A showdown is upon us. Here’s what you can expect

Bill Harris, ex PayPal The CEO and veteran entrepreneur took to a Las Vegas stage in late October to declare that his latest startup would help fix Americans’ broken relationship with their finances.

“People are struggling with money,” Harris told CNBC at the time. “We’re trying to bring money into the digital age, to redesign the experience so people can be more in control of their money.”

But less than a month after launching Nirvana Money, which combined a digital bank account with a credit card, Harris abruptly shuttered the Miami-based company and laid off dozens of workers. Rising interest rates and a “recessionary environment” were to blame, he said.

The reversal is a sign of more carnage to come for the fintech world.

Many fintech companies — especially those that deal directly with retail borrowers — will be forced to shut down or sell themselves next year as startups run out of funding, according to investors, founders and investment bankers. Others will accept financing at steep valuations or onerous terms, which extend the runway, but come with their own risks, they said.

Top-tier startups that have three to four years of funding can ride out the storm, according to Point72 Ventures partner Pete Casella. Other private companies with a reasonable path to profitability will typically get funding from existing investors. The rest will start running out of money in 2023, he said.

“What ends up happening is you get into a death spiral,” Casella said. “You can’t get funding and all your best employees start jumping ship because their equity is underwater.”

Thousands of startups were created after the 2008 financial crisis when investors plowed billions of dollars into private companies, encouraging entrepreneurs to try to disrupt an entrenched and unpopular industry. In a low interest rate environment, investors sought returns beyond public companies, and traditional venture capitalists began to compete with new arrivals from hedge funds, sovereign wealth funds and family offices.

The movement went into overdrive during the Covid pandemic as years of digital adoption happened in months and central banks flooded the world with money, prompting companies that Robin Hood, Chime and Stripe are household names with huge valuations. The frenzy peaked in 2021, when fintech companies raised more than $130 billion and minted more than 100 new unicorns, or companies with at least $1 billion in valuation.

“20% of all VC dollars went to fintech by 2021,” said Stuart Sopp, founder and CEO of digital bank Current. “You just can’t put that much capital behind something in such a short period of time without crazy things happening.”

The flood of money led to copycat companies being funded whenever a successful niche was identified, from app-based checking accounts known as neobanks to buy-now, pay-later entrants. Companies relied on shaky metrics like user growth to raise money for eye-popping valuations, and investors who balked at a seed round risked missing out on companies that doubled and tripled in value within months.

The thinking: Give users a marketing blitz and figure out how to monetize them later.

“We overfunded fintech, no question,” said one founder-turned-VC who declined to be identified and spoke candidly. “We don’t need 150 different neobanks, we don’t need 10 different bank-as-a-service providers. And I’ve invested in both” categories, he said.

The first cracks began to appear in September 2021, when the shares of PayPal, Block and other public fintechs began a long decline. At their peak, the two companies were worth more than the vast majority of financial players. PayPal’s market cap was second only JPMorgan Chase. The specter of higher interest rates and the end of a decade-plus era of cheap money was enough to drain their stocks.

Many private companies created in recent years, especially those that lend money to consumers and small businesses, had a central assumption: low interest rates forever, according to TSVC partner Spencer Greene. That assumption ran afoul of the Federal Reserve’s most aggressive rate hike cycle in decades this year.

“Most fintechs have lost money for their entire existence, but with the promise of ‘We’re going to make it and be profitable,'” Greene said. “That’s the standard startup model; it was true for Tesla and Amazon. But many of them will never be profitable because they were based on faulty assumptions.”

Even companies that previously raised large amounts of money now struggle if they are deemed unlikely to become profitable, Greene said.

“We saw a company that raised $20 million that couldn’t even get a $300,000 bridge loan because their investors told them, ‘We’re not investing another penny,'” Greene said. — It was incredible.

Throughout the private company life cycle, from embryonic startups to pre-IPO companies, the market has reset lower by at least 30% to 50%, according to investors. It follows the decline in shares of public companies and a few notable private examples, such as the 85% discount that Swedish fintech lender Klarna took in a fundraiser in July.

Now, as the investment environment shows a newfound discipline and “tourist” investors are flushed out, the emphasis is on companies that can show a clear path to profitability. That’s in addition to the previous requirements of high growth in a large addressable market and software-like gross margins, according to veteran fintech investment bank Tommaso Zanobini in Moelis.

“The real test is, does the company have a trajectory where their cash flow needs are shrinking that will get you there in six or nine months?” Zanobini said. “It’s not, believe me, we’ll be there in a year.”

As a result, startups are laying off workers and cutting back on marketing to expand their runway. Many founders are hopeful that the funding environment will improve next year, although that looks increasingly unlikely.

As the economy slows further into an expected recession, companies that lend to consumers and small businesses will suffer significantly higher losses for the first time. Even profitable older players like Goldman Sachs could not sustain the losses required to create a scaled digital player, and pulled back on its fintech ambitions.

“If the loss rate goes up in a rate-rising environment on the industrial side, that’s really dangerous because your financials on loans can really go out of whack,” said Justin Overdorff of Lightspeed Venture Partners.

Now investors and entrepreneurs are playing a game to see who will survive the coming downturn. Direct-to-consumer fintechs are generally in the weakest position, several venture investors said.

“There is a high correlation between companies that had poor unit economics and consumer companies that became very big and very famous,” Point72’s Casella said.

Many of the country’s neobanks “are just not going to survive,” said Pegah Ebrahimi, managing partner at FPV Ventures and a former Morgan Stanley executive. “Everybody thought of them as new banks that wanted technology multiples, but they’re still banks at the end of the day.”

Beyond neobanks, most companies that raised money in 2020 and 2021 at nosebleed values ​​of 20 to 50 times revenue are in trouble, according to Oded Zehavi, CEO of Mesh Payments. Even if such a company doubles the revenue from its latest round, it would likely have to raise new funding at a deep discount, which could be “devastating” for a startup, he said.

“The boom led to some really surreal investments with valuations that can’t be justified, maybe ever,” Zehavi said. “All these companies around the world are going to struggle and they’re going to have to be bought or shut down in 2023.”

As in previous down cycles, however, there is opportunity. Stronger players will snap up weaker ones through acquisitions and emerge from the downturn in a stronger position, where they will benefit from less competition and lower costs for talent and expenses, including marketing.

“The competitive landscape changes the most during periods of fear, uncertainty and doubt,” said Kelly Rodriques, CEO of Forge, a private equity trading venue. “This is when the bold and the well-capitalized will win.”

While sellers of private equity have generally been willing to accept larger value discounts as the year went on, the bid-ask spread remains too wide, with many buyers holding out for lower prices, Rodriques said. The problem could break next year as sellers become more realistic about prices, he said.

Eventually, established and well-funded startups will benefit, either buying fintech outright to accelerate their own development, or picking off their talent as startup workers return to banks and asset managers.

Although he did not suggest in an interview in October that Nirvana Money would soon be among those shuttered, Harris agreed that the cycle was turning for fintech companies.

But Harris — founder of nine fintech companies and PayPal’s first CEO — insisted that the best startups would survive and ultimately thrive. The opportunities to disrupt traditional players are too great to ignore, he said.

“Through good times and bad, good products win,” Harris said. “The best of the existing solutions will emerge stronger and new products that are fundamentally better will also win.”