Five valuation formulas in finance that everybody needs to know

What are the five most important formulas in finance for company valuation? And how can you apply them to your everyday life, whether you are in the venture community or not?

1. The Time Value of Money:

Or, “a dollar today is worth more than a dollar tomorrow”.

The formula:

Present Value = Future Value / (1+r)^n, where “r” is your discount rate, and “n” is the number of periods.

Today’s inflation makes this clear:

Price of milk is increasing by 10% every year, so a gallon of milk that costs $1.00 today will cost $1.10 next year.

And $1.21 the following year. That $10 bill in your pocket buys you 10 gallons today, but only 8.2 gallons in two years!

The “r” in the formula is the discount rate at which we discount future profit.

$1 in the next period is only worth 1/(1+r) today.

And $1 in three periods is only worth 1/(1+r)^3. The further out the future cash flow, the exponentially smaller its value today.

It is also important to note that “r” takes not only inflation, but also risk into account. If your neighbor tells you they will give your $10 in two years, not only does that buy you less milk, but they may move house and never pay you.

Given the risk, you may want $5 today vs. $10 in two years!

So how can you apply time value of money to your life?

Be aware that with 10% inflation and 0% interest on your $9,000 savings account, you are $900 poorer at the end of the year. Congratulations, you just paid the inflation tax!!

Invest your money (wisely) and don’t let it melt away!

2. The value of a constant growth annuity:

Or, “even an infinite cash flow has finite value”.

The formula: Present Value = Perpetual Cash Payment / (r – g)

In this formula, “g” is the constant growth rate, and “r” the discount rate from Formula #1.

The simpler version of this formula is the No Growth Perpetuity – a cash flow forever that does not grow.

That formula is: Present Value = Perpetual Cash Payment / r

If “r” is 10% and you win the lottery to receive $1,000 every year that is worth $10,000 in today’s dollars.

You can apply this formula to value mature companies quickly:

If a company will only grow 5% over the foreseeable future, and is earning $10 million in after-tax profits, and your “r” is 15%;

The company is worth $100 million today.

$10mn / (15% – 5%) => 10mn / 0.10 => 100mn

There are many implications of this formula.

i.) companies & cash flows have finite value, driven by math

ii.) growth increases the value of future cash flows

iii.) risk & inflation decrease value

iv.) predictability decreases risk

You can see why “predictable growth” is something of a home run in valuation terms!

3. The Black-Scholes formula:

Or, “options have value”.

The Black-Scholes is a bit too complex mathematically to get into here.

But the implications of Black-Scholes are simple and valuable!

The implications:

i.) Options have value; never give one for free unless you are getting something in return

ii.) Value of options increase w/ volatility & duration

In risky times, (or if you are wise enough, before the risky times come knocking at your door), secure options.

Flexibility has value as it lets you pursue more options.

Value flexibility.

4. Enterprise Value vs. Equity Value

Or, “debt is never free”.

The formula:

Equity Value = Enterprise Value – Net Debt.

The best way to think of this is in terms of your house.

Your house may be worth $300,000. But you have a $250,000 mortgage – debt to the bank.

Your equity in your house is only $50,000.

The same concept applies to a company valuation. So in a situation where a company has taken on debt, we need to think of two concepts.

Enterprise Value: The analog to the value of the house from above.

Equity Value: The analog to “equity in your house”, or what is left when the debt is paid off.

If your valuation is based on net income, this is not an issue.

100% of net income is for equity holders, & is net of debt service.

But if your valuation is based on revenue or EBITDA you need to look at how much debt there is.

And subtract it from the Enterprise Value.

Implications:

i.) Debt gets paid of first. When enterprise value goes down, equity value gets wiped out first. Be aware.

ii.) Do not confuse enterprise cash flows (revenue, EBITDA), with equity holder cash flows (Net Income)

iii.) There are things that don’t look like debt, but are

iv.) When you are referring to a company’s value, especially in private markets, know if you are talking about enterprise value or equity value.

v.) Public markets do not have this confusion: All stocks are traded based on equity value.

vi.) Take on debt judiciously

5. The Capital Asset Pricing Model (CAPM)

Or, “return expectations are driven by inflation as well as a risk premium”

The formula:

Expected Return = Risk Free Rate + Risk Premium

The Risk Free Rate is measured by a safe asset such as a short dated U.S. T-bill.

This is what investors can earn without taking risk.

In the long run, this is very correlated with inflation.

In the short term there can be lots of deviations we need not get into here.

The Risk Premium is derived from:

– The overall risk appetite in markets (equity risk premium). This can go up and down based on the macro situation.

– The systemic risk of the security (also known as Beta, it is a measure of how much risk a security contributes to a portfolio).

Implications:

i.) Higher inflation => higher risk free rate, higher “r”

ii.) Macro uncertainty => higher equity risk premium, higher “r”

iii.) A risky venture => higher Beta, higher risk premium, higher “r”

More macro risk & more inflation, is not great for venture valuations!

In summary:

Pass on inflation into your net profits if you can. Predictability of growth will reduce your investors’ “r” &  increase valuation. Take on debt judiciously. We are in a new reality with valuations, get used to it, and accept it. Things will change, but only as the macro situation and the inflation outlook improves.

Ten Implications of Higher Inflation

Here are ten fundamental insights about inflation, how they will impact you – and how to change your thinking and behavior to best adapt to inflationary times.

1. Inflation is a tax on cash.

With 10% inflation, the $100 bill in your pocket is only worth approximately $90 next year.

If you keep your money in a savings account with zero or close to zero interest, the same is true.

You are paying a 10% tax on your nominal cash balance.

2. Inflation is also a tax on nominal contracts.

If somebody has promised to pay you $100 twelve months from now, and inflation is 10%, that contract is only worth $90 today.

What is a good example of this? Most employment contracts!

Inflation is a tax on wages and all other contracts denominated in fixed terms.

3. The impact of inflation compounds.

With inflation at 10% for 2 years, the price of things will not go up by 20%, it will go up by 21%.

After three years, it will go up by 33%, not 30%.

The impact of inflation compounds over time. Think of it as interest, but in reverse!

4. Whether you win or lose with inflation, depends on how you position yourself.

As a business, if you can keep your costs nominally flat, but pass on inflation in your price you can win.

If inflation increases your costs, but not your revenue, you will lose.

In other words, to understand the impact of inflation on your life or your business, ask yourself the following:

Is inflation increasing my costs? Is inflation increasing my income?

Depending on the answer, the impact can be good, neutral, bad, or ugly. Ideally you want to be in a situation where you can keep your costs constant, but increase your income due to inflation. If you find yourself in the reverse situation – increasing costs due to inflation, with no increase in your income – be careful! And take action.

5. In macro terms, inflation equals uncertainty.

If inflation is 1%, and goes up by half, it becomes 1.5%

If inflation is 10%, and goes up by half, it becomes 15%

Higher inflation thus increases uncertainty and volatility. Both are bad for markets, the economy and risk premiums. High inflation creates more volatility and risk in markets.

6. Emerging economies have to think harder about safe assets

If you live in a country that suffers from high inflation, the the U.S. Dollar or the Euro was “the” safe asset.

There is now a bigger inflation tax on those currencies. That means that a person living in Argentina may put their savings into dollars to protect against the peso losing value, but the dollar itself is losing 10% per year to inflation!

As a result, crypto, gold and other non-inflationary (or even deflationary) assets may start becoming more attractive.

7. We need to start thinking of “Real vs. Nominal” price changes.

With inflation at 1%, this difference was largely academic.

However, at 10%, the difference really matters.

For example: If your nominal house price stays flat, it is actually decreasing rapidly in real terms!

Similarly, with 10% inflation, if your house price goes up by 10%, in real terms it has only stayed flat.

And if your nominal house price goes down by 10% it has actually decreased by almost twice as much in real terms!

We have to get used to start thinking of real vs. nominal!

8. Real vs. Nominal interest rates really start to matter, and are driven by different economic factors.

In simple terms, Real Rates = Nominal Rates – Inflation

If your nominal mortgage rate is 6%, and inflation is 10%, your real rate is negative 4%.

If inflation drops to 4%, your real rate becomes 2%.

Thinking of real vs. nominal rates can be confusing, but it has very important implications for the economy.

Let’s illustrate this with a simple framework where real rates and inflation are either “low” or “high”.

There are four possible outcomes in this framework. i.) Real rates and inflation both being low, ii.) real rates and inflation both being high, iii.) real rates being low with inflation being high, and iv.) real rates being high with inflation being low.

In much of the 2010s, we lived in an environment where both real rates and inflation were low.

This was very good for asset prices. Nominal AND real house prices increased a lot.

The opposite of the 2010s would be an environment with high inflation and high real rates. E.g. 10% inflation, and 5% real rates would imply nominal rates around 15%. This clearly would not be good for asset prices or house prices.

But this is not where we are today.

Today inflation is close to 10%, w/ mortgages around 6%. High inflation, and very low real rates. This brings us to our next implication. What can we expect will happen to house prices today?

9. With real rates negative or very low, it is hard for nominal house prices to come down in the medium term.

It is likely that nominal & real house prices will diverge. Nominal prices may go up, real prices down.

A severe recession could always dent nominal house prices in the near term. But if this environment persists (very low real rates, high inflation), nominal prices will go up eventually.

What would happen to real prices is more difficult to predict and could be the subject of another blog.

10. Real vs. Nominal rates are driven by different economic forces and are hard to predict.

Inflation is driven by monetary policy. In other words, the more money we print, the more inflation we get.

Real rates are ultimately driven by the supply and demand for capital.

Forecasting how real and nominal rates will move, or what will happen to inflation is extremely difficult.

In summary, embrace the fact that we are now living in more volatile times. Adapt the right analytic framework, and design for flexibility in your life & business. Avoid nominal contracts unless it is your cost base. Pass inflation into your income stream whenever you can. And start getting used to thinking in real vs. nominal terms!

Back to School Part II: The Value of Options

As if we need a reminder that we live in volatile times, the global currency markets gave us a bone-rattling jolt over the last week as the British pound hit a historic (or arguably hysteric) all-time low against the U.S. dollar, prompting abundant commentary and an avalanche of new memes in social media. While a lot of what happened was idiosyncratic issues related to Britain, the U.K. is certainly no island when it comes to being exposed to the vagaries of global markets.

In fact, in our last blog we had covered the precipitous drop in tech valuations and how we could make use of simple discounted cash flow formulas to estimate what a company may be worth fundamentally. After all, in a world where markets seem to be prone to changing their minds by an order of magnitude over short periods, we all need something solid to hold on to. Mathematic formulas certainly seem to be as good as any place to get some comfort.

While discounted cash flows are a big part of modern finance, as promised, there is one other big area that we had not yet covered – the realm of options and how to price them.

Stated simply, an option contract gives the holder the right to buy, sell or use an asset at a pre-determined price at some point in the future. While many people think that option contracts came into existence along with the Chicago Board Options Exchange (CBOE) on January 1st, 1973, they have existed for much longer.

In fact, the first record of financial options in history date back to the fourth century B.C. when the ancient Greek philosopher Thales of Miletus decided to take a break from the rigors of philosophy in order to profit from his prediction that the forthcoming season would bring with it a record olive harvest. Not having the funds to buy olive oil presses at scale, Thales instead gave a smaller sum of money to each press operator in Miletus, securing the right to use them during harvest season. And when his prediction came true, Thales sold the right to use these presses (for a considerable profit) to all the olive producers who were eager to convert their record harvest into oil.

Of course, the modern option contracts that were written at the CBOE in 1973 have come a long way over the ensuing millennia. More importantly, the way options are valued has evolved just as dramatically.

Specifically (and not entirely coincidentally), 1973 was also the year in which Robert C. Merton published his seminal paper “The Pricing of Options and Corporate Liabilities” in the Journal of Political Economy. This paper was revolutionary as it was the first to expand the mathematical understanding of a formula which had been under development by Fischer Black and Myron Scholes since 1968. Calling it the “Black-Scholes option pricing model” the formula revolutionized modern finance and provided scientific legitimacy to the CBOE and other options markets around the world, and ultimately resulting in Robert Merton and Myron Scholes receiving the Nobel Prize in Economics in 1997.

The formula itself is based on a parabolic partial differential equation, and can look quite intimidating to those not well versed in post graduate levels of math and physics.

However, there are several practical implications of options pricing that are relevant for the start-up and early stage investing world.

First and foremost, as Black-Scholes tells us, options have value. Hence, if you are giving somebody an option, you are giving something of value and vice versa. As an early-stage founder, if you can incorporate free options into your business, you should always look to do so. These can take the form of distribution agreements, supply contracts, or even a built-in feature to take your product in a certain new direction in the future. So keep your options open whenever it is practical to do so. Conversely, when you are asked to give somebody an option, for example a bank asking to do a proof of concept with an option to extend the contract, know that you are giving away something of value.

This actually brings us to the world of real options, which is the right to make (or else abandon) some choice or course of action that is available to the founders and managers of a startup. There is a whole host of literature that is focused on using real options to value startups since using a discounted cash flow can be so tricky given how uncertain the future can be. In this view of the world, the value of a startup goes up in proportion to the number of options it has to go after big market opportunities as new information flows in.

Speaking of uncertainty, one of the key takeaways from Black-Scholes is that the higher future expected volatility is, the more valuable an option becomes. So in volatile environments, and the startup world would certainly qualify as such, options become even more valuable. Similarly, the longer a period the option is valid for, the more valuable it becomes.

There are also implications here for your organizational design and the kind of people you recruit to your company in the early days. The more flexible your organization is, the more it would be capable of rapidly persecuting different courses of action, thus taking advantage of various embedded real options.

Hence, for an early-stage company, having a culture and organizational structure that enables rapidly tacking or jibing as the business environment changes is not just valuable – it can mean the difference between winning or losing in a volatile world.

Back to School on Valuation

As the warm and fuzzy memories of summertime fade into the distant past, it is once again time to start setting the alarm clocks, buying new textbooks, and catching up with our friends we have not seen over the break. In other words, it is back to school time.

While I used to think that the year starts on January the first, I have now come to the realization that much like the English Premier League, the year really starts in late August and goes with a frantic and exciting pace all the way to the next summer. So welcome to the 2022 – 2023 season! I hope that it will be one filled with excitement, lots of goals, and most importantly, fair play.

As we think back to the second half of the 2021 – 2022 fintech season that we left behind, the defining feature was of course a momentous shift in company valuations. On the public side, there was no hiding from this painful reality, whereas on the private side it seems like many people are still coming to terms with it. Our more practical minded Swedish friends such as Klarna seem to have accepted the fact, dealt with it, and moved on, while others that are living in a sort of denial can still be found.

Lots of good pieces have subsequently been written on valuation over the summer, some dealing with the relationship between EBITDA and revenue, and translating revenue multiples into the context of future growth expectations, etc.

Those have all been good to read, but in the spirit of back to school time, it would be good to look at company valuations from a very rudimentary perspective. Specifically, let’s look at four simple principles that can be used to create a valuation framework for companies – profits, time value of money, growth, and risk.

Let’s start with profits. To put it very simply, companies are ultimately only valuable if they can generate net income that can then be distributed back to investors as a dividend. If I told you that I had a company that will never generate a single dollar of profit in its lifetime, or there was one where all pre-tax profits would be swept up by an evil troll (no, I am not talking about the IRS here) at the end of the day such that they can never dividend out any profits, the answer to what those companies are worth would be very simple. Zero.

Now that we know we need profits (one would hope we really didn’t need a reminder), let’s look at a way to value those future profits. This takes us to our second principle, the time value of money. Stated simply, this principle tells us that a dollar today is worth more than a dollar tomorrow. The current inflationary environment illustrates this fact very clearly. If a tomato costs $1.00 today, but will cost $1.25 next year, my $10.00 buys me ten tomatoes today, but only eight tomatoes next year.

Hence, $10.00 to be received next year is only worth $8.00 today if measured in tomatoes. The rate at which we discount the future cash flows (25% in our tomato example) is denoted as “r” in finance, and is called the discount rate, interest rate, or cost of capital depending on the context. Hence, $1 in the next period is only worth 1/(1+r) today which is one of the three key formulas you’ll ever need in finance.

The second formula you’ll need (and with these two you can derive other more complex looking formulas) is a mechanism for valuing an annuity. An annuity is a constant but perpetual cash flow, and is the other basic building block for valuing cash flows over time.

For example, let’s assume we have a company that will generate exactly $100 million of dividendable net income per year, from now until the end of time. What is this company worth? I will give you a hint – it is not infinite!

To answer the question, let’s assume that the cost of capital, or “r” from above, is 10% – in other words, investors can put their money in an equally risky venture and earn a 10% return. So what is the answer?  

While many people get this question wrong, the simple answer is that it is a unicorn – worth $1 billion! The formula for valuing an annuity is simply to multiply the annuity (in this case the $100 million) with 1/r. Put simply, 1/10% = 1/0.10 = 10, so multiplying $100 million by 10, we get to a billion.

A convenient way to keep this formula in mind (and also to prove it to be correct mathematically) is to ask the reverse question. If I could earn a 10% annual return on my capital in perpetuity, how much would I need to set aside today to generate $100 million year after year? The answer is $1 billion – just put it to work and clip that 10% coupon – not a bad way to earn $100 million per year!

While these two formulas are all you need to derive other time value related formulas in finance, they leave out one important fact we in the venture capital world care dearly about – growth. A cash flow that grows is obviously worth more than a cash flow that does not, and our annuity example above related to a zero growth, constant cash flow.

So how does the growth rate, usually denoted as “g”, impact the value of an annuity? The answer is that the value of an annuity becomes 1/(r-g), so if we assume a 5% perpetual growth rate, the unicorn in our prior example suddenly doubles its value to become worth $2 billion ($100mn/(10%-5%) = 100mn/5% = 100mn/.05 = $2bn).

[A note to those who want to geek out a little bit: As promised, this seemingly new formula is derived from the prior two formulas under time value of money. Follow the proof & derivation from this link: https://en.wikipedia.org/wiki/Dividend_discount_model

However, there is one more important insight around growth that we need to keep in mind while valuing companies. In the long run, nothing can grow faster than GDP. Think of this as the speed limit of the universe – nothing can travel faster than the speed of light. Taking Apple as an example, after they have produced billions and billions of phones and computers, at some point they will have saturated their addressable market, and their growth will be bound by how fast GDP can grow. If this were not the case, at some point Apple would literally take over the world.

So if you want to value Apple, one way to do it would be to model out the growth in profits year by year until they reach that “end state”, then come up with a terminal value based on the constant growth annuity formula from above, and then time value all those cash flows into the present. Sounds simple, right? No wonder stock prices can be volatile!

But the point is that the problem is not one of lacking the necessary math – it is actually one around the difficulty of forecasting how fast exactly Apple will grow, what their competitors and regulators will do, etc.

Which finally brings us to our fourth and last principle, risk. In simple terms, the more difficult it is to forecast and rely on those future cash flows, the higher the risk, which in turn means the higher the “r” you need to use to discount your cash flows. And vice versa.

To summarize, our unicorn from above, that has $100 million in net profits, and will grow at 5% until eternity, is worth $2 billion if our cost of capital is 10%. If they manage to grow faster, they will be worth more, but they cannot grow faster than GDP in perpetuity. If our cost of capital (i.e. risk) goes up beyond 10%, they will be worth less.

So sharpen your pencils, take out your calculators, and get to work – there are many companies to value out there, and don’t worry about running out of interesting subjects – we’re creating new ones every day!

Plug and Play Finance

This article was originally published in Business Age on 6th July 2022

Plug and Play (PnP) Finance is a new term, but it has been a long time in the making. It has its roots in the world of embedded finance, which refers to financial products becoming so ingrained in our everyday applications and experiences that they become virtually invisible.

However, there are important differences between embedded finance and PnP Finance.

Firstly, embedded finance is a result and can be achieved in a number of different ways. Some of those ways can be quite hard and costly to implement. For example, a marketplace may be able to facilitate payments on its platform, which are then embedded, but the marketplace in question may have to deal with a lot of thorny issues around customer onboarding, KYC, payment flows, settlements, etc. This requires a lot of work for the marketplace, both in terms of developing software, as well as dealing with the implementation and management of regulated products.

Conversely, Plug and Play Finance refers to the means by which one achieves that same embedded result. And in the case of PnP Finance, the solution is already modularized and implementing it takes weeks, not months. So one way of thinking about plug and play finance is that it is a subset of embedded finance, but a particular subset that is much more easy for businesses to use and integrate.

PnP solutions are easier to implement because they contain all the elements needed to on-board customers, provision financial instruments, and conduct financial activity without innovators (the businesses using PnP solutions, such as the marketplace in the above example) having to get into the details themselves.

Specifically, onboarding is easier because the plug and play finance provider takes on the risks and responsibilities associated with onboarding customers such as KYC and other AML requirements. This in turn is possible because the PnP provider tokenizes sensitive customer data, and the innovator hence never has to handle this data in its raw form, which saves them the burden of being subject to more regulation.

Similarly, the provisioning of financial instruments such as cards, accounts, insurance policies etc. is all done by the PnP provider, and the innovator using the plug and play services does not need to get into the details of doing any of that. On the other hand, a customer that wants to simply embed a financial service may have to get into a lot of nitty gritty detail around the specifics of each product. PnP Finance means that the business just gets ready to consume modules where all key decisions and parameters have already been taken care of.

A good example of such a plug and play finance solution in the market today is Stripe Connect, Bolt, or Weavr where the innovator is taking the financial solution as is. Big tech is also moving into this space one giant step at a time. For example, Apple, who had entered the payments space with Apple Pay has now taken one step further by announcing it will let its users in the United States benefit from a buy now pay later service to split their purchases into instalments.

So what of the future? What will come next?

The next step in this evolution will be the emergence of PnP platform providers. Most PnP solution providers today only offer one solution. For example, Klarna delivers one solution around Buy Now Pay Later (BNPL) that can be integrated into an online checkout experience, Stripe Connect delivers a PnP solution for marketplace payments, etc. PnP Finance platform providers will enable the creation of multiple PnP solutions in one place from one vendor.

Another likely outcome in the not-too-distant future is that financial institutions will realise that providing an embedded finance solution such as Banking-As-A-Service (BaaS) is difficult because it requires a very high level of supervision of the innovator and their end customers. They may then start migrating to a more PnP approach, where parameters and use cases are pre-determined, any sensitive data is tokenized and hence not accessible to the innovator.

Finally, Because PnP Finance is easier to implement, it will become a driving force for more and more products and services having financial modules ingrained inside them.

While these new developments clearly come with significant customer and societal benefits by making commerce even more friction free and ubiquitous, there are nonetheless significant risks and warnings to which one needs to pay careful attention.

Warning one is that we are at an inflection point today, and the rules we set in place will reverberate well into the future, magnifying in significance and scale over time. Regulatory bodies such as the FCA cannot ignore the implications of these developments and need to think carefully about how concepts like customer outcomes, affordability, and competition translate into this new world. For example, is Apple offering BNPL good or bad for competition? How much bargaining power will merchants have? How does one define regulatory jurisdictions? The key here is to find the right balance of letting the market develop while intervening in the key areas.

Warning two is to do your homework carefully when using a plug and play finance service provider. If you are a business owner or manager looking to reap the benefits of plug and play finance, be mindful that all is not always as advertised. Do your diligence carefully before choosing your PnP provider. Reach out to those who know the space well to ask their views on which providers to use. Hold your service provider accountable. Many companies have a nasty habit of over-promising and under-delivering.

Warning three, and perhaps the most important one, is to not get left behind. Innovators that successfully embrace the full potential of PnP Finance will be able to offer embedded finance solutions faster, with better user experiences, and by taking on less regulatory risk. It stands to reason to think that these businesses will leapfrog those that are slower or do not offer embedded finance solutions in the first place.

Whether it be making payments or providing any other financial service, we need to keep up with the latest developments as business owners, managers, regulators, or law makers. The world is moving forward at ever increasing speed, and the future of finance belongs to those that adapt the fastest.

When Is BNPL Not BNPL

From multibillion-dollar valuations to regulatory scrutiny, and Apple now boldly entering the space, it seems we don’t go a day without reading some story about Buy-Now-Pay-Later, or BNPL as it is commonly known.

Amidst all this noise, activity, and chaos, it seems prudent to take a big step back and ask a simple question. What is BNPL? What exactly makes a loan BNPL – and consequently, when is BNPL not really BNPL but just plain lending?

After all, I could call any loan, such as my house loan, BNPL as well. I buy my house now, and pay it off later, over thirty years to be precise. But as we all know, that is not called BNPL, it is called a mortgage.

While there is no official definition out there yet (yes, the regulators in various jurisdictions are working on it) there are a few specific things that make BNPL what it is, and work as it should.

When all these specific attributes are in place, BNPL can create very favorable consumer outcomes. However, as one deviates from these pillars, a sort of cascading failure takes place where the various components that all rest on each other stop working, and what could have been a BNPL starts morphing into something else such as “mere” point of sale finance, a.k.a. POS finance.

So let’s take a look at the eight key attributes that make BNPL work as it is meant to, and why they all simultaneously need to be in place.

1. BNPL is free

POS finance, as alluded to above, has existed for a long time, and you can always go into a retailer and apply for a loan once you have bought your couch or your bicycle (the latter being a better idea if you want to work on your figure).

This usually involves a loan application which can feel like a proctology exam in the worst case and involve filling out some quick forms in the best case. The loan is then approved or declined, and the borrower goes on to pay interest over a pre-determined period of time.  

BNPL on the other hand is free, meaning that if the bike cost me nine hundred dollars, I can pay for it in three installments of three hundred dollars each over three months. Given the concept of time value of money (money today is more valuable than money tomorrow, all else being equal), this is an NPV positive proposition for the consumer and as such has great appeal.

2. In BNPL, the merchant pays a discount rate

As economists often like to point out, there is no such thing as a free lunch, and since the consumer is not paying for the loan, somebody else has to. In BNPL, this is the merchant, and they pay for it with what is called the merchant discount rate.

In simple terms, this means that if the dress we bought cost one hundred dollars, the merchant only gets something like ninety-seven dollars for selling it. The BNPL provider gets the remaining discount rate. In this example we used three percent, but in reality, this can range from something as high as eight percent to a low of less than two percent.

But why is the merchant willing to pay this discount rate? This brings us to the third attribute of BNPL.

Big tech is now entering BNPL as well

3. BNPL results in higher sales conversion for the merchant

Yes, the merchant is only willing to pay the discount rate because they can sell more goods and services if they use BNPL.

Especially for bigger purchases, being able to spread the payments over several months lightens the burden on the consumer’s cash flows, and a result they end up buying more. The merchant, who is after all in the business of selling goods, likes this, and is hence willing to pay for it. They would rather sell eight dresses and collect ninety-seven dollars per dress than selling five dresses and collecting a hundred dollars per dress.

Even so, how much of a discount the merchant is willing to pay depends on several other factors as well. Which now brings us to the fourth attribute.

4. BNPL works best when the purchase is discretionary

If my boiler breaks down, the merchant that comes to my home knows I will need to get it fixed very soon unless I am particularly keen on cold showers in the frosty London mornings. Hence, these merchants knows that their “sale” is easy to make and will likely be less interested in offering BNPL. They know that the consumer will pay for the new boiler whether BNPL is offered or not. Nobody likes cold showers, except perhaps Wim Hoff and his followers.

If, on the other hand, I am contemplating buying new windows, that is a discretionary purchase. It is nice to have more modern windows installed, but I can always do it next year. In fact, in London many people seem to wait about a century before contemplating putting in new windows.

The merchants who are in the business of selling new windows are aware of this, and if they can make the purchase easier by offering BNPL, they know they can get a much higher conversion. Hence, it is no surprise that these merchants like BNPL. In fact GreenSky, a QED investment that was recently acquired by Goldman Sachs for something close to $2.2bn built their multibillion dollar business on this very insight.

Of course much more is needed to build the ideal BNPL business. Which brings us to:

5. BNPL works best with good credit quality customers

The discount the merchant is willing to pay is not infinite, so whether it is three percent or eight percent, the BNPL provider needs to fit their entire unit economic equation inside that discount.

And the BNPL provider has many costs such as operational and salary costs, but also very importantly, credit losses. If a consumer does not pay back, the BNPL needs to foot the bill, and still make money from the merchant discount they get.

So let’s assume that in a simple example, the merchant discount is three percent, the BNPL now has to pay for its own cost of finance (which cannot really be much less than two percent), its operational costs (which even at scale will be tens of basis points), and the credit losses.

If the credit losses go to two percent in the example above, the BNPL provider suddenly starts losing money. What’s worse, if losses go up, the banks and capital markets that fund the BNPL provider start charging a higher borrowing rate.

A cascading failure or death spiral can very quickly set in, so watching the loss rate is existentially important for the BNPL provider, and the key to that is good underwriting and having an underlying population of positively selected high credit quality consumers.

If not, the BNPL may have to start charging interest and fees to covers its losses, and the whole thing then starts to morph into POS Finance as we saw earlier.

Having a high credit quality population is also important for insuring the sixth element of BNPL, conversion.

6. BNPL has high conversion

If the merchant offers BNPL to one hundred customers, it is important that at least seventy-five, but ideally something close to eighty percent plus of these consumers are approved for the BNPL product.

This is because customers that apply and get declined tend to not take it so well, and the merchant does not want to lose their sale or otherwise annoy their customer because they were declined, which can be embarrassing.

This particular point illustrates how all these attributes rest on each other. In order to have high approval rates, yet low losses, point number five from above, good credit         quality once again reveals itself as a crucial component of an ideal BNPL equation.

Again, this does not mean that lending would not work in a general or high risk population – but to have the purest form of BNPL you need to control your losses with a combination of superior underwriting and a positively selected population. Otherwise your BNPL proposition can quickly start to morph into something else.

7. BNPL is frictionless

The seventh component is that in order to avoid the merchant worrying about customer friction, the BNPL process itself has to be tech driven, seamless, and embedded for the end user.

Again, this also drives high conversion as well positive selection, illustrating once again how all these pillars rest on each other.

The best BNPL providers employ technology to its very fullest to achieve this goal.

8. BNPL has good customer outcomes

Finally, and perhaps most importantly, BNPL need to have good customer outcomes. This means that the BNPL provider has to focus very closely on affordability – can the consumer afford to pay back the installments over the agreed time period?

If the customer ends up buying too much, and becomes unable to pay back the installments, credit losses go up, the BNPL unit economics stop working, and everybody loses.

However, when assembled correctly, these eight pillars can support a win-win-win outcome where the merchant, the customer, and the BNPL provider all have great outcomes and are better off for using the model.

More Than Wars and Covid, Founders Worry About The War for Talent

In a recent LinkedIn survey, I asked founders and the fintech community at large what they saw as the greatest challenge in the new year. The options in the survey included market volatility, Covid, political turmoil, and the war for talent. Whereas only 6% of respondents picked Covid as the top challenge, an overwhelming 48% pinpointed the war for talent as their top concern.

Believe it or not, based on board room discussions over the last few months, this does not come as a big surprise. In board after board, the founders we work with raise their hand to highlight being able to recruit the best people as their greatest challenge. 

Given the amount of funding that has flowed into startups, (two record years in a row after all), most successful startups are now flush with cash, and as they now have to deliver on their lofty goals and ambitions. Not surprisingly, they are all trying to hire rapidly, and in most cases they are going after the same kind of talent, if not the very same people.

So what are the big takeaways from this? There are implications here not just for founders and VCs, but for cities and governments as well. There are many forces at work here, and the conclusions can be nuanced, so it worth picking them apart carefully. 

To start with cities and government policy first, one clear conclusion is that cities where top global talent congregates have a lot to gain. Given a legacy of many years where we saw anti-immigrant sentiment rise in Western societies, it is now much harder for talented workers to gain entry and find jobs in big cities across Europe and the United States. Cities and countries which are more welcoming and more attractive for the global talent pool will attract more of these workers, and then will in turn become more attractive places for setting up the big startups of tomorrow. 

Phone taken by yours truly at the London Wetland Centre in Barnes. No, it has nothing to do with the war for talent.

It is worth noting that the primary axis of competition in this context will be between cities, not countries. For example Miami is emerging as an attractive competitor vs. San Francisco and New York given recent legislative changes to the tax code in that instance. This is not to say that national policies do not matter – decisions around granting visas are usual taken at the federal or national level, and can influence the relative attractiveness of cities within a given country. 

Another strong force at play here is the emergence of remote working, especially for tech teams and developers. While some of this will undoubtedly get reversed as Covid (God willing!) becomes more endemic, it would be naive to think that there will be no permanent changes to remote work. Hence, companies that are able to hire remotely, and work effectively across a dispersed geographical base, also stand to gain. 

Another winner will be companies that provide the necessary legal and operational infrastructure for remote work, and as QED we have already made several investments into this space we are very excited about. 

From the perspective of the founders, there are also a myriad of takeaways that are worth noting. As we have been saying at QED for some time, it is now clear that every founder is first and foremost not in the fintech business, but in the people hiring business. Founders that internalize this fact as well as all the implications that follow, will clearly be better positioned. This probably means that founders will spend at least half of their time on either hiring, people strategy and organizational structure related issues in 2022. 

The other big implication is that the cost of losing a team member in 2022 is higher than it has ever been. This in turn implies that retention and employee satisfaction are at all time highs in terms of organizational priorities. While this may be clear to most of us, what to do about it, and how to keep retention high can be far from obvious. While this short article does not allow itself to explore the issue fully, one important insight can be pointed out with confidence. Culture will matter more in 2022 than it ever has before. 

At QED, we are known to be big advocates of building businesses on solid foundations such as strong unit economics, but the foundational importance of culture is one that we emphasize just as often. And culture is not something that a founder can outsource or let a Chief People Officer deal with. Culture is existential, and once lost or gone astray, finding your way back home may be impossible. Cherish and nurture your culture, and be clear about what your culture is, but just as importantly, what it is not. The best way to reinforce culture is to openly reward those that exhibit the cultural qualities you are looking to promote, and swiftly deal with those that do things that are counter to your culture. This is especially true for rapidly growing companies. We have many companies in our portfolio that are looking to more than triple their headcount in 2022, and the best founders in those circumstances are keenly aware the challenges involved in maintaining the right culture in with that sort of growth. 

In fact, when expanding to a new geography, one of our founders spent a year growing and setting up the new location, primarily because they wanted to make sure that the new country is set up with the right culture. That sort of leadership sets the right tone for the whole organization, and lays the foundation for an amazing culture, not just today, but for many years in the future. 

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.

  1. 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. 
  1. 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.
  1. 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. 
  1. 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. 
  1. 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 
  1. 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. 
  1. 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.