where the Sumerians were borrowing and lending livestock and seeds that would later be repaid from the offspring and yields harvested from the original “capital”.

Shortly afterwards the Sumerians discovered that it was more convenient to use silver as a medium of exchange, and not too long after that the Code of Hammurabi defined the price of silver and how the interest charged on silver loans was to be regulated. It seems that Hammurabi was quite concerned about usury and preventing abusive payday loan practices. If he were alive today, he may be disappointed (but perhaps not too surprised) to see that the need to regulate overly greedy lenders has not gone away. Four millenniums may have passed, but human nature does not seem to have changed much!

On the other hand, what has changed is the technology available to borrowers and lenders, and the good news is that there is now a new breed of lender emerging that uses this new technology to drive better outcomes for all parties involved.

This new type of lending is characterized by five main features: It is embedded, it operates in real-time, it unlocks and underwrites with sources of data that were previously locked up or inaccessible, the collection mechanism is “default on”, and the use of proceeds are laser targeted.

The net result of these five features is that the losses for this type of lending is orders of magnitude lower, in some cases approaching zero. Coupled with operational cost efficiencies enabled by technology, this in turn enables the lender to charge the borrower rates that are dramatically lower than other lenders, creating a virtuous cycle. Let’s now quickly examine all of these five factors in some more detail.

The first factor, embedded lending, has been written about and discussed a lot in the fintech community, including in my previous blog on the topic. In summary, it refers to the lending itself being invisible to the borrower and moving in harmony with the needs of the customer. An example we used in the past is how mortgages can be embedded into the property purchase to make the whole process last hours not weeks (or months as is the case in the UK). Imagine being able to buy a house with a few clicks!

Secondly, these new lenders operate in real time. In practice this means that they in real time ingest not just the data from the borrower, but also the third-party sources of data about the borrower, and hence can also make and communicate their decisions in real time. To take small business loans as a case study, consider how those were made in the past. The business owner would have to print pages and pages of financial statements that were already out of date at the time of submission, the loan officer would review these, and make the loan some weeks later. The business might have ended up in a totally different state by then, but again the loan officer would only find out once the new set of financial statements were prepared, reviewed by an accountant, and submitted some months later. Now contrast that with having real-time access to not just the customer’s bank account but also their sales data. Quite a difference!

One can only hope for lower interest rates in the future!

Thirdly, yes, the data is in real time, but crucially it also contains new and relevant information that is usually locked up inside the business. This can include anything from recent bank account movements to real time sales data or data on how many shifts an employee has worked that week. This incremental data not only provides better performance from a credit underwriting perspective, but it also ensures way better customer outcomes by making sure calculations like affordability and the potential vulnerability of the borrower can be made with superior precision.

The fourth factor is a collection mechanism that is “default on”. In simple terms this means that in the ordinary course of business, the collection of the loan is automatic and does not require any extra effort. Following the insights of behavioral finance that have emerged over the last decade thanks to Professor Richard Thaler from the University of Chicago (where I had the good fortune to take his class) and his mentors Kahneman and Tversky, this actually makes the loans much easier and painless to collect, resulting in substantial costs savings that can in turn be passed onto the borrower. A good example of such a mechanism is collecting a portion of sales receipts at the point of sale to repay the loan, but there are many other examples.

Finally, the use of proceeds is targeted with laser precision. The loan is not made as a general disbursement for the borrower to spend as they wish, but rather for a specific purpose. Another way to look at this is that the lender understands very well why the borrower needs the funds, and how that fits into a sustainable pattern where the borrower can pay back the loan without falling into distress. This leads to a much more borrower friendly situation, where funds are only drawn down subject to affordability and a sensible use of proceeds.

In closing, it is also very important that one does not lose sight of the most crucial element of the narrative: Done rightly, 21^st century lending enables far superior borrower outcomes where consumers and small businesses can borrow money when it is most needed, at a fraction of the cost, with minimal disruption to their lives, knowing that affordability and sustainability has been embedded into the process.

Building the Unbuildable

An interesting concept in architecture is the idea of “unbuildable buildings”. These are designs that when once finished would be able to stand on their own as sustainable structures yet cannot be built as the intermediate steps needed to create them are not technically feasible.

A good example of this may be a building that rests on concrete pillars in a wavy sea. Once built this may be a beautiful and stable structure, but if the intermediate step of pouring concrete into the sea and letting it solidify is not technically possible it cannot be built. Only as technology improves and develops sufficiently, pouring concrete into the sea may become possible, at which point the building can then be built.

Another example could be a colony on Mars – while a fully functioning dome with solar panels and atmosphere control could be a sustainable and self-standing structure, the intermediate steps of setting up a construction site on Mars and shipping workers and materials there is not economically and technically feasible, at least not as of yet.

The same concept actually exists in the world of evolution as well. There are theoretical organisms that could possibly exist in our world, yet do not because the intermediate steps needed in their evolution were not possible. Put another way, any species that exist today (e.g. birds) do so because each step in their evolutionary journey (e.g. developing wings) was sustainable. Prior to wings, the ancestors of today’s birds developed wing-like appendages that enabled these bipedal species to leap higher into the air, and thanks to whatever small advantage that gave them, they were sustainable as an intermediate step to developing the full-fledged wings of today. If the intermediate steps had not been sustainable, wings would not exist.

There is clearly a very interesting parallel here for the startup world. A founder’s end vision for their company may very much be possible, but if the intermediate steps needed to build the company from zero to one are not possible, the founder may never reach their end vision. These intermediate steps may not be possible for a whole host of reasons and include the current state of technology, availability of financial infrastructure, the funding environment, and the applicable legal and moral rules, to name just a few.

For example, if the intermediate step of creating the end vision requires a multiyear journey with heavy losses and lots of big investment along the way, that particular company may not be buildable in a bad funding environment, but could in fact be built in a situation where there are deep pocketed investors willing to fund these losses for many years. Similarly, if the technology or regulatory license needed is impossible to obtain for a small company, until the regulatory environment or technology improves, the company cannot be built.

The big takeaway here is that for a founder to have an end vision that is self-standing and sustainable is not enough. The intermediate steps needed along the way also need to be self-standing in their own right, and the founder has to pay very close attention to what those steps are.

By extension, successful founders are those with a very keen eye for changes in these constraints. Things like infrastructure, regulations, and funding environment are very much dynamic and in constant flux. As laws change, new technologies become available, or central banks decide to pump trillions of dollars into an economy, previous constraints may suddenly be lifted. The best entrepreneurs are the ones ready to pounce quickly when they sense these changes that make their previously unbuildable visions buildable.

To illustrate this point, an interesting example worth taking a deeper look at is the building of a new exchange for residential real estate investment properties. Known as buy-to-let investing in the UK, these are the kinds of properties where landlords buy them to rent them out for a profit.

Currently this is a fairly illiquid market, and rather than being traded on an exchange, it is traded in one to one transactions where buyers and sellers find each other via property listing sites such as Zoopla (which are a big improvement in their own right as in the past one would have had to go to the listings sections in newspapers). Once buyers and sellers find each other (after lots of viewings) and agree on a price (after tense negotiations), it may still take weeks, if not months before the transaction actually closes. When all is said and done, the process will have involved real estate brokers, lawyers, viewings, tons of paperwork, and lots and lots of costs for both sides.

Contrast this with somebody that has invested in a company via the stock market – they can buy and sell their shares instantly because the ownership certificates (shares) are standardized and their trading is regulated by the exchange (e.g. London Stock Exchange). We can think of these standardized certificates as “securities” and the process of taking a non-standardized, clunky asset and turning it into an easily tradable security as “securitization”.

But why should one not be able to “securitize” buy-to-let investing? The end vision is surely feasible with today’s technology: Each property could be owned within a legal structure (a company) with a standardized legal contract. Then the shares in those companies could be traded on a big exchange that lists thousands of those companies with standardized and regulated ownership structures, and one could browse and filter properties, make an offer online, and trade it with a few clicks. While this process may still not be instantaneous like buying stocks today, the time to transact may nonetheless be cut down from the months and weeks that it takes today to days or perhaps even hours.

One obvious difficulty here is the intermediate step of bringing together the supply and demand (the buyers and sellers of property) under one roof on day one. If there is not enough supply then the demand will not show up, and vice versa. Hence, the entrepreneur that wants to build this new exchange will have to find a way to solve this conundrum by bringing the sellers and buyers onto the platform in incremental yet sustainable steps. If this can be cracked, the pot at the end of the rainbow surely is full of gold: buy-to-let properties represent an asset class of GBP 1.2 trillion in the UK alone and are currently housed in very illiquid structures. Solve the intermediate step, and the end vision is yours for the taking!

To summarize, having the courage and stamina needed to be an entrepreneur is one thing, but the best founders also need to be the kind of visionaries that see changes as they are about to happen, understand how those changes enable cracking the difficult intermediate steps, and imagine what kinds of future structures all this enables. With that kind of vision, what was once impossible and in the realm of science fiction, becomes reality.

To Lend or Not To Lend

Over the last decade many fintechs have contemplated this very question, with some choosing to lend, some choosing not to, and yet many others ending up in the undiscovered country from whose bourn no traveler returns as a result of doing lending badly.

When dealing with such existential questions, a simple framework can be of great use, so let’s examine one here, with some real-life examples of each instance where it makes sense or not to embark upon a lending journey.

In the simplest of terms, the economic equation from lending can be described as follows:

Π = NPV(Y) – X where

Π = Profit from lending

NPV = Net Present Value of future cash flows at the firm’s cost of capital

Y = ( [Interest + Fee Income] – [Interest + Fee Expense] – OpExCost – Losses)

Χ = Customer Acquisition Cost (CAC)

So in simple terms, a firm can expect positive economic profits from lending if it is able to charge its customers interest and fees that exceed all its expenses which include cost of funding, operational expenses, losses from credit and fraud exposure, and customer acquisition costs including all marketing expenses.

Now, it is very important to keep in mind that this equation exists in the context of a very competitive market, and in striving to generate a positive profit from lending, a firm will be competing with others that are trying to do the very same thing. Much like the story in which two campers come across a bear outside their tent, the key to survival is being able to run faster than their fellow camper even if one cannot outrun the bear.

In other words, to embark upon lending successfully one needs to have a competitive advantage in ideally all (being able to outrun the bear), or at the very least one (being able to outrun the other camper) of the key areas outlined in the equation above.

We can now look at some real-life examples from each of the categories.

Traditional players like banks have a clear competitive advantage when it comes to cost of capital given their vast branch networks where they hoover up deposits at close to zero marginal funding cost. A tech enabled fintech may have an advantage when it comes to operational cost given state of the art infrastructure that automates many manual processes. Players like Capital One used vast databases and superior analytics to keep their losses low relative to their interest income, in other words data mining pockets where the risk reward equation was superior. Yet other players may have found superior customer acquisition tools by virtue of a unique partnerships or value propositions to their customers.

Interestingly, while having a competitive advantage in some of these areas is a prerequisite for not being eaten by the proverbial bear, it does not mean that going down the path of lending is the best decision for that particular firm. Playing in just one aspect of the value chain may in fact provide a higher return on equity than lending which is capital intensive.

Let’s take the prior example of a fintech company that has the infrastructure that enables it to originate and service loans at a lower operational cost compared to anybody else. It may in fact be more profitable for that company to outsource its origination and servicing technology to other players, thus being an infrastructure provider vs an actual lender itself. QED’s portfolio company Amount is a great example of this very case.

Another example would be a company that has a clear advantage in customer acquisition costs. Rather than using this to become a lender, the company could become a loan originator or broker, and originate loans for lots of other lenders. Again, from CreditKarma to Capitalise, there are many examples in the QED portfolio of companies that have adapted this approach.

So, to summarize, founders that are thinking about taking their company down the path of lending first need to ask themselves if they have a competitive advantage in any of the key areas needed for success. If the answer is affirmative, then the next question is to determine if the company is better off selling its unique skills to the broader market, or becoming a lender itself. The answer to this question is to a great extent determined by how tradable those skills are: licensing tech infrastructure, or a loan originator selling leads to a lender is relatively easy. On the other hand for Capital One to transfer the complex analytical framework it has developed over the years is somewhat harder and likewise it is hard for a big banks to “sell” their cheap cost of funding (though they can monetize their advantage in other ways, by for example becoming a wholesale funder of other smaller lenders).

Finally, let’s look at a few examples where it does not make sense to become a lender. One example that we have often seen is when founders mistake having good data scientists as a sufficient condition for being able to create a good risk reward equation (interest income relative to credit losses). While having good data scientists (or statisticians as we used to call them back at Capital One) is undoubtedly a crucial ingredient, it is by no means enough in and of itself. The models and scores that are produced by the data scientists need to be placed in a wholistic business context, where the business analyst takes the model output and determines where to make the right cut offs and tradeoffs. For example, a data scientist with a model can produce an expected fraud probability score for a credit card transaction, but a business analyst needs to determine the optimal threshold where a transaction is declined or approved taking into account the business impact of false positives as well as false negatives. In other words, credit is a culture, not a model. Building the right organizational structure to get it right is not easy.

Another example that comes to mind are companies trying to engage in what could be described as “multiple arbitrage”. The classic example of this is a fintech start up (for example a mortgage broker) that gets allured by the high revenues that lending can provide, and starts lending, hoping that it can attract a tech multiple on its lending revenues. While this may work with some investors initially, if the company does not have a competitive advantage for lending in at least one of the key areas, the bear will catch up with them eventually.