On Monday, the Fintech City Tour took a return trip to Zurich, where I moderated a Meetup Panel with three startups:
Thanks to John Hucker for organizing the FinteCH Meetup Zurich, which meets about once a month and has a great group of bankers, technologists and entrepreneurs (mostly from Switzerland but some from other countries as well).
There was a good discussion about the value of Accelerators and Pitchathons. The summary was that they can provide good value if approached with a clear set of objectives; lots of good, practical advice was given by the panel.
The discussion then moved on to the challenge of raising “innovation capital” in Switzerland. I avoid terms like venture capital or angel or seed or growth as they all get blurred and misused over time. The objective is always the same – to fund something radically new. So I call it “innovation capital”.
It maybe easier to raise innovation capital in London than in Zurich, but folks in London will tell you that it is hard compared to Silicon Valley. You will hear exactly the same complaint in New York. Every city has Silicon Valley envy when it comes to VC money.
There are three ways to deal with this:
- Change the ecosystem. Work to make a center more attractive to investors and entrepreneurs through regulation, tax incentives and networking to connect investors and entrepreneurs. These valuable initiatives take time because it is about changing people’s mindsets.
- Do without external capital. Avoid the capital raising process by bootstrapping from customer revenues. This is a rational response by entrepreneurs. It tends to lead to incremental rather than transformative innovation (there are some fascinating exceptions that prove this rule). This requires innovative customers (consumers or businesses). If I could select one reason why America is the home of so many great tech companies it is innovative customers (VC is an enabler, but far less important). So even bootstrapping requires a culture of innovation in which to thrive. Rather than getting investors to believe, you get customers to believe.
- Just wait. Change happens, albeit sometimes too slowly. Access to innovation capital in Switzerland is far better than it was 10 years ago and in 10 years time it will be far better than it is now. Entrepreneurs are not patient, that is why they are entrepreneurs and that is why the world needs entrepreneurs; so this advice is unlikely to be heeded.
So none of these three ways is ideal.
There could be a better way. To think about that, one must first discard the notion that the Silicon Valley model is ideal. Then one must “skate to where the puck is moving” as the whole asset management business is going through disruptive change and VC is one part of the asset management business. Then one must do the judo trick of turning weakness into strength. There could be a way to do this in Switzerland that is specific to Fintech; that is the ideation part of my post at the end.
The Silicon Valley model (as practiced in Silicon Valley or London or New York or Zurich or anywhere else) is brilliant at creating game-changing companies, but here are three reality checks:
- Real innovation risk is passed to founders and their families. The phrase “come back when you have x” is the common refrain from investors. The x changes as you progress, from “working prototype” to “customer validation” to “revenue growth” to “profit growth”. This is a rational response from investors who are looking for the optimal risk adjusted return on capital. You can see examples of concept stage ventures funded with a lot of capital but a) these only happen to serial entrepreneurs who are wired to Sand Hill Road and b) the track record of these deals has been bad (so they are getting even more rare).
- 90% of startups fail. You can debate the % and it varies by stage of venture. The key fact is that the % looks totally different to investors and entrepreneurs. Investors protect through portfolio diversification. Entrepreneurs do not have a portfolio of lives and despite the great tales of repeated failures and then one glorious success, the reality is that you get one or two a shots at grabbing the “brass ring” if you are lucky. If you have put in years of your life and the hard-earned money of family and friends, failure really does hurt.
- In aggregate the VC asset class is seriously challenged. In aggregate, VC as an asset class does no better (net after fees) than putting money into an Index Fund and the few great returns (the ones you read about) go to a tiny number of VC Funds that most investors don’t get to invest in. See this Report entitled Venture Capital Firms in America: Their Caste System And Other Secrets in the Ivey Business Journal from August 2010 by Hatim Tyabji and Vijay Sathe. Two data points 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”.
In this environment, the risk aversion that gets discussed a lot in Switzerland is perfectly rational for employees, entrepreneurs and investors. Related to this is the pleasant fact that employees of banks in Switzerland did not suffer the bankruptcies and mass layoffs of their colleagues in London or New York. Out of that trauma emerged the Fintech revolution (just like the Boston Route 128 tech innovation grew out of the implosion of DEC and Wang). Nobody should wish for this cycle of boom, bust, boom; it works at a macroeconomic level, but it is tough on lives and families.
On the other extreme, nobody would wish for the stagnation that Japan went through because there was no motivation for Banks to change. The Fintech revolution is for real and unless Banks innovate, there will be bankruptcies and layoffs. It is not feasible to cling to a mythical golden age. Change is inevitable. The question is, what sort of change? You cannot take the Silicon Valley model and plant it in Switzerland and expect it to flourish.
Innovation has to be native to the culture.
Before looking at a model that could be native to Switzerland, we need to look at where the puck is moving and study Angel List, which is deeply threatening to that permanent aristocracy of VC Funds that the Ivey Report describes. That is good, because permanent aristocracies may make for entertaining TV (Downton Abbey), but they are seldom good for most people. Angel List is slaughtering 3 sacred cows of the Private Equity Asset Management business:
- Paying 2% of Funds under Management. A Syndicate does not have a permanent fund structure, so the concept of Assets Under Management (AUM) simply disappears.
- Raising multiple Funds every few years. This is a huge cost and as the Ivey Report shows, very few achieve this. Take this away and you take away the artificial constraints on entrepreneurs to get an exit within a pre-defined time. Take this away and the Fund manager can concentrate on what matters – finding and helping great ventures – rather than spending their management bandwidth courting investors.
- Paying 20% Carry. Angel List Syndicates compete in a very dynamic environment that enables investors to judge their net returns and a Syndicate that charges 10% will give twice as good a return as one charging 20% assuming the underlying performance is the same.
Those three sacred cows are all about aligning the incentives of the LP and the GP. Charlie Munger (Warren Buffet’s partner) has said:
“Never, ever, think about something else when you should be thinking about the power of incentives.”
In summary so far, it does not make any sense to try to re-create Sand Hill Road on Bahnhofstrasse, because the asset management revolution led by Angel List and others will change Sand Hill Road beyond recognition.
Switzerland has two great advantages when it comes to Fintech:
- Talent. Switzerland has good public education and a hard working and efficient workforce; there is a great mindset around engineering, quality and design.
- A trusted brand. The Swiss brand, when it comes to money, speaks to safety, reliability, precision and trust. When it comes to money, these are the brand attributes that matter.
Switzerland is an expensive place to do business. The recent move by the SNB has made that even more painfully obvious. That forces Swiss companies that want to compete globally to be even more efficient and to make sure that most of the costs are outside Switzerland if most of the revenues are outside Switzerland. The jobs that are in Switzerland will be highly paid and the ones getting those Swiss Franc salaries will need to constantly show that they are adding value compared to cheaper workers in other countries.
Growth stage capital is global and efficient. Large growth equity funds such as General Atlantic, Summit Partners, Bain Capital and Francisco Partners invest wherever they find the right companies. By the time ventures get to public markets, capital is totally global and efficient; I can invest in a company anywhere with a few clicks of a mouse.
It is during the early stage of a venture where the whole ecosystem needs to be in one place. That is why top tier Silicon Valley VC firms such as Sequoia, Benchmark and Andreessen Horowitz will only invest in teams that are physically close enough that they can meet face to face regularly when the venture is young. When a venture is more mature, it becomes feasible to manage your investment remotely with lots of emails, metrics dashboards and phone calls plus the occasional face-to-face board meeting. Once a venture is mature enough, these VC funds morph into Growth Equity funds and compete to invest wherever on the globe the venture is based (for example, Sequoia investing in Klarna and Andreessen Horowitz investing in Transferwise).
The early stage VC fund model does not scale. Top Tier VC Funds make fortunes but do it with very small teams and have had great trouble globalizing. The ventures they invest in can scale at hyper speed, but the size of their partnership grows at a glacial pace. The early stage VC Fund works because of a few partners meeting every Monday and the venture in discussion being near enough for regular face to face meetings.
So, top tier VC Funds will not come to Zurich to do early stage and the chance of a Zurich Fund breaking into the Top Tier is statistically and historically unlikely.
It is also unrealistic to expect Swiss angel investors to suddenly discover an appetite for early stage risk.
Motivation to take early stage risk in Fintech has to come from the Banks.
Banks do have motivation to take early stage risk because the old model of acquiring scale is not working.
Banks can acquire scale the traditional way by buying other Banks. However they may be buying just when that Bank is about to be disrupted by Fintech digitization.
So Banks want to “get on the right side of the wave” and invest in Fintech startups. However the model that Banks have followed to do this may not work as well due to the scaling impact of network effects driven by the fact that nearly 50% of the 7 billion people on the planet have mobile phones.
Banks (along with other strategic acquirers) have historically followed a simple model of waiting until a venture gets to IPO Scale (typically north of $100m revenue) before acquiring. This takes out the risk and ensures that the venture has a real chance of reaching Bank Scale (meaning it can “move the needle” of a Bank with $ billions in revenue).
Consider Lending Club to see why this model is no longer working. Lending Club became a highly valued public company through network effects in a very short time. Growth equity investors understand this and provided capital at massive valuations that a Bank could never justify.
That explains why Banks are investing in Accelerators, Corporate VC Funds and other ways to invest in early stage ventures. However, Banks need to think like entrepreneurs. Banks need to think how they can change the game, rather than play the game according to the rules that others have been training at for much longer.
Corporate Venture Capital sooner or later has to face the question of which mission they focus on. You can either focus on serving the strategic needs of the Bank or you can focus on serving the strategic needs of the venture you have invested in. Corporate VC funds that succeed long-term, such as Intel, focus on the venture because they know that they compete with pure play VC who focus 100% on the venture.
Banks can change the game when it comes to Fintech ventures, because the needs of a Fintech venture are different.
The optimal organizational strategy will combine the best practices of high velocity startups (“VC Model”) with the best practices of large global banks (“Bank Model”):
- Use the VC Model until you get to IPO Scale (usually north of $100m annual revenues).
- Use the Bank model to get to Bank Scale (usually north of $1 billion annual revenues).
The interesting change that is happening in the VC Model is that the relatively linear model of Series A to B to C and beyond is being replaced by:
- Very small amounts of capital until you get to the stage of Product Market Fit (PMF). The cost to build and launch a digital product (even if the developers are in Switzerland) is ridiculously low these days with all the open source tools, cloud services and APIs. However, only a small number “catch fire in the market”. In other words, most ventures fail to get Product Market Fit. This is the risk that everybody is trying to avoid.
- Massive amounts of capital after Product Market Fit has been proven. These are sometimes called “shovel in rounds”. These rounds often recapitalize the Cap Table, meaning this is an exit for friends and family, angels and small scale VCs who invested early.
Banks have the motivation to create the game-changing Fintech innovation. They also have a low risk way to do this by replacing the really early stage pre Product Market Fit capital.
This is where the terminology of the Venture Capital business needs to be updated. The whole Seed, Angel, A Round, B Round, C Round language that gets reported is increasingly meaningless. The numbers are “all over the map”. The reality is a simpler model that has three Phases:
- Phase # 1 is Pre-PMF (Product Market Fit). This is the world of moonlighting, friends and family, angels and some minor VC funds.
- Phase # 2 is Post-PMF to IPO Scale. This is the world of Top Tier VC Funds, Growth Equity Funds and increasingly, Hedge Funds, Public Market Mutual Funds, Sovereign Wealth Funds.
- Phase # 3 is Post Exit to Bank Scale. This can be public market investors after an IPO or after a Trade Sale (because the acquirer is a public company).
Fintech is a special case in the venture world.
The Pre-PMF phase cannot follow the model that worked in social media ventures, which is just to launch and see if you get traction. Money involves friction – for good reasons. Sending even $1 is totally different from hitting Like or Retweet. Regulatory compliance, security and auditability are all essential BEFORE YOU LAUNCH.
Doing the Pre-PMF phase within a Bank means you can easily handle the issues around regulatory compliance, security and auditability. You can also tap into knowhow and maybe technology, customers and partners. You also take away the risk from founders and their family. Developers creating the PrePMF product (also known as Minimum Viable Product) can be paid from day one, while keeping control with the Bank. You can create a Special Purpose Vehicle so that developers/management can get an upside share and so that when you get to the Post PMF Shovel In Round, outside investors can participate.
This is Incubation not Acceleration. Post PMF, Acceleration will be needed but, that is when it is easy to raise a lot of capital to win on a global scale.
Once a venture gets to that Post PMF stage, capital will flow. That capital might come from America or Asia or elsewhere in Europe. It might come through the wealth managers and Family Offices that call Switzerland home. Capital at the Post PMF stage is easy; there is far more capital than investable opportunities.
Swiss Banks that invested small sums to get ventures to the PMF stage could reap a big reward. Not only is the capital required very little, the bank can add strategic capability (know-how, maybe technology and co-branding) to ensure the venture gets past the critical PMF stage.
There is a simple switch that changes the game. Historically, founders going through all the usual rounds end up with around 10% to 30% of the equity at exit. You start at 100% and end up at 10% to 30%. Change that to start with 0% and earn your way to 10% to 30% by hitting the same sort of milestones that entrepreneurs have to hit to get funding.
Tie-ups with Academia is a natural. Coding is young person’s game and young people (Millenials) are digital natives who can relate to the value propositions of Fintech startups.
Post PMF, the capital will come knocking. It might come knocking from US Funds or Asian or from elsewhere in Europe or from within Switzerland from Family Offices. At that stage, it does not matter where the money comes from. At that stage, the entrepreneur calls the shots and is fielding multiple offers. At that stage, intellectual capital (aka entrepreneur and team) has the upper hand over cash capital (aka investor). That is what Angel List figured out and why they charge investors rather than entrepreneurs.
There are a lot of details around getting this right. That is true with any innovation. However I believe that there is an opportunity for Swiss Banks to change the Fintech Innovation Capital game.
The trickiest part of getting this right is – as always – culture. Specifically, how do you recreate the wonderful in the zone, high energy, creative flow and peer based pressure without politics or bureaucracy that truly great startups have? In Silicon Valley it happens because the guys with the money have figured out two things:
- The best talent is not just a bit better than the average, they are 3x or 10x better. Attracting that talent is really the driver of economic value.
- Talent likes to be surrounded by talent and getting a bunch of stars to pull like a team (and not act like prima donnas) is the real secret sauce of Silicon Valley.
That is the culture to import. It is a tax free import. That is the real capital. Forget about the money capital, there is plenty of that in Switzerland.