Why serving small business is a smart move (after decades of being a dumb move)

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In 1954, Fortune 500 companies accounted for around 1/3 of GDP in America. By 2000, that share had doubled to 2/3. Hidden in those numbers are the countless family farms that could not withstand the onslaught of Agribusiness and the Mom & Pop shops that closed when Wall Mart came to town.

During those years it was a very dumb move to serve small business. You did better by focussing on either enterprise or consumer – both had a well proven path to success. Small business had the CAC of enterprise with the price point of consumer – OK, I am exaggerating to make a point.

Imagine a world where that cycle reversed. Imagine that small businesses got back the 1/3 of the economy that they lost in the last 50 years.

This may be about to happen. This shift will have dramatic implications for investors, entrepreneurs and employees.

Professor Coase, Please Explain

Ronald Coase won the Nobel Prize for Economics in 1991, but his key work was done in the 1930s.

His main theory, described in his 1937 essay The Nature Of The Firm, is that a company exists because it is cheaper to do transactions within a company than outside the company.

The Internet has resurfaced this theory as a practical consideration.

Coase’s theory about transaction costs was pretty much ignored by business executives because it was only theoretical. Big companies took a bigger chunk of the economy during the last 50 years because they served a very real historical purpose. That purpose was to turn scarcity into abundance by manufacturing mass-produced products and selling them through mass-market distributors to retailers through warehouses and road/rail/air freight logistics. Surrounded as we are today by an abundance of mass produced products, it is hard to remember a time when people were concerned about scarcity of basic things such as food and cars. Big companies solved that problem. Small companies could not solve that problem. The job required economies of scale, vertical integration and large amounts of capital.

Digitization erodes the value of traditional economies of scale and vertical integration. This is what tilts the playing field in favor of small business.

The Internet now enables transactions of all types to be managed more efficiently externally than internally. Start-ups outsource everything that is not the one thing that they have to excel at.

A few brilliant entrepreneurs figured this out early

Scale is not dead. It is just that digital scale based on network effects has replaced analog scale based on purchasing power and vertical integration. Platforms to serve entrepreneurs have done well – think Alibaba, eBay, PayPal, Uber, AirBnB.

What gets Blockchain aficionados excited is the prospect of fully decentralised versions of these platforms with a much lower take (ie more cash for the entrepreneur, lower costs for the consumer). So we are only in the early days of this trend of meeting the needs of small business.

Meet the AirBnB entrepreneur

I dislike the Sharing Economy moniker – it smacks of marketing hype. Uber and AirBnB are not about sharing. Nor do I like the idea that we should regulate them away to protect the incumbents. They do serve a real purpose for entrepreneurs.

One of the pleasures of using AirBnB is talking to the hosts. They are entrepreneurs. Some are mini-hotel entrepreneurs. Most use AirBnB to give them a bit of financial freedom to work on a passion project that may turn into a business or to supplement that business while they get it going.

I am sure the same is true of Uber drivers, I just don’t have enough time on a short cab ride to get to know them.

The reason it is so hard to see the AirBnB host and Uber driver as entrepreneurs is that we look at this through the prism of a very brief period of history in the West.

First the Rest then the West

In the post war era in the West, the economy was dominated by big companies – and their employees who were referred to as consumers once their 9-5 gig was done.  There were very few Entrepreneurs, even though the media hype disguised this statistical reality. Entrepreneurs were much lauded in the media, but only if they later became big companies; Mark Zuckerberg is story that sells pixels, but another restaurant or gift shop is not.

In the Rest of the World (China, India, Africa, Latin America etc) it is a very different story. Most people there are self-employed entrepreneurs. Most of these micro entrepreneurs make less than a minimum wage employee in the West, but in aggregate these billions of micro entrepreneurs is one of the biggest market opportunities around – as long as you don’t try serving them with traditional Western consumer models.

Despite all the talk of the Millennials digital nativeness, the much more critical fact is that Millennials are financially much worse off than their parent’s generation, labouring under student debt loads in a weak job market. This explains the gig economy that Uber and AirBnB serve. However, Uber and AirBnB are only the tools to create some short term cash. For many, there are also platforms such as Alibaba, eBay, PayPal and Skype that let them trade globally as micro multinationals.

The 3 ways that the playing field is getting more level

When small businesses were being crushed by large businesses, from 1950 to 2000, focusing on serving small business would have been Quixotic at best. Now the playing field is getting more level in three key areas:

• Finance.  Real time supply chains are getting rid of the curse of inventory and new low cost financing networks are emerging (tracked by Jessica Ellerm every Wednesday on Daily Fintech).

• IT. Cloud technology with a consumer UX is replacing expensive complex enterprise IT. Innovation is flowing from small business IT to big business IT (a reversal of the historic trend).

• Sales & Marketing. Selling online (via B2B or B2C or B2B2C networks) is replacing those highways and distributors as the key to success.

With this leveling of the playing field, serving small business might be the smartest thing to do. This is especially true if you want to take advantage of the fast growth economies through globalization.

Daily Fintech Advisers provide strategic consulting to organizations with business and investment interests in Fintech. Bernard Lunn is a Fintech thought-leader.

What Data feeds your robo-advisor?

robot-picking-fruitMuch like vegetables, we should all be concerned with the Kind of Data and the Quality of Data. Choices of data (and veggies) abound and we need to pick the appropriate set-combo. Quality of Data is a more complex issue that troubles mostly risk managers and regulators but should also be of great concern to the broader investment ecosystem. These issues – Picking Type and Checking Quality of Data – affect increasingly our risk-adjusted returns and their properties over time.

In this post, we will focus on the conventional investment subsector and explore what types of Data robo-advisors of all sorts use or will invest in. In future posts, we will look at the same issue – Data gathering and Quality control – in other WealthTech sectors, like marketplace lending and private markets. If you want to start a conversation on these topics, click here.

The conventional investment subsector operates mainly with publicly traded securities and has been focusing mostly on individual stocks and wrappers like ETFs, mutual funds, and only lately PTFs that provide exposure to other asset classes (e.g. fixed income, real estate, digital currencies, or private equity).

Primary Sources of Basic Data

Stock exchanges have traditionally been feeding the market with basic, fundamental data for stocks and ETFs. In our coverage of the innovations out of stock exchanges, we looked at the areas of digitization and realized that focus is either in clearing and settlements or in private markets. In the area of primary data, we only note the adaptation of XBRL for financial reporting.

The Fintech Sandbox in Boston, is a non-profit that has been facilitating access to such basic quality data for startups to test their MVP reliably without incurring the usual costs. Xignite is the major disruptor in the space of primary financial data.

All robo-advisors use this type of data.

Secondary Sources of Data

Conventional Financial Data

Data related to mutual funds and indices, which at their core are nothing more than a portfolio of individual holdings, are the next kind of Data that the industry consumes insatiably. Lipper’s, Thomson Reuters, Bloomberg and Xignite, are the big providers in this space.

The rich variety of this kind of Data, starts with Fund Flows, insider activity, fund classification (e.g. value, growth, small cap etc), expense ratios, performance measures (e.g. Beta, volatility measures, return-to-vol etc), historical benchmarking, etc.

In this category, we include financial data that is used as an input for equity valuations, and projections on whether a stock is overvalued or undervalued. Data therefore, with estimates of earnings, revenues-sales, and growth, which traditionally have been provided by financial analysts on the Street. Estimize is the leading Fintech in this space, offering crowd sourced estimates for stocks.

Unstructured non-financial Data 

This is any data beyond the usual company filings. It can be web site traffic and mobile access for online businesses, parking lot traffic for physical locations, human resources data (turnover), twitter trending key words, drug pipeline for pharmaceuticals etc.

1010Data, has been offering such data to hedge funds for both equities and fixed income. Thinknum is a Fintech that focuses also in this space.

Sentiment Data

Using sentiment data (i.e. optimism, fear, trust, capitulation, etc), to drive investment decisions, is an alternative way that will eventually be combined with the other kinds of data.

In our two part coverage of the Sentiment space, we identified a couple of early partnership that are combining primary and secondary data types (e.g. Thomson Reuters with Amareos, E-trade with TipRanks, Ameritrade with Likefolio). Since this is a nascent space, we have opened a conversation on the Fintech Genome that tracks the developments. Edit the wiki or simply post in this live conversation that monitors the adaptation of sentiment data and analysis into the mainstream.

There aren’t any robo-advisors using yet this type of data. Currently robo-advisors don’t allow for a scenario “Go cash, don’t invest now” or combining momentum with fundamental and therefore, sentiment data doesn’t add value.

Model generated Data – Alpha-generated, AI & ML

Using model-generated data to rebalance a robo-advisory portfolio is the next trend that we anticipate. We foresee, that the robo-advisory space will be moving from a primitive MPT portfolio-rebalancing method, to one that is dynamic and uses data generated by models to enhance the rebalancing and also allows for “I am out of the market for now”.

 In summary, robo-advisors are mainly using the primary resources of data. Any robo-advisors using any of the secondary sources of data?

Alpima is producing and using model generated data. They are actually offering a rich variety of model generated fundamental data. Similarly, Elm Partners is using Value-momentum models; combining fundamental analysis with momentum-technical signals. Logical Invest, is a Fintech focused on signal providing for financial advisors and therefore, producing model generated data.

Quandl is producing unstructured non-financial data, sentiment data, and alpha generating data. Their offering is rich and is coined, Alternative Data; and for now is refered to as “unorthodox data”. Is Quandl, the alternative for Yahoo Finance? Join the live discussion on this topic here.

Daily Fintech Advisers provides strategic consulting to organizations with business and investment interests in Fintech & operates the Fintech Genome P2P Knowledge Network.  Efi Pylarinou is a Digital Wealth Management thought leader.

Wrap of Week #33: Fintech Index, VCs, SmallBiz banks, US Health insurance, US Credit cards

 

Dailyfintech_logo_blue_2016-04-14-03We started the week with coverage of a new US Fintech index, a collaboration between KBW and Nasdaq.

On Tuesday, we looked at the disruption in the VC business that has been anticipated and happening, happening, …..

In Small Business, we covered the second installment of the reputation economy and our insights on the blueprint of a small Business bank.

In Insurtech, we covered the second installment around the complexity of health insurance in the US.

The week ended with a focus on America and the view that “Chip on plastic is incremental change, but Chip on mobile phone is a game-changer”. Check out our insights here.

The Fintech Genome platform is in its second month. More topics and longer conversations are shaping up. Here are more recent ones on: Chatbots, Mortgage banking, Corporate Lending, P2P lending Transparency, Banking APIs, disruptive insurance products, Yirendai, etc.

You can read about How to generate great conversations or listen to a podcast version from the moderators of the platform.

If you enjoy reading the Daily Fintech insights by our experts è Subscribe to this newsletter.

If you want to engage and converse with the Fintech community è Register on Fintech Genome. 

The opportunity to disrupt the credit card rails may finally be opening up

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The transition to Chip and PIN credit cards in America currently looks like just a big conversion cost – good for vendors and consultants and a big extra cost and time suck for everybody else. 

However, below the surface something bigger is brewing.  Chip on plastic is incremental change, but Chip on mobile phone is a game-changer. 

Payments has been the boulevard of broken dreams for entrepreneurs, but there is a reason it attracted so much attention – it is a massive market. According to Boston Consulting Group:

“In 2013, payments businesses generated $425 billion in transaction revenues, $336 billion in account-related revenues, and $248 billion in net interest income and penalty fees related to credit cards. The total represented roughly one-quarter of all banking revenues globally. Banks handled $410 trillion in noncash transactions in 2013, more than five times the amount of global GDP.” 

The accepted wisdom is that dreams of disrupting those credit card rails is foolish. You can see that wisdom baked into the stock price of Visa and Mastercard (just shy of $300 billion as I put keys to pixel).For a while, the disruptive crowd looked to Bitcoin but that hope has faded. The accepted wisdom now is that you can only make money within the existing credit card rails.

That maybe about to change (and it is nothing to do with Bitcoin). 

First, lets look at the big switch from mag stripe to chip cards in America

The big switch from mag stripe to chip cards in America

To the rest of the world, America moving from mag stripe to chip cards merits this reaction – “what took you so long?”

AITE Group has run the numbers. Here is one of the headlines from their report:

“the cost to implement PIN for all cards at merchants with PIN pads already installed is low, the costs are much higher for merchants that have yet to install PIN capability”

That is why many merchants in America are currently implementing a strange variant called Chip and Signature – you know, those signatures that nobody ever checks! Signatures are a relic of the past, useless in the digital age. That is why in countries that went to Chip cards a long time ago, it is all now Chip + PIN (but there was a period of transition where check out staff were clearly trained to look at the signature, although what they could actually check is unclear). That combo of Chip + PIN is pretty secure and that is a big deal for retailers because they now have the liability for fraud.

Chip cards alone are more secure than mag stripe cards. A criminal can steal the PAN (Primary Account Number) if they have your mag stripe card for a minute (one crooked waiter is enough) but with a Chip card they need the card itself to get cash or goods and consumers know when they have lost a card and will report it lost to the bank/issuer, so the time window for a criminal is less. This is a better Single Factor Authentication – something you have.

However Two Factor Authentication – something you have  + something you know is better. That is Chip + PIN.

Where the puck is headed. At some point merchants must start saying “if we are responsible for fraud and all the costs to prevent fraud, why are we paying such a big transaction fee?” Credit Card networks rely on all the parties – consumers, merchants, banks – having aligned interests. If one or more starts to question “whats in  it for me” the network starts to break down,

The next headline focusses on the issuers/banks:

“Issuers would also face significant incremental expense, including the costs to reissue cards, establish and maintain a PIN management system, educate customers, and modify ATMs and interactive voice response platforms. Issuer costs total more than US$2.6 billion, which would result in a five-year fraud-avoidance benefit of about US$850 million”. 

Well that sounds like a lousy ROI argument – invest US$2.6 billion and get back US$850 million! Pass, thanks. Of course one can argue with those numbers, but even if they are wrong by a lot, the ROI still looks lousy. Maybe those numbers are so far off that the ROI is viable. Common sense says that they maybe way off, because issuers did all that in other countries and they would not have done that if the ROI was that bad. Does anybody have better data?

Where the puck is headed. To Issuers (aka Banks), credit cards are the way to to do unsecured consumer lending at the point of need aka point of sale. A consumers is at a store and wants to buy a $1,000 item and  not confident I have $1,000 in their account so they opt for credit.  Unsecured consumer lending is what Marketplace Lenders do. Banks want to be there at the point of need/sale because that means low Customer Acquisition Cost (CAC). So Banks will tighten up limits and be more selective on who they give credit to. That has happened in countries that moved to Chip + PIN. That means that Issuers will implement Chip + PIN no matter what it costs because it it is way to stay at the front end of unsecured consumer lending. Any vendors helping them reduce those costs will do well. However the big picture is that while we use the term issuer and bank interchangeably, because most issuers are banks, you do not need to be a bank to be an issuer. You could be an Altfi Lender or MarketPlace Lender or a Merchant.

King Consumer is OK with the big switch

So much for merchants and issuers. What about the critical third player in this network – you and I?

Consumers find Chip + PIN easy enough (spoken as somebody who lived in America for many years and then moved to Europe). Sure, it is a muscle memory change, but it really is not that hard.

Retailers will make the switch because they have to and Issuers/Banks will make the switch because they have to. There will be lots of debate about who pays and how much, but the switch has to happen. The mag stripe alternative is simply not viable  – it is a relic like a fax machine.

But lets consider the other switch, the ones that the criminals do.

The criminal big switch

After Chip + PIN is introduced, fraud in Card Present transactions (aka physical retail) becomes too hard, so criminals shift attention to Card Not Present (CNP aka e-commerce).

Again, who has liability is key. If retailers have liability, they will impose one more step on consumers.

Both Visa and Mastercard have a solution. MasterCard has SecurePay. Visa has Custom Payment Service.

Using myself as a market panel of one, I can tell you that it is no more than a minor irritant, like learning to use a PIN.

So far, the 4 cornered marketplace – consumers, merchants, and issuers and payment networks – is intact and the credit card companies sit in the middle earning their fees as the 4th corner.

However, the big change is when we go to mobile transactions.

Three factor authentication is better

Chip is better than mag stripe for single factor. Chip + PIN is better two factor than Chip + Signature. But 3 factor is best and that is what mobile phones enable:

  • Factor 1: something I own (can be a chip on a card or a chip in a phone)
  • Factor 2: something I know (PIN)
  • Factor 3: something you know about me (location in a mobile phone, not possible with a Chip card).

If the payment authoriser (basically what a credit card company does) knows all three, the chance of fraud is very low. If you reduce fraud costs, the actually costs of making a payment are a blip of attention in one of your servers i.e. so close to zero that you might as well count it that way.

The Mobile Payment tipping point.

If this data from eMarketer is even close to right, we are at the Mobile Payment tipping point:

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When Merchants move into Payments via Tokenisation

Shh, don’t tell, but Uber is really a payments company with an e-commerce skin. So is Amazon. So is AirBnB. People make a big deal about Uber, Amazon and AirBnB not owning the actual physical stuff/service that we buy – as if vertical integration was an issue in the 21st century. What is much more critical is when a when Merchants become payments businesses through Tokenization.

Tokenization 101

Tokenization is the one time password that a student of cold war espionage stories would recognize. If you steal the token/one time password, you can steal the contents of that message/payment and only that message. That is fundamentally different from stealing the Primary Account Number (PAN). If you steal the PAN (by physically stealing a card or reading the mag stripe encoded data from a merchant) you can steal a lot of money.

Remember those merchants upset by the cost of switching to Chip + PIN? They would like to do this as well. Any entrepreneur who figures out how to offer that to small merchants will do well – maybe Square?

It is an aggregation job. If you aggregate a large number of tokens (ie consumers who trust you enough to do payments through you) you have a valuable business.

Think about these giant commerce players – Uber and Amazon and AirBnB – in terms of the 4 cornered marketplace:

  • King Consumer – well somebody has to pay
  • Merchant – tick
  • Issuer – Merchants can also be Issuers. They can lend (the often do, calling it Supply Chain Finance or something)
  • Payment processor. This is where we need to look at Debit Interchange Fees & Mobile Wallets.

Interchange fees & Mobile Wallets.

If you pay via Debit from your bank account, it is simply a blip in a server somewhere i.e. cost is close to zero and where regulation around Interchange Fees come into the picture.

If you pay via Debit from your bank accountDebit from cash in your mobile wallet, the cost should be zero. It is like paying in folding notes and coins, with no intermediary. If a merchant who already has your consumer trust, offers you mobile cash as an option at a lower cost it is an easy call. Even in a drunken Uber cab ride home you can peek into your mobile wallet and see if you have enough cash. This is where mobile wallet interoperability and the leapfrogging to mobile money in the Rest (which is a big theme on Daily Fintech) is key.

Daily Fintech Advisers provides strategic consulting to organizations with business and investment interests in Fintech & operates the Fintech Genome P2P Knowledge platform.

Insurtech ventures going after big & complex health insurance pain points

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This is a guest post by Amy Radin. It is the second of a two-parter. (Thursday is always InsurTech day on Daily Fintech).

In my last post I outlined the four dimensions that are defining the opportunities for health Insurtech innovation: the health of the American people, marketplace trends, the role of regulation, and the players.

Incumbent health insurers are pursuing legacy tactics to compete in the ACA world: M&A (big deals either approved — Centene/Healthnet; facing regulator challenge – Aetna/Humana; or being reconsidered – Anthem/Cigna); increasing premiums (also see some of the latest news this week); and reevaluating participation in the public exchanges (notably, United Healthcare withdrew earlier this year).

Innovators addressing the root of user pain points can influence how plans are selected and health care is consumed. The levers are not easy to move. Success requires compliant ways of combining big data analytics and personalization with user-centric digital experiences.

The headline of a just-published New York Times article, Cost, Not Choice, Is Top Concern of Health Insurance Customers would seem to state the obvious. Yet insurers have expressed surprise at the policy mix and which plans are proving to be most popular. Carriers participating in the public exchanges report poorer actual performance than anticipated in premiums (lower) and claims (higher). Users are gravitating towards lower-cost plan options, and show a trend to self-select into higher-cost plans when they know a big health care expense looms.

This is not just an issue for incumbents. Oscar, among the most visible innovators in the US health insurance marketplace, reported a $105MM loss in 2015. Lack of scale is a challenge, but the company has also been impacted by the user decision-making dynamics affecting established carriers.

The results suggest (at least) three pain points:

# 1 People don’t see value because they don’t understand what they are buying.

  • When people think something is too expensive, it is because either they cannot afford it (i.e., it really is too expensive) or the perception of value does not justify the price.
  • Reportedly one in seven employees do not understand the benefits being offered by employers, of which health insurance is by far the biggest piece.

# 2 People are being held accountable for health decisions that they are not equipped to handle.

  • Faced with a complex set of choices and opaque information, it is no surprise that many opt for the easy option: saving money now.

# 3 People don’t always make rational decisions.

  • A basic primer in behavioral economics will tell you that:  (1) emotion, bias, and other limitations drive decisions, not rational analysis, and (2) people discount perceived upside relative to downside. There is not enough upside to pay more in the short term.

Players who manage to affect these behavioral drivers stand to gain.  Here are examples of companies working the issues.

Connecting disparate sources of data

PokitDok creates “APIs that power every health care transaction.” They aim to enable data connectivity across the silos that in today’s world require manual navigation. They define an ecosystem including Private Label Marketplaces, Insurance Connectivity, Payment Optimization and Identity Management. The company closed a $35MM B round last year. PokitDok is a pure technology play. Achieving their vision could be the “holy grail”: better economics and better patient experiences and outcomes without owning underwriting risk.

Helping employers

It hasn’t been lost on the startup world that 150MM employees purchase health care via employers, which is why many companies are focused on improving the benefits buying experience and promising to help employers lower costs. The ACA requires that all companies with more than 50 employees offer health insurance. This aspect of the regulation, coupled with the fact that health benefits expense has risen steadily, provides a specific and large innovation space.

Competitors include:

Lumity, who reported raising $14M last Fall, acting as an insurance broker. The company claims to be “the world’s first data-driven benefits platform for growing businesses” promising to simplify benefits selection for employers and employees.  Employees are asked to provide health data, which are compared with aggregate profiles using proprietary algorithms. The big question: Will employees see enough benefit to share potentially sensitive information?

Zenefits, recovering from widely publicized regulatory issues, has new leadership. The company acts a broker, and focuses on small businesses.

Collective Health is targeting a wide range of businesses via “ready-to-go,” “configurable,” and “advanced” solutions.  The employee experience components of the offering are aimed at helping users make better-informed decisions with less hassle.

SimplyInsured aggregates health insurance plan options for small businesses to make comparisons easier, and aims to automate processes presumably essential to creating a viable cost structure for serving this segment.

A number of established benefits consultants including Aon and Towers Watson (the latter via their acquisition of Liazon in 2013) offer larger employers private exchange capabilities – these include portals for employee benefits enrollment enabled by data analytics and a friendly user interface. They act as or engage brokers to create benefits plans tailored to employers’ goals. Such portals can be helpful to employees, and check a box for employers seeking to improve the benefits experience, not just reduce expenses.

Motivating people to adopt healthier habits

Vitality, reported on in an earlier post, is a cobranded platform offering deals and rewards designed to motivate people who take steps towards better health. Humana offers the HumanaVitality program, integrating Vitality’s rewards program into the insurance relationship. If people see near-term benefit to behavior change this could be a good use case upon which to build.

Facilitating patient payments to providers

Patientco is a “payments hub” supporting “every payment type,” “every payment method,” “every payment location.” Focus is on efficiently increasing revenue for providers, secondarily to improve the payments experience for patients. The company provides the ability to integrate its solution with other health technology solutions.

Providing better experience capabilities to carriers

Zipari is a customer experience and CRM platform providing a product suite including enrollment, billing, and a 360-view of members across engagement channels. The company targets is product line at insurers, both direct-to-consumer and group or employer channels.

The multiple miracles that would have to occur for a quick fix make it unlikely that we will see a simple, logical health insurance experience any time soon. We are relatively early in what is likely to be a long game. But, Insurtech innovators are demonstrating the capacity to go after the possibilities that data and technology offer to mitigate the pain.

Daily FinTech Advisers provides market development services to FinTech ScaleUps, Financial Institutions and Investors and operates the FinTech Genome P2P Knowledge Network.

Harnessing the reputation economy to build the next small business bank

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Photo by Denis Dervisevic

In this two part series, we delve into the reputation economy and its impacts on small business finance and banking. In today’s second and final post we put forward a blueprint for a new kind of small business bank – one that actively improves its customers reputations with their own customers and suppliers.

In last week’s post we explored why the concept of the reputation economy is central to the development of a post-industrial society’s financial system. This week we look at how a small business focused bank could help enhance the reputation of its own customers, so they can gain an advantage in their own business dealings.

To gain an understanding of how this might work, it helps to have a look at two core issues small business face when dealing with finance providers today.

Small business borrowers are generally price takers

There are a myriad of factors that result in this. One of these is often a lack of competitive tension in a marketplace, however this is changing with a stronger non-bank lending market.

The second factor is an inability for a bank or lender to understand the business and price risk accordingly e.g. how is a newsagent different from a hairdresser. The typical benchmarking tool – a business or director’s individual credit score – is a blunt axe by which to measure a business by and takes little account of these industry nuances. Add to this the fact that many small business owners are entrepreneurs themselves and inherent risk takers, then the chances of negative marks recorded against their credit score increases. The ‘does the punishment fit the crime’ is opaque to most lenders, thus relegating most of them to take a ‘glass half empty’ approach to the majority of adverse findings.

Small business borrowers want to improve their financial standing but don’t know how

Many small business owners are regular victims of bank rejections – especially when seeking capital. The difficult part about these rejections is that the reasons behind them are often undisclosed by the bank, or at least can be difficult to understand. The ‘theatre of compliance’, where endless paperwork must be completed, IDs scanned and signatures matched can add to the confusion, ensuring many are reluctant to even bother considering moving banks. Thus they remain stuck with a sub-par bank, with a faint hope they may one day be rewarded for their loyalty.

But what if we had a blank slate for a small business bank? What would we do differently?

Start small, aim high

Trust is a two way conversation. That means neither a bank or its customers should take the relationship between the two for granted. But creating a trust balance by using technology to actively assess data points on both side of the equation regularly would help both parties better understand the other, and price accordingly.

Let’s imagine a startup business, with no credit history to speak of and an urgent need for capital to grow. The business also has no reputation amongst the supply network either and are eager to build credibility. What if a bank could help them on both fronts, simultaneously?

Firstly on the capital front, lending small amounts to begin with and building up as repayment milestones are met is an obvious approach – and one strategy many banks already implement. But translating this ‘good behaviour’ into a portable reputation is how the business could really get traction in its wider business dealings and enabling it to grow faster.

For example, what if a small business, in partnership with its bank, could build a personalised reputation profile, unique for a particular industry and share this with a new supplier or business partner? The new supplier could then apply their personalised weighting to the raw data or use the auto-generated, out-of-the-box score. A tech first bank doesn’t simply have to rely on financial data in order to build this profile. They could leverage a number of disparate and alternative data points from across various digital footprints, including repayment patterns with other suppliers and sentiment metrics from social networks.

Examples where this is happening outside of the traditional banking system include Cignifi, Lenddo and EFL , the latter who use a psychometric tool to inform credit scoring. A business focused bank offering this as a one stop shop solution could use this to differentiate itself in the market and create a compelling reason for business to switch.

The old adage, ‘we grow when you grow’ is one a small business bank could truly embody using this type of approach. Creating differentiation in the marketplace, without asking a small business to split off small chunks of their banking to a fintech provider is critical. Business owners are wary about spreading their financial life to thinly across multiple providers.

This is no mean feat however, ensuring the barrier to entry for new banks remains high. The ecosystem approach seems to be the best avenue here, bringing together a selection of specialists providers and creating a personalised banking solution for a business owner. It will be interesting to see if this plays out in any meaningful way over the next few years in the banking and fintech arena.

Daily Fintech Advisers provides strategic consulting to organizations with business and investment interests in Fintech. Jessica Ellerm is a thought leader specializing in Small Business.

The VC business is finally being disrupted

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VCs love to invest in technology and business models that disrupt the old established way of doing things. The irony that VC is now an old established way of doing things has not been lost on many people and the disruption of VC has been much forecast for many years (and as cynics will point out, this has not yet happened). This post explores the thesis that this is finally about to happen thanks to the confluence of investor demand, technology and tax change.

 ”Your fat margin is my opportunity” (Jeff Bezos). 2% AUM fee on a $1bn fund is $20m a year. That is not a lean, mean operation – that is a fat margin. That is before delivering any result to Limited Partners (LPs). That is $20m out of investors pockets before they see a dime from the profit share. That is incentive to raise a big fund and research shows that big fund size is a contrary indicator to fund performance. Who cares about profit share when you can earn $20m a year without earning any profit for your investors? Of course that cannot last and that is why change is coming to the VC business, enabled by the technology innovations that VCs funded in the past.

Investing in startup funds is as risky as investing in any other startup

Two data points from that Ivey report will make investors pick up that Vanguard brochure selling low cost Index Funds:

•For two-thirds of the VC firms, the first fund is their last fund.

•Only 10% of the VC Firms Launch More Than Four Funds.

You cannot invest in those 10% of top tier Funds, unless you happen to be lucky/smart enough to invest in their first fund and have the right to invest in future funds. Yes, it is like the old Groucho Marx joke: “I don’t want to belong to any club that will accept people like me as a member”.

VC Has become part of the asset management business

It did not use to be like this. Finding a young and unproven team and backing them all the way with everything (money and contacts and advice) is still done by a few real Innovation Capitalists but a lot of what we call VC has become Momentum Capital, chasing hot deals.

The preferences that some VC load onto deals make it almost a debt instrument and create fundamental misalignment with entrepreneurs.

Late stage deals are like investing in public companies.

The 2 and 20 model is at risk across the whole private equity business. VC may simply be the canary in the coal mine.

From gather then invest to invest then gather

If you wanted to be a VC GP (General Partner), you first approached investors (Limited Partners  or “LPs”) and persuaded them to invest for about 10 years while you as the GP invested in and exited from the next Facebook. This model is flawed for both LPs and GPs:

  • LPs have to invest in a startup fund and like most startups, it is possible that the startup fund will become the next Sequoia Capital, but read that Ivey Report to see why this is statistically unlikely.
  • GPs have to spend a lot of time gathering assets (which gets harder as the data points described here get commonly accepted) when they could be investing in startups or doing something else more lucrative.

From 2 and 20 to 0 and 40.

Investors are quite happy paying 20% as a profit share compensation (called “carry” in VC land). Heck, they will pay 30% or even 40% (particularly if it is 40% over some nominal risk free hurdle such as US Treasuries) if the GP will drop that 2% AUM fee.

The job of finding and nurturing tiny, young companies that turn into great big mature companies is hard. The people who know how to do it should be well rewarded. Most business are usually happy to share a big % of the profits on something if the other party takes a big risk as well. Paying 2% of AUM is zero risk to the GP and total risk to the LP. If you took away that zero risk 2%, most investors would be willing to increase the carry/profit share % from 20% to 30% or 40%.

If we stayed in the mode of gather assets then invest, the 2% fee will stay – it is the only game in town and it is a game that rewards skills in asset gathering more than skills in investing. However, the new crowdfunding services using syndicates such as Angel List and Syndicate Room change this dynamic to invest then gather assets. This post on Angel List describes how this works.

This matters more now than ever now that software is eating the world

Many investors have studied that Ivey Report and simply decided to stay away from VC as an asset class. Instead they focus on companies that have already reached maturity. The problem is that if software really is eating the world, this “safe strategy” is increasingly risky because it is more of a zero sum game than the venture business likes to talk about. If AirBnB scales, it does so at the expense of the traditional Hotel business. If Fintech ventures scale, they does so at the expense of the traditional Financial Services business. If Cleantech ventures scale, they does so at the expense of the traditional carbon fuel business – and so on. Investors looking to the long term – such as Family Offices and Foundations – need to invest on the right side of this disruption.

Many VC will follow Hedge Funds to become Family Offices 

Masters of the Universe don’t die, they just fade from the headlines. VCs that already made $ billions don’t need AUM fees. They can simply invest their own money, without the hassle of managing somebody else’s money. Many Hedge Funds have already done this. The tax law in America that taxes carry as if it is risk capital (i.e at the lower capital gains tax rate) not fee income has a high likelihood of changing no matter who becomes President. These VC turned Family Office can then invest in Syndicates who invest first and then gather assets. This is where the confluence of technology, business drivers and tax law change creates the tipping point.

Daily Fintech Advisers provides strategic consulting to organizations with business and investment interests in Fintech & operates the Fintech Genome P2P Knowledge platform.