Lately, those saying that fintech lenders have been overvalued are being vindicated by an across-the-board slashing of valuations. Numerous fintech lenders have taken down rounds or markdowns, while Wall Street has largely pummeled the few companies brave enough to enter an IPO. Indeed, as of this writing, Lending Club, OnDeck Capital, and Enova have each lost major ground versus their respective IPO share prices.
This is a troubling trend for all companies in this space. It underscores the difficulty of properly assigning a valuation to a new business category that combines qualities of both a technology company and a financial services organization. My previous experience as a venture capitalist taught me how difficult it can be to properly value emerging companies, particularly when the entire domain is new.
While I have skin in the game as a fintech founder, after surveying the landscape over the last several years, I believe fintech lenders, which were previously overvalued, are now undervalued due to an overreliance on valuation methods that are better suited for banks or tech companies — not for companies that share qualities of both.
Online lenders are not SaaS – but they aren’t banks either
If you were developing the first car in history — something no one had seen or used before — would you compare it to a train? What about a horse? Although it is a vehicle for transportation, the car is neither of those things. Today, fintech lenders find themselves in a similar situation; for proof, just look at the different ways their valuations have been calculated to date.
Back in 2014 when Lending Club and OnDeck Capital went public, their relative valuations were largely based on the most common approach to valuing a SaaS company — a revenue multiple. However, online lenders — whether they are factoring companies, term-loan providers or line of credit providers — have structural risks (like capital losses) that SaaS companies don’t, leading them to be overvalued by these multiples.
Today, instead of revenue, these fintech lender valuations tend to be based on the price-to-book ratio — the de facto bank stock multiple. This, however, is also a poor comparison.
Comparisons are good if …
Properly valuing a company requires understanding future cash flows and structural risk. While a discounted cash flow analysis is the theoretical gold standard of valuations, it is time-consuming.
For this reason, comparables (comps) are frequently used as a shortcut: If you are confident in your valuation of a certain company, you can find a multiple and apply it to another company as a shortcut. Obviously, however, this is only useful to the extent that the companies in question are genuinely similar.
In this case, fintech lenders are structurally very different from both SaaS and banking companies. Whereas fintech lenders leverage cutting-edge technology to deliver their product to the market, traditional banking incumbents rely on legacy systems, huge workforces, and to some degree on physical infrastructure such as branches and ATM locations.
The result is vastly different returns on assets between banks and fintech lenders. JPMorgan Chase manages $2.3 trillion in assets and generates nearly $100 billion in annual revenue, whereas in 2015 OnDeck Capital generated $200 million in revenue on assets of only $750 million. When a bank typically returns 4-5 percent of its book, while some fintech lenders return 40-50 percent, how does it make any sense to apply a bank metric to fintech lenders?
While I am not opposed to using multiples like revenue for SaaS companies or book value for banking entities, they are designed to evaluate comparable companies against each other in order to assign relative value. Alternative lenders have now established themselves as neither banks nor SaaS businesses. It is time to find a new multiple.
A multiple to call its own
Fintech lenders deserve their own valuation method, and I believe it should be a gross profit multiple. Let me explain my thinking: While fintech lenders have a similar cost structure to SaaS companies (e.g., inside sales divisions, large research and development arms, customer acquisition via online marketing, etc.), SaaS revenue does not have losses or cost of capital concerns.
Gross profit calculates how much a company is making net of cost of capital and losses; in other words, it strips out what is different from lenders and SaaS companies. Of course, this is not a one-size-fits-all metric given the differences between fintech lenders, but I believe it better reflects the true value of fintech lenders.
The actual multiple — 5x, 10x, etc. — will vary between fintech lenders based on relative growth rates, inherent risks, margins, and other factors just as multiples vary within SaaS or banking. For example, a short-term lender is less vulnerable to changes in the macro credit environment, which should increase its multiple versus a similar longer-term lender. While investors will still need to scrutinize individual fintech lenders, starting with gross profit will ensure that the baseline for the multiple more accurately represents the value drivers of a fintech company.
A more nuanced approach
In spite of the falling valuations of public fintech lenders, alternative lenders aren’t going away anytime soon. The continued confidence in fintech lending is reassuring, but we will most likely continue to see delayed IPOs until these companies believe they are receiving a fair assessment of their future prospects.
Square, the last fintech company to go public, has also struggled to find its way and still trades below its initial IPO price. While lending is currently a relatively smaller portion of their business, its stock serves as a daily reminder that all private fintech companies — not just alternative lenders — need an appropriate evaluation criteria to properly measure the value they provide to the market.
Whether we use a gross profit multiple or another metric, I hope we can take a more thoughtful approach to valuing these innovative companies instead of haphazardly applying convenient shortcuts from “similar” sectors. Ultimately, the market will correct itself, and those investors who have recognized that current multiples undervalue these fintech lenders will be well-positioned for outsized returns.
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