Big banks and tech start-ups are collaborating to plug the gaps in financial technology, with the start-ups acting as a testing ground for technologies before they are scaled up. 

For every 10 start-up companies, five could fail outright. Of those remaining, four could limp along, while one could really make it.

The disruptive innovators in the financial technology or fintech sector are all hoping to be the one that makes it, but with so many companies striving to make their ideas a success, which ones will take off?

It is a little like asking which horse is going to win the race; if anyone does know the answer they are unlikely to reveal it. But one thing is certain: investors and banks are now more interested in finding out who the fintech winners will be.

Alex Macpherson, head of ventures at London-based Octopus Investments, notes that this interest comes at a time when there is less bank investment in innovation since the financial crisis. Meanwhile, there has been an explosion in the use of technology and the expectations of customers, who are now au fait with cloud computing, smartphones, tablets and social media.

Investment surge

Consultancy Accenture describes a boom in the fintech sector, with investment tripling in the past five years. Global fintech investment rose from $928m in 2008 to $2.97bn in 2013.

Europe still lags behind in its share of that financing with 13% compared with 32% for the US’s Silicon Valley, but London stands out for its recent emergence as a fintech hub. The compound annual growth rate for the UK and Ireland’s deal volume between 2008 and 2013 was 74%, compared with Silicon Valley’s 13%, and the bulk of that fintech investment was in London-based companies.

The fintech start-up scene covers a range of innovations, all looking to take on the technology gap that banks cannot fill. This includes payments, mobile, loyalty, big data, compliance and security solutions.

London’s emergence has been aided by UK government initiatives, which include the Seed Enterprise Investment Scheme, which allows tax breaks to investors in start-ups. Another initiative is the Financial Services Investment Organisation (FSIO), which aims to bring together private and public sectors to encourage investment in the UK’s financial services. Sue Langley, who heads the FSIO, says that the fintech sector is now a crowded space, pointing to the numerous accelerator programmes that have been set up in the UK.

Start-up bootcamp

These accelerator programmes provide a way for banks to get involved in fintech start-ups. Take, for example, the FinTech Innovation Lab, an annual mentoring programme that was first launched in 2011 in New York and which has now come to London. The lab brings together start-ups so they can pitch their ideas to the chief technology officers of major global banks.

Barclays has its own accelerator programme, launched in partnership with Techstars, which provides mentoring and seed funding. And there are other such programmes, such as Startupbootcamp and 3D FinTech Challenge. The winners of these challenges typically receive funding, intense mentoring and help with product development.

The 3D FinTech Challenge is held at Level39, an initiative based in east London’s Canary Wharf financial district. Situated on the 39th floor of the One Canada Square building, the space aims to incubate technology start-ups, creating a cluster effect. Level39 is somewhere that bank technologists and investors can meet start-ups in the knowledge that the most promising start-ups will be incubated there.

Financing for fintech start-ups is a massive challenge, says Eric van der Kleij, who heads the Level39 technology accelerator programme. “It is not the easiest sector to get into because of the long sales cycle,” he says.

Start-ups typically go through stages of self-financing, seed investment, angel funding and Series A, followed by Series B financing. But fintech start-ups have the additional pressure of developing a product that involves the transfer of money and so cannot fail.

“Fintech innovations are different from social media – they need a different skillset – and investors in it [need] an understanding that these companies take longer [to develop their product and solutions],” says Mr van der Kleij.

Digital Shadows, a cyber intelligence company, is one start-up that was incubated at Level39 and has now moved up three floors to the ‘high-growth space’. Chief executive and founder Alastair Paterson explains how the company has been financed so far. At first, he says – as is the case with many start-ups – Digital Shadows was self-funded and ‘boot-strapped’. It then won awards and grants, took angel investment in 2012, venture capital investment in 2013 and is currently in the process of securing a much larger round of funding from the US.

Mr Paterson says: “The UK is fantastic to get the first round of funding; the challenge is scaling that up. There is not so much Series A and B rounds of funding as there is not much competition among venture capitalists [in the UK].”

Venture funds

Without doubt, accelerator programmes are helping fledgling start-ups to get off the ground. Another way for banks to get involved with start-ups is to set up their own fintech venture funds.

One such fund is SBT Venture Capital, which was launched in 2013 by Russia’s Sberbank with a $100m venture fund that could rise to $700m. The fund invests in Series A and B rounds with a minimum of $1m and up to $10m. Matteo Rizzi, a partner at the venture fund, says it was set up with a number of motivations, including financial return and changing the bank’s image. The investment also fits in with the bank’s wider digital strategy.

Sberbank, Russia’s largest bank by Tier 1 capital according to The Banker’s Top 1000 World Banks, is undergoing a massive digital transformation. To keep up with the disruptive innovations that may affect banking technology in the future, the fund lets the bank keep an eye on the latest innovations.

Banks are now more interested in supporting start-ups, according to Mr Rizzi. “The fact that funds are focusing only on fintech is a great demonstration of the strength of fintech and how money is available to disrupt this [banking] business,” he says.

It is likely more banks will set up their own venture funds. In 2013, for example, Spanish bank BBVA announced the launch of BBVA Ventures, which has $100m to invest in fintech start-ups. At the time of the fund’s launch, Jay Reinemann, the executive director of BBVA Ventures, said: “Investing in start-up companies committed to new business models enables BBVA to learn and anticipate the emerging challenges facing the financial services sector. What’s more, entrepreneurs and co-investors can leverage BBVA’s extensive experience, brand and global distribution network in the financial sector to accelerate their growth.”

Testing ground

Banks can use start-ups as a testing ground without having to commit fully to a new technology. For banks, product failure is not an option, whereas venture firms expect a level of risk when investing in start-ups.

Alan Morgan, chairman of MMC Ventures, says he has noticed that banks have become more interested in fintech start-ups. One issue for the banks is whether they can use them as frontrunners to go ahead of the pack to test the terrain, instead of banks developing the technology in house.

As a rule, Mr Morgan expects four out of 10 investments to fail and of those that do not fail, MMC Ventures aims to get them the right help, for example, with recruitment. He explains that the firm’s failure rate is relatively low because the company gets involved at an early stage and is an active partner with the start-up through several rounds of funding.

Mr Macpherson at Octopus describes the venture fund’s relationship with the start-up as a marriage, “but we know we want a divorce at some point. We want an exit.”

Bank collaboration

Banks may also get involved in the process of testing and scaling up an idea. Aside from the accelerator programmes, or having their own venture funds, banks can be part of a hybrid of these two options where they work in collaboration with the start-up, potentially providing them with working capital or investment.

These are obviously for the start-ups looking to sell their solutions to banks, a segment that is beginning to be defined separately from those who are seeking to disrupt banking business models altogether.

Ms Langley at FSIO notes that a distinction is emerging in the fintech space between ‘inner’ and ‘outer’ fintech companies. The inner fintech start-ups are those who will work with banks, whereas the outer fintech companies are those who are seeking to disrupt the industry and challenge the banks.

Banks are changing their response to fintech start-ups, says John Chaplin, president of prepaid payments company Ixaris Systems and director of Anthemis Edge, the advisory firm of fintech investor Anthemis Group. He notes that five to 10 years ago, if a bank saw a start-up with a good idea, their first thought would have been “I need to buy it”.

“It’s actually better to partner with them,” says Mr Chaplin, rather than treating an acquired start-up as a division of the bank. He says people working for an innovative start-up tended to leave if the company was acquired by a bank.

One challenge, Mr Chaplin notes, is for banks to overcome a mentality where they only buy from, or partner with, large technology companies: most of the really innovative stuff comes from small start-ups, says Mr Chaplin. If banks do partner with smaller companies, however, these tech entrepreneurs do not want to be selling on a transaction basis (if it is payments technology, for example), they may expect to share the revenue. Banks are reluctant to do this but “if you as a bank do not do that you will find that – if the technology is good – your competitor will do the deal”, he says.

Deal scarcity

Although there are hundreds of start-ups, the issue with financing them is not a scarcity of funds but rather a scarcity of good quality deals for investors. One observer says that because of the US’s expansionary monetary policy in recent years, there has been plenty of money looking for a place to invest. And even with the ones they do choose to invest in, many of them will fail.

“A lot of people are saying they want to invest. But it depends on the quality of the deals being brought. There is a lot money floating around but it is very hard to get it out of them,” says Mr Chaplin.

There may be some good ideas, but the business case may be lacking. One of the problems, notes Mr Chaplin, is that certain start-ups just are not viable. “Venture capitalists will invest if [the start-up] is not making money but not if you don’t know how it will make money.”

Mr Chaplin says that venture capital and private equity firms are more conservative in Europe than they are in the US. Ms Langley at FSIO agrees, saying this could be a state of evolution; Europe is not as mature as the US in terms of fintech investment.

Mike Laven, chief executive of fintech company the Currency Cloud, says Europe’s seemingly conservative approach is more a question of the expertise available. As an entrepreneur with experience of both Silicon Valley and London, he says there is a long history in Silicon Valley of investing in the early stages where an understanding of the product is needed. But London – as a large financial centre – has a private equity community that has plenty of depth and expertise to invest in fintech companies at a later stage.

Beating the banks

In April 2014, the Currency Cloud raised $10m in a Series B funding round to complement the $9m invested in 2012. The full round came from existing investors Atlas Venture, Anthemis Group, Notion Capital and XAnge Private Equity, with Silicon Valley Bank providing a future line of capital.

While there are many innovative ideas and technology that makes new things possible, without the business case they are unlikely to take off. The Currency Cloud is an example of a start-up gaining traction because its proposition offers something better than what the banks can do themselves. Rather than seeking to disrupt the banks and challenge their business model, Mr Laven’s approach is to work with the banks.

The Currency Cloud enables business-to-business cross-border money transfers at a fraction of the cost of existing technologies. The service integrates into the banking system as the people sending and receiving the payments need a bank account. Mr Laven is targeting the gap he feels banks have neglected: in the small and medium-sized enterprise segment.

For start-ups partnering with banks, a challenge can be integrating with their legacy systems. Innovation in this sense is never going to be reinventing the wheel, but making incremental changes and slight improvements on the banks’ existing order and tweaking the gaps that can be improved.

Challenging tradition

Mr Chaplin says that when it comes to innovation, banks are unlikely to back anything or partner with a start-up that challenges its existing business model.

US-based payment start-up Square, for example, could be seen as such a challenger. As a solution that enables sole traders – such as plumbers – to use their smartphone to receive card payments, this could be seen as disruptive to banks that have relied on the relatively higher fees of their traditional merchant acquiring business. However, a segment of merchants has been excluded from the banking sector – as their payment volumes are not large enough to justify the bank charges – and so Square’s innovation targets a previously untapped market.

Such a proposition may be interesting for venture capitalists, but not necessarily for banks, who may see it as challenging their existing sources of revenue. As with all good innovations, the idea has spread internationally and in Europe it now appears in various forms, such as Sweden’s iZettle.

While at first glance such innovation may seem to challenge a bank’s business model, banks can choose to partner with such companies, rather than be challenged by them. For example, in June 2013, Santander invested €5m in iZettle and at the time of the announcement Jacob de Geer, co-founder and chief executive of iZettle, said: “We want to bring iZettle to the world and to do that we must have strategic partnerships with the world’s leading banks.”

This is an example of how an innovation that gained traction in one market soon spread elsewhere. The ability to scale up in this way is one of the qualities that investors look for when assessing the potential success of a fintech start-up.

Mr Morgan at MMC says that banks may select solutions from fintech start-ups based on their immediate need. For example, a bank might choose compliance software so it can meet new regulations. But investors' approach to choosing a solution is different. “A venture capitalist will say ‘that is great, but how far is that going to go and how long will it last before someone else comes up with something better?’,” says Mr Morgan.

Mr Morgan points to the ingredients that investors look for. The first is the demand (for example, with international remittances for migrant workers); low intermediation cost (for example, technology and processes that are cheaper than the existing alternatives); and the solution has to be easier and more convenient for the customer.

Many observers comment how the initial idea is different from what is finally developed by a fintech start-up. Mr Macpherson says: “At Octopus, we back people: the entrepreneurs and the team that they build around themselves. London [and other fintech hubs are] a magnet for talent and the entrepreneur also needs to be a magnet for talent.”

It is a matter of opinion whether spotting the right start-up is an art or science. For every 10 fintech start-ups that are invested in, four or five could fail. The difficulty, however, is knowing from the outset which ones they will be.

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