The banking crisis deals a new blow to financing fintech start-ups

The errors to the largest bank to startup, Silicon Valley Bankand two others that bankrolled young tech firms — Silvergate Capital and Signature Bank — are making it harder for startups to raise money.

“It’s gotten a lot more expensive to secure capital right now,” Rudy Yang, an analyst at Pitchbook, said in an interview. “A return to quality is definitely happening, and many fintechs have yet to show that their business models have been profitable. When you combine all these factors, it definitely makes for a very tough market, especially because fintech was one of the sectors that benefited the most from coming out of the pandemic.”

The closure of Silicon Valley Bank contributes to this effect.

“SVB was an established bank for almost 40 years,” Yang said. “For a lot of these players, it was the epitome of reliability and trust, and now that’s pretty much been shattered.”

Venture capital firms invested $97.2 billion in fintechs in 2021 and $57.6 billion in 2022, down 40.7% year over year, according to Pitchbook.

“We had a boom in 2021,” Jim Angel, an associate professor at Georgetown University who teaches fintech and financial markets, said in an interview. “Now we’ve got the hangover as VCs overzealously try to deal with their headache.”

A general tightening among venture capital firms has been exacerbated by interest rate hikes, Ed Zimmerman, co-founder and chairman of The Tech Group at law firm Lowenstein Sandler and co-founder of accelerator VentureCrushFG, said in an interview. This is true for all startups, not just those in fintech, noted Zimmerman, who is also an adjunct professor at Columbia Business School and an investor in fintechs and venture capital firms.

“The dual force of increased interest rates with this questionable availability of the dominant venture lender in the market means that capital is going to be much less available to fintech startups, among others, than it has been,” Zimmerman said.

By “dominant venture lender”, he meant Silicon Valley Bank, which did about half of the venture debt deals with fintechs. Startups like venture debt because it gives them access to additional funds when they need them without giving up equity in the company.

“Silicon Valley Bank had such a significant market share and so many interconnected relationships that I would actually describe it as irreplaceable in the venture debt market,” Zimmerman said.

Fintechs will try to expand their runways by cutting their burn rates, he said. Some will go out of business and some will be acquired for amounts that they would have found disappointing two years ago. Of these acquisitions, some will be “acquihires”, where the company is bought only for its team, and others will be to acquire the startup’s intellectual property rights and the team will be discarded.

“A lot of these buyouts will be private to private, so you’re trading a fist full of magic beans for another fist full of magic beans,” with “the illiquid shares of a venture-backed startup trading for the illiquid shares of a other venture-backed startups as they merge,” Zimmerman said.

Although the FDIC has said that all Silicon Valley Bank depositors will have access to all of their money, “you could still have a scenario where a lot of portfolio companies are affected,” Yang said. “They can be even shorter on the runway than before. And because of that, you now have a lot of people losing faith in the VC market, and because of that, you’ll have less capital deployed from limited partners to general partners. That can lead to an even slower pace of funding this year.”

He expects to see fintechs make more use of cash sweep accounts that spread customer deposits across multiple banks so they can stay covered under the $250,000 deposit insurance limit per account per bank.

“A lot of startups are probably going to start implementing this very soon,” Yang said. “In the long term, this could lead to more confidence in banks in general.”

Fintech outliers

Not all fintechs are struggling.

StellarFi, a startup that pays customers’ bills for them, gives them money when they fall short and reports the bill to credit bureaus to boost users’ credit scores, announced a $15 million Series A funding round on Tuesday. The company was officially launched in June.

Its customer base has grown by 86% per month since its launch in late June, founder and CEO Lamine Zarrad said in an interview.

“In an economic downturn or even a time of uncertainty, a product like ours takes up a lot of mental real estate for consumers,” he said. “We’ve done well and that translated into our ability to raise more capital paradoxically when everything comes together.”

About 210,000 customers use StellarFi for free, to get credit bureau reports and keep an eye on credit scores, he said. Close to 40,000 customers subscribe for either $5 or $10 a month. The “overwhelming majority” of customers go for the $10 plan, he said. The $5 monthly plan pays up to $500 in monthly bills, the $10 plan pays up to $25,000 a month.

This helps people avoid overdraft fees and credit card interest. The service also helps people boost their credit scores, Zarrad said.

The startup is not immune to the banking crisis: it was a Signature Bank client and lost the venture debt financing it had lined up with the bank, which Zarrad envisioned as a runway extension.

“This was just to have operational resources to make sure we have as much runway as possible in this economy,” he said.

StellarFi had obtained term lists from several banks; Signature Bank had the most attractive terms. It seemed like a safe bet – exposure to the tech industry was minimal, and it served many accounting firms and law firms in New York.

When the bank closed, Zarrad assumed the venture debt deal was off.

“But then they come back to us literally within 12 hours of closing to tell us we have this bridging bank, it’s now business as usual, you still have your debt, we’re going to meet all our obligations.” he said. “A day later they came back and said, just kidding, we got bought out by Flagstar and they don’t want to buy a venture debt portfolio. So we don’t know what’s going to happen.”

Few banks offer risky debt. “Most players these days doing venture debt are typically non-banks,” Zarrad said. “There’s a bunch of fintech now that’s backed by private investors, and they kind of got into the venture debt game.” Hedge funds have also offered venture debt.

He is considering his options. He prefers a bank, because generally banks have better terms than non-banks.

Impact on the banks’ digital transformation

If it doesn’t end soon, the current banking crisis could dampen banks’ digital transformation efforts, which generally means upgrading to modern core systems, real-time payments, real-time data and analytics, and advanced mobile and online banking.

“One thing we saw 20 years ago was that there were cost cuts and [research and development] went out the window,” Zimmerman said. “Big companies fell further behind because R&D went out the window. They were also less interested in acquiring startups, and they were less interested in doing a lot of business with startups because they were unsure about them.”

In one instance, Zimmerman assisted a fintech incorporation in June 2000 and signed a term sheet for a venture agreement on September 10, 2001 in New York.

“As start-ups were doing increasingly poorly, the company began to be asked to show balance sheets and financial statements more broadly to clients because clients began to worry about whether it made sense to do business with start-ups as opposed to larger, better-capitalized companies,” he said .

There is a fear among banks to do business with startups because they are less stable, less likely to be there in the future, Zimmerman said.

“So why should I spend money to integrate their products into my business?” he said.

The banks have said they will continue to do so finance their venture arms.

“I’m sure the banks will continue to invest as they have,” Zimmerman said. “Whether they’ll do less of it or not, I can’t say.” Strategic investors often buy high and sit out when prices fall, he noted.

On the other hand, “if they feel like their core business is under attack and their cash reserves are going down, then they’re not going to spend money doing non-core investments,” Zimmerman said. “I’m sure we’re going to see people cutting back in a whole bunch of ways that will disadvantage them three or four years from now.”

Will fintech funding take off

Fintech funding, like all venture capital funding, is cyclical, Angel noted.

“Sometimes the window is open, sometimes it’s closed,” he said. “But I think that the fintech industry is here to stay. Large and highly regulated financial companies find it easier to buy innovation off the shelf than to build it internally.”

A lot of fintechs that have raised a lot of money didn’t have good business models, Zarrad said.

“Investors are indexing business models that make sense these days, which is smart,” he said. “But the problem is that most investors, and it’s just human nature, like to follow other investors. You see people who made the right choices and you tend to follow. So when a correction happens, it inevitably becomes an overcorrection .”

Startups must be high-growth companies, Zarrad pointed out. “That’s the only advantage a startup has over an incumbent, its ability to take risks and move quickly. There has to be an organization or an entity that takes more risk than anyone else and then moves quickly and gets to profitability.”

But it also needs to have a good business model, he noted, and at least a plan to become profitable.

“Investors are going to expect models that are profitable from day one, which means they’re going to be very conservative models, which means they’re not going to move quickly, which could make them uncompetitive,” said Zarrad.

Startups in Middle America, places like Austin, Texas and Columbus, Ohio “will never be unicorns,” he said. “They can go out one day for $10 million, they’re going to make money and they’re going to have a small team, but ultimately they’re not going to impact the culture. They’re not going to change the way people interact with whatever. They’re not going to be disruptive. That’s my fear, we’re going to kill a lot of disrupters.”

But other observers have more hope that this too will pass.

“Things come in cycles,” said Michael Held, partner at WilmerHale. “I’m reminded of the first internet bubble – some things popped and then new things sprouted in their wake.”

In an environment of rising interest rates, people are more judicious about the kinds of things they finance and the risks they are willing to take, he noted.

“I think that there will be venture capital funds that have prepared for this type of environment and will be willing to continue to fund and take risks,” Held said. “But I think in virtually every part of the economy right now, people are more thoughtful about where they’re making investments, and they need to reevaluate their risk tolerance because we’re in a place where the messaging from the Fed is that they really want to get control of inflation.”

Efforts to bring inflation under control can slow down economic growth.

Any rational investor is keeping an eye on that to make sure they don’t get caught on the back foot depending on how quickly and forcefully the Fed moves to fulfill its mandate,” Held said.

Startups that have brought discipline to their business plans, that have realistic short- and long-term goals and that have concrete explanations of how they will ultimately achieve profitability are more likely to receive funding, he said.

“It’s probably going to be a little bit less of, trust us and just have faith in us,” Held said.