Valuation Compression in Fintech Hitting Bitcoin/Blockchain in 2016

In 2016, expect what has already become an increasingly difficult funding climate to become even more challenging.  Thus far, fintech has been immune to this but there are cracks starting to form even in the hottest sector in startupland.  The trickle down effect has led to difficulty even amongst VC darlings and the white-hot bitcoin and blockchain segments as well.  This post will explore what has happened to cause value compression in startups and why it is leading to compression all the way down the chain (pun intended). 

Valuation Compression

Throughout startup land we are starting to see valuation compression.  Some of the darling companies of days past have suffered from down rounds (Foursquare), the effects of ratchets (Chegg & Square), going public at prices lower than their last round of funding (Square), being acquired at prices much lower than their last round of financing (Good Technology) or their valuations being written down from where companies invested in them (Snapchat by Fidelity).  Read here for the effects of ratchets on both Square & Chegg. These are all symptoms of valuation compression.

Valuation compression can occur for many reasons. In times of easy money, investors are willing to invest large amounts of money into companies at friendly valuations, multiples expand and this trickles into all startups as whole.  Essentially companies raise money at the valuations they want and this leads other companies to raise at these levels or higher. Investors begin to have fear of missing out (FOMO) and want to get a piece of companies in hot sectors. As more money flows and valuations rise, the expansion continues unabated, until it doesn't.  Private markets follow public markets (or so the theory goes) and as those markets deteriorate or get shaken (as they have been since China devalued the yuan and the Fed raised interest rates) questions start to arise throughout the whole capital spectrum.  This is when VC's and other investors start questioning business models, wondering how companies will make money and looking at the global macroeconomic environment and start wondering if the good times are coming to an end. The real question becomes what is company X really worth and is the industry it is in as a whole really as big as it once appeared. Are there too many companies competing for too little pie?  The answers to these questions are inevitably always yes and that's when the consolidation phase begins but it starts with multiple compression and ends with funding becoming harder and harder. Warnings of a bubble have been heard for years and have gone largely ignored except within the media and some circles. (I am not saying a bubble has formed.) 

It all starts in search of returns and money flows to where it can make money. VC's are always the first ones in and have benefited the most from the spectacular rise in private company valuations. Then a funny thing happened on the way to the theater; hedge funds like Tiger Global, financial institutions like Fidelity & T.Rowe Price started investing in late stage rounds for private companies because they saw opportunities they weren't getting in their other business lines and the public markets. This to me is where the beginning of valuation compression started.

Even some closed-ended mutual funds were formed to capitalize, companies like GSVC Capital (GSVC). GSVC invested in companies like Twitter and Facebook before they were public. GSVC defines itself as:

"externally managed, non-diversified closed-end management investment company. The Company's investment objective is to maximize its portfolio's total return, principally by seeking capital gains on its equity and equity-related investments. It invests principally in the equity securities of venture capital-backed emerging companies. It seeks to deploy capital primarily in the form of non-controlling equity and equity-related investments, including common stock, warrants, preferred stock and similar forms of senior equity, which may or may not be convertible into a portfolio company's common equity, and convertible debt securities with an equity component. It seeks to acquire its investments primarily through Private secondary marketplaces and direct share purchases, and direct investments in private companies." 

With such successes in its portfolios you would think its stock price would be up in this boom for private companies. Ummm not so much.  In fact it trades way below Net Asset Value (NAV). This is commonly referred to as trading at a discount and while there are many reasons for this it's generally not a good thing unless there are extreme market distortions( not to be discussed in this blog post).  Below is a chart of the performance of GSVC since it first started trading.

This is the portfolio of GSVC. Companies like Lyft and Palantir remain it. 

IPO's Are The New Down Round

Another sign of what's coming is that there were only 2 IPO's in total in December. One of them being Atlassian which was a big success. However the numbers for IPO's are shockingly bad according to this article:

"The two measly IPOs in the US in December brought the total for the year to 170, down 38% from 2014, according to Renaissance Capital. By that measure, it was the worst year since 2012.In terms of dollars, only $28.7 billion in IPOs were booked in the US in 2015, down 48% from 2014, and by that measure, according to Thomson Reuters, “their worst year since 2009.”

“We will see several unicorns come public below their highest late stage private rounds,” predicts Max Wolff, chief economist at Manhattan Venture Partners. “This is part of an overdue and long-term healthy reset.”

This certainly has implications for fintech. 

Fintech

Fintech has been spared for the most part as it has been one of the hottest sectors for VC/private capital over the last few years. 2014 was a record setting year for investment into fintech according to Accenture, and 2015 will be bigger when the final numbers are out.  In the past 5 years, 10% of all VC money has gone into fintech and those companies have produced 20% of all private companies valued at 1 Billion + (unicorns).

872 fintech startups have benefitted from significant investments in 2015. Some have been huge winners and below is a list of fintech unicorns whose valuations have been lifted to lofty levels: 

- SoFi / US / p2p lending / raised $1.2B in 2015 / valued at $5B
- Avant / US / lending marketplace / raised $725M in 2015 / valued at $2B
- One97 Communications (parent of Paytm) / India / mobile payments / raised $680M in 2015 / valued at $4B
- Lufax / China / p2p lending / raised $500M in 2015 / valued at $10B
- Zenefits / US / insurance / raised $500M in 2015 / valued at $4.5B
- Credit Karma / US / personal finance / raised $175M in 2015 / valued at $3.5B
- Prosper / US / p2p lending / raised  $165M in 2015 / valued at $1.9B
- Stripe / US / payments / raised $90M in 2015 / valued at $5B
- Adyen / The Netherlands / payments / raised an undisclosed amount in 2015 /valued at $2.3B
- Transferwise / UK / payments / raised $58M in 2015 / valued at $1.009B

Many of these companies will probably look to go public at some point to capitalize on these numbers but as the environment starts to change it will be time to separate the wheat from the chafe.  If we look to the top fintech IPOs and the spinoff of Paypal, performance of these companies has been pretty rotten overall.

Top Fintech IPOs

If we look at the charts below, the public companies can be seen as the fintech canaries in the coal mine.  While fintech has been donned as the hottest sector in startupland the performance of many of the darlings has not been so great.  This is what value compression looks like public market style.  The story of Square provides a harrowing tale and while the chart doesn't look terrible since the IPO remember where Square's valuation once was as a private company.  Click here to read the full story of Square in case you aren't up to speed. Of course, time will tell if it's a success but the point of this blog is talk about the beginning of valuation compression for fintech all the way down to bitcoin and blockchain. 

 

The Remittance Space as an Example

The SaveOnSend blog is something I read whenever a new post comes out and I highly recommend it to all.  One of the hottest spaces in fintech has been remittance and that's because the market size is massive. (~.6trillion USD) There a couple of behemoths in the space, particularly Western Union and to a lesser extent Money Gram.  The startups have raised an enormous amount of money as the chart below shows:

Xoom was acquired by Paypal at $25 per share, in what the saveonsend blog describes succinctly, despite revenue and gross sending volume falling off a cliff, because Paypal wanted a piece of the remittance pie. The public markets are not always the smart money as can be read in full here.

The main point is that these startups all competing with incumbents and amongst themselves for funding, customers and valuations and there are a few ways to do this: through increasing revenues, through differentiation and by competing on price in top remittance corridors. Competing on price has been the way they have been trying and this has led to declining revenues and margins which can be read in detail here. The point is when the funding dries up these businesses can't continue burning through cash and generating losses. Saveonsend hits the nail on the head:

"So, based on the above, will these and other remittance startups be around for awhile? Only very few like TransferWise. Long-term, current valuations don’t seem to be justified in a market with declining revenues, rising costs, and increasing competition. It has been relatively easy to raise money for “payments-mobile-fintech” startups, but when another downturn comes in 2016, 2017, or 2018, investors will again remember the millennial-old adage: "Eventually all businesses are valued as a multiple of earnings."

This is one example but can be extrapolated to all other sectors of the fintech landscape.

VC Funding of Bitcoin & Blockchain

Inevitably this even trickles down to what's been labeled the hottest of the hot: bitcoin & blockchain. While this market is still in its infancy, it has attracted a fair amount of money, although it has not reached levels of other sectors within fintech.  In 2015, 21 Inc raised $116 mill, Coinbase raised $75 mill, Circle raised $50 mill, Ripple raised $32 mill and Chain raised $30 mill.  However, since the Chain raise funding has decreased on both the bitcoin and shared ledger sides of the table; R3CEV, Abra and Align Commerce are the most notable.  The Coindesk VC database shows all the companies and amounts that have raised since September:

Tim Swanson of R3CEV provides a nice chart showing bitcoin funding by month over the last two years in his most recent blog post . The chart can be found below:

What Has Happened to Cause This? 

As mentioned above it's a general valuation compression affecting the whole of startup land.  However, it seems that bitcoin and blockchain/shared ledger has run into some problems independent of fintech which has not been hit this hard yet.  In fact the hot blockchain space has hit peak interest as this Google Trends chart shows:

A recent article by Nathaniel Popper in the New York Times has shown that some of the more well known companies in the shared ledger space have run into trouble in their fundraising efforts, despite extraordinary financial leaders at their helms.  The reasons for this range from valuations to technology.  There certainly seems to be a bloat in the shared ledger space as many companies have pivoted away from bitcoin and are looking to work with banks in many areas where shared ledger technology makes sense.  Many new entrants have also entered the space. While there are many companies working on this, banks also have their own internal projects as well working side by side and possibly in competition with some of the companies in the space.  There are also questions on different model types: consortium or private chains. Until the space becomes more developed and projects with financial institutions more defined, it might be a wait and see approach for funding companies if the technology actually lives up to all of its promises.  This could mean a pause in funding until design and implementation are developed properly.  

This has caused many bitcoin startups to suffer as well because there are now questions of which chain will win as there has become a great divide between using bitcoin's blockchain or the shared ledgers being developed.  This has probably left many VC's on the sidelines to see what shakes out.  Other problems with bitcoin as far as funding goes could be around the blocksize debate and how that shakes out from a community perspective and a technology perspective. Many of the older companies continue to look for ways to monetize and for the "killer app".  While the bitcoin price has grinded higher in the last quarter of 2015, this has not caused a renewed interest in funding companies as of yet.  In fact interest in bitcoin over time remains low despite the price in an uptrend.

The reality is we are starting to see valuation compression happening to fintech and bitcoin and blockchain startups will not be spared of this fate.  There always comes a time when you batten down the hatches and build. Execution becomes the key and metrics begin to matter.  It seems the time has come.