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Banking Is Broken Start-ups Try To Fix It.


Bill Harris, former PayPal CEO and veteran entrepreneur, strode onto a Las Vegas stage in late October to declare that his latest startup would help solve Americans' broken relationship with their finances.




Banking is Broken Start-ups try to fix it.


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"We overfunded fintech, no question," said one founder-turned-VC who declined to be identified speaking candidly. "We don't need 150 different neobanks, we don't need 10 different banking-as-a-service providers. And I've invested in both" categories, he said.


In September, Insider's Mary Meisenzahl reported that the chain's frequently broken ice-cream machines were under investigation by the Federal Trade Commission. McDonald's countered this claim by saying it had no reason to think it was under investigation.


O'Sullivan told Newsweek: "If their mission was to destroy Kytch, they absolutely succeeded. What has blown up in their face is this massive trail of really damning evidence of all the laws they've broken."


Holding together the shadow banking system is why the Fed initially pumped up its balance sheet in 2008. It bailed out Bear Stearns and AIG. It lent hundreds of billions to broker dealers on Wall Street and foreign central banks abroad. By 2008, these institutions were too critical to fail; businesses relied on the money they issued and without a functioning money and credit system, trade and commerce would rapidly contract.


Vene is chief executive of Modularbank, an Estonian FinTech startup that offers a cloud-native banking platform for organizations wishing to offer financial services to their customers, or looking to move away from legacy systems.


Modularbank was founded in 2019 when Vene and co-founders Rivo Uibo, Jan Lakspere, Ove Kreison, and Jüri Kirme discovered an appetite for tailored, cloud-based banking services that could be rolled out quickly to customers.


The idea had been forming in Vene's and her fellow co-founders' minds for some time. Vene, Lakspere, and Kirme launched their FinTech careers in the 1990s at Hansabank, which grew to be the biggest bank in the Baltics. Vene helped build the entire banking system from scratch, and headed the IT development division when Hansabank launched its online banking system in 1996.


The sheer breadth of banking services Modularbank covers is one of the company's key strengths, says Vene, who points out that competitors have often had to partner with third-party firms to provide the same services.


She also believes that the decades of technology and banking experience under Modularbank's belt mean it can tackle complex use cases and customer demands more comfortably than some of its competitors. "To build highly configurable modules, you have to know the product side of finance well. It's not enough to have great technology and great engineers in your team if you don't know what the customer needs to configure in your products," says Vene.


A 2020 report by Morgan Stanley4 documents several key trends in venture capital, particularly the falling rate of returns over the last forty years (these findings are summarized in figure 1). Investments in VC funds by individuals and institutions have risen over the last twenty years, as have VC investments in start-ups, the latter reaching a record high in recent years. Yet returns on VC investment fell dramatically in the mid to late 1990s and have stayed low ever since, now barely higher than those of major stock market indices, an astonishing change when one considers the far higher risks associated with funding start-ups.


Within this twenty-year period, several major changes occurred in our start-up system that have contributed to these low returns.5 First, investor exits for most start-ups, at least until 2020, are now largely accomplished by acquisition, rather than by taking companies public through an initial public offering (IPO) on the stock market. The problem here is that the returns on investment from an acquisition are typically much smaller than those from an IPO, and thus the trend towards acquisitions is probably one reason for the falling returns for VC over the last twenty-five years. Second, among those start-ups that do go public, the percent that are unprofitable at the time of their IPO has increased dramatically over the last few decades, exceeding 80 percent in recent years, according to analysis by Jay Ritter of the University of Florida.6 This increase has continued despite the falling overall percentage of IPOs versus acquisitions, a change that should have caused the percentage of unprofitable start-ups at IPO to fall.


These two trends together form a vicious circle. Lower profitability at the time of IPO naturally leads to smaller share price increases and thus to lower returns for start-up IPOs. These lower IPO returns in turn discourage start-ups from going public and thus drive the trend toward acquisition. But without profitability, incumbents will be unwilling to pay high prices for the start-ups that they acquire, and so returns on acquisitions will also fall. Lower acquisition valuations in turn affect IPO valuations. Poor IPO performance and low acquisition prices thus reinforce each other, and jointly lead to poor returns for the original investors in VC funds.


A glance at the rest of the developed world suggests that these problems of VC-funded start-ups are not exclusively American. The rest of the world got a late start with venture capital, but by the end of the 2010s other nations were also setting new records in VC investments, particularly China and India. By June 2020, the number of unicorn start-ups in China (227) had nearly equaled the number in America (233). And global unicorns have now reached an enormous $1.9 trillion in total value.9 But, as I shall discuss below, the lack of VC profitability is a global problem, with Chinese funds earning only slightly better returns than American ones.10


There was a time when venture capital generated big returns for investors, employees, and customers alike, both because more start-ups were profitable at an earlier stage and because some start-ups achieved high market capitalization relatively quickly. Profits are an important indicator of economic and technological growth, because they signal that a company is providing more value to its customers than the costs it is incurring.


Likewise, their relatively small market capitalizations also show the poor performance of unicorn start-ups. None of the publicly traded ex-unicorns had the $98 billion market capitalization required to be among the top 100 companies in 2019 or the $109 billion required for top-100 status in the first half of 2020.15 A remarkably small number were even a fraction of the way toward top-100 status by early 2019: Uber had a market capitalization of $60 billion at that time; only two others, Square and Zoom, had greater than $20 billion; and ten had between $10 and $20 billion. There is clearly still a long road ahead for even the most valuable ex-unicorns.


There are many reasons for both the lower profitability of start-ups and the lower returns for VC funds since the mid to late 1990s. The most straightforward of these is simply diminishing returns: as the amount of VC investment in the start-up market has increased, a larger proportion of this funding has necessarily gone to weaker opportunities, and thus the average profitability of these investments has declined.


The problem with the contemporary start-up system, however, extends beyond the average return on investment; it also includes the decrease in the number of start-ups founded after 2004 that have achieved top market capitalization. If we set aside the unique social and economic conditions of 2020, not a single start-up founded after 2004 is among the top-100 most valuable companies of 2019. Even if we include companies founded since 2000 in our analysis and count figures through 2020, there are only two exceptions to the trend: Facebook, founded in 2004, and Tesla, founded in 2003. But Tesla is a company that had less than 2 percent of the U.S. auto market in 2019 and did not achieve its first annual profit until that year. Further, it would not have achieved this profit if it had not enjoyed substantial tax and regulatory credits or if it had been obliged to split revenues with dealers or pay typical advertising costs as incumbents do.17 Thus, if we can ignore the hype around Tesla (a difficult thing to do in our hype-heavy media environment), it is clear that the start-ups founded during the last fifteen years have been far less successful than those of the preceding fifteen to thirty years.


A more plausible explanation for the relative lack of start-up successes in recent years is that new start-ups tend to be acquired by large incumbents such as the faamng companies before they have a chance to achieve top 100 market capitalization. For instance, YouTube was founded in 2004 and Instagram in 2010; some claim they would be valued at more than $150 billion each (pre-lockdown estimates) if they were independent companies, but instead they were acquired by Google and Facebook, respectively.18 In this sense, they are typical of the recent trend: many start-ups founded since 2000 were subsequently acquired by faamng, including new social media companies such as GitHub, LinkedIn, and WhatsApp. Likewise, a number of money-losing start-ups have been acquired in recent years, most notably DeepMind and Nest, which were bought by Google.


Other than artificial intelligence and data analytics, none of the technologies being developed by unicorns is a breakthrough comparable to those seen by previous generations of start-ups. But here, too, the large losses taken by ex-unicorns developing AI technology, the exponentially rising costs of achieving increases in accuracy, and the small market for AI in 2020 ($17 billion) suggest that AI and data analytics are still a long way from being truly revolutionary.20


In addition, some contemporary start-ups have also entered industries that have traditionally been subject to significant state regulation and therefore face challenges much greater than those seen by the start-ups of previous decades. Taxi services, for instance, are regulated by city governments out of concern for congestion and other issues; these concerns and contests over city regulations continue to plague rideshare companies and also present an obstacle to new scooter- and bicycle-rental services. Fintech start-ups are trying to challenge traditional banks, a class of firms that has been heavily regulated since the Great Depression. Education start-ups are fighting to enter an even more highly regulated industry and risk being caught up in political clashes over public and private schools.


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