Yesterday, senior managing director David R. Strachan introduced us to DRS Advisors, an I-banking think tank specialized in Finance 2.0. Today Strachan tells us what to look for in financial tech startups, common mistakes investors make, and some of the hottest niches in the financial tech industry.
* Edited interview
VH: What should we look for if we want to invest in financial tech startups?
DS: As with any investment opportunities, investors should look for a sound management team who understands the marketplace; a demonstrated demand for the product or service; and, perhaps most importantly, a plan for monetization. Gone are the days of “If we build it, they will pay.” While investment capital isn’t scarce, contrary to some reports, investors today are far less willing to bet on ideas without a meaningful business model.
I’d like to stress that it’s important to invest in people, not in ideas. Ideas are important, but without a team with the passion and ability to execute, the idea is doomed. That being said, we’re encouraged by the approach taken by some of the startup incubators such as Y Combinator and LaunchBox. These investors are willing to take a chance on budding entrepreneurs with great ideas as long as they demonstrate the drive and passion to make the idea succeed.
VH: What are the most common mistakes investors make when funding a financial tech startup?
DS: Bad information or insufficient analysis. The key to mitigating risk and avoiding common pitfalls is to conduct thorough and complete due diligence. The due-diligence phase helps investors make informed investment decision; it also represents the beginning of a long-term relationship between the investor and the entrepreneur, thereby helping to identify potential psychological or emotional conflicts before it’s too late.
Also, it may seem obvious, but it’s important to have a solid understanding of the industry in which an investor is investing in. The best investors are, of course, those who have extensive experience in a particular niche. They’re often better equipped to identify risks and maintain objective opinions than an overly optimistic but well-meaning entrepreneur. Passion, or a burning interest in a particular industry, can sometimes substitute for experience, but at the end of the day, there’s no substitute for hard facts and rigorous analysis.
VH: And the common exits for financial tech startups are …
DS: This is perhaps the topic of greatest concern to both investors and entrepreneurs at the moment. The IPO market has largely disappeared, and M&A transactions have slowed dramatically. We’re encouraged by developments in the secondary/alternative market space, but this idea is still very much in infancy. Whether it’ll provide a workable solution to the liquidity drought remains to be seen.
As the economy recovers, the M&A marketplace will show signs of life long before the IPO marketplace, particularly in financial services. There’ll likely be a race to acquire social media and emerging technologies within the industry. Therefore, we advise startups to develop business models that include co-branding, joint ventures, strategic alliances, and white label partnerships to not only diversify their revenue streams, but also to cultivate relationships with potential acquirers.
VH: Which niches or subverticals should be on our radar?
DS: At the moment we believe the micropayments space, both mobile and virtual, has the greatest potential for growth. The explosion in mobile phone and PDA usage and adoption throughout the world will increase demand for mobile payments. As well, the increasingly popular social networks and social gaming will fuel continued growth in virtual currencies and micropayments.
While they’ve yet to gain significant traction in the United States, mobile payments are becoming widely accepted in many parts of the world, particularly in Africa where the technology has been a boon for microfinance and economic development.
Virtual payments are also gaining popularity as web apps and web startups seek a viable, and potentially more lucrative, approach to monetization. This sector has seen a fair share of deal activity recently. PlaySpan, a provider of virtual currency and payments solutions for social games, recently acquired SpareChange and partnered with social network Hi5 to roll out its virtual currency, Hi5 Coins. Facebook also appears to be on the brink of deploying its own virtual payments system using Facebook Credits, possibly through a partnership with Jambool.
As for P2P, we recommend caution when considering investing in lending platforms, as regulatory challenges continue to dog several of these companies, such as Prosper and Lending Club. We do believe, however, that this sector is attractive in the long term.
* For series, references are published in the last installment of the series.