Abstract: Covid19 has changed the capital and market environment for neobanks and challenged the strategic assumptions underlying a #blitzscaling approach. In this article we examine what these assumptions are and over 2020 and 2021, why the optimal path to profitability for neobanks might be to shrink away from some regions and products now and pivot from payments centric services to lending or build and scale an embedded platform business for when a more favorable environment takes shape.
Entrepreneurship is easy, getting paid is hard
In 2020 this truism applies not only to individuals and ordinary startups but also to legendary unicorns like Uber and Airbnb. It’s even harder when the environment changes so precipitously and unpredictably that businesses have no chance to pivot. For all of us inspired by Steve Job’s Turtleneck or Elon Musk’s Rockets, there’s just one guy named Charles Darwin on a boat who is not amused. A simple change in the environment - whether economic, technological or regulatory can make genius entrepreneurs look like mere mortals. It turns out, the whole point of entrepreneurship is to battle on, course correct and keep building. As Randy Komisar would say, “it’s the journey, not the destination” - and as Ben Horowitz would say, “that’s the hard thing about hard things”.
Silicon Valley Business Models
During my MBA I realised that most of the authors of management literature had never actually built or operated a business (genre: fiction). On the other hand, much of the management theory that emerges from the valley is generally current, based on actual business experience and forward looking (genre: nonfiction). At the same time SV literature is based on a small cross section of experiences, usually one or two startups and things that worked for them. Things that work in the valley become memes for us plebs and first principles are soon forgotten.
Three such strategy memes are “Platform”, “Marketplace” and “Blitzscaling”. Entire books have been written on each and contain a lot of practical, valid insight. Blitzscaling is the art of grabbing so much marketshare so quickly that competitors have no oxygen left to breathe. Yes its very cost-inefficient but its the cost of survival. The fundamental assumption being that the underlying business is a classic winner takes all, horizontally scalable, “webscale”, global digital business.
Surely if someone made a billion dollars, they must have done everything right? Right (Wework, Uber, Theranos anyone)? So the book became unquestionable folklore. If Blitzscaling seems to be working for Uber and Airbnb, surely it must work for Revolut, Monzo, Crypto companies and such?
Unfortunately in 2020, neobanks are being criticised for blitzscaling as much as they were being revered for it in 2019. What people don’t remember is that 2019 was a year when even consulting businesses were advertising their plans for blitzscaling. In his book however, Reid Hoffman repeatedly reminds us when blitzscaling is appropriate. It’s appropriate for high gross margin, horizontally scalable, winner takes all businesses, not time, materials, salary and expenses businesses or businesses operating in a fundamentally fragmented market. Banking is not winner takes all. Consulting is most definitely not so.
What led VC funded European neobanks to take an unquestioning approach to blitzscaling “app-banking” is the assumption that capital will remain cheap and that you could build once sell everywhere. Maybe it was the right approach in 2019 given the assumptions then. Now that we are in a new environment, it’s the assumptions we need to challenge, not the entrepreneurs themselves. No one who is not an incorrigible optimist makes a half decent entrepreneur afterall.
What’s changed? Environment
I too had the pleasure of working for a brilliant and visionary tech business that blitzscaled from 300 to 1500+ within a year when the main source of funding i.e. return on crypto assets was practically free. Crypto years are dog years and things move fast, so when the market crashed 95% and capital was no longer available, we sort of went back down to the original size give or take and significantly pulled back our activities in all areas.
Blitzscaling works when capital is cheap and the TAM is huge. We’ve been in a cheap capital environment since the Google IPO and now the Fed has printed a few trillion to take the US stock market to gravity defying levels. The IPO gravy train is longer than ever and sustainable profits are entirely optional on the path to riches (Lemonade, Plaid, Kabbage etc etc.). Unfortunately, this is not true in Europe.
What has not changed: Funding Sources
PwC India’s Sanjeev Kumar’s analysis of Revolut, Monzo and Starling tells a compelling story. Revolut have the most “silicon valley” mindset and funding among UK neobanks. It turns out, sources of funding have a disproportionate impact on strategy. Revolut have implemented the blitzscaling playbook beautifully - they have brilliant UX a full and growing product stack, a growing coverage of countries, high customer acquisition costs, a hockey stick curve of customer growth and aggregate losses growing like Amazon’s until 2015.
Monzo have followed the same tech startup playbook. They are just loved a bit more in British media than Revolut and often use different colours than Revolut but the similarities in these summary slides overwhelm the differences.
In the meantime, Starling Bank one of the few neobanks run by an experienced banker (before T S Anil joined Monzo) have a flatter growth curve, a simpler product stack and a much more conservative cost structure. They also have a banking license, a UK focus and sources of funding that are qualitatively different from Monzo and Revolut in terms of investment and risk profile. That means more operating freedom for the CEO to deliver “banking metrics” and less pressure to deliver “growth metrics”.
Strategy is a function of Vision, Assumptions and Environment
Strategy is choice. Choice means doing some things and not doing everything else. Oaknorth and Starling are doing fine in a small but rich market a la UK. The "bank" strategy is working. The "app" strategy is the one that's suffering from lack of China or US sized scale. Why?
Let’s check the assumptions behind blitzscaling app-banking:
Digital banking can be delivered at web-scale i.e. cross border, global, one consistent customer experience for customers worldwide similar to Airbnb and Uber. This is the “SAAS” model of neobanking. This assumption has always been suspect because even large European banks have always been local with credit institutions sitting at the core of social policy, forcing app-banks to invade the US, which is a rather expensive proposition.
Capital will remain cheap as long as you deliver marketshare growth and we will find a business model (profits) later like Amazon did. This assumption is predicated on the first assumption. Monzo’s 40% downround disproved this assumption causing widespread panic. Going back to assumption 1, this is where businesses that conquer US and China first have a huge advantage. They are usually already profitable or cash flow positive before they invade Europe.
In Banking, payments are appetisers for lending. If you delight customers with a brilliant payments experience, they will come to you for lending too and then you can make interest income. Unfortunately this requires data ( a-la cash-app) and Machine Learning (‘AI’) capabilities, which in turn requires scale. Unfortunately, Europe is an aggregation of fragmented local markets - in other words, nothing like China, US or India.
It’s not only the customer base that’s scale-limited but the data as well. Then banks can’t sell ads or data like Google or Facebook… sorry silicon valley.
Profit = Revenue - Cost
When B-school students prepare for McKinsey case interviews, they start with “Profit = Revenue - Cost”. To make a profit, either you grow revenue or cut cost or both.
Then we graduate, enter the world of work, get a twitter account, learn about the future, the digital revolution and other such things and forget that equation. That equation didn’t mean anything between 2010 and 2020 because every company was supposedly a technology company so the rules that applied to Silicon Valley venture funded businesses applied to all of us. Then came the virus, Brexit, de-globalisation and gravity and the equation returned with vengeance in the scale unfriendly Europe (not in the US where Lemonade, Tesla and such are still all the rage because this time is different innit?).
Banking is Simple
So let’s assume for a second that neobanks want to be banks and want to grow the topline similar to Oaknorth and Starling. Unlike Amazon or Uber, Banking is quite a simple business. Banks make more money from lending than they charge on deposits. That’s the cake. The rest is cherry and cream. Payments have been going to zero with SEPA, Faster Payments and the like. Banking is so simple that no amount of technology can make it more complicated.
To quote myself from about 20 previous tweets over 3 years…
Now let’s look at Revolut’s numbers. They delivered 60% income from card use and interchange fees, 23% from app subscription and 106 million in net loss. In this interest rate and consumer credit default environment, what sized loan portfolio is needed to fix the numbers with interest income? Presumably 2x the size of their deposits portfolio? Well, for that someone will have to launch a meaningful lending product first?
So if the topline can’t suddenly grow, the cost figure has to go down across the board. Where’s this cost coming from? Neobanks are hardly overstaffed and certainly don’t pay massive salaries - at least 30% less than established banks for 30% more hours - and 30% more intensity per person(?). So pay/bonus cuts aren’t an option and scaling doesn’t go well with layoffs (a la monzo).
Platform and Marketplace
Ok so Blitzscaling is not working because the environment change. What strategy prescriptions can we offer? There are two more Silicon Valley strategy patterns we can lean on: Platform and Marketplace.
What does that mean though? Provide infrastructure for commerce (embedded finance) or forward integrate into commerce? Both prescriptions have been offered.
Paul would prefer neobanks to get into commerce like Tencent.
Both approaches make sense but there is one execution issue with each.
1: It costs capital to launch new businesses and capital is no longer free. So capital needs to be freed up from losing products and regions to be invested in new product lines and businesses. I am done repeating that.
2: If it’s a good business, the competitors aren’t idling around and you have to have a clear competitive advantage. Railsbank. OpenPayd and SolarisBank are three examples of exceptionally well run firms in the embedded/infrastructure business that’s now packed with competitors. What gives Revolut or Monzo the edge in that business?
So where’s the capital to do either this or that going to come from and if you’ve actually been inside a startup, which startup CEO is going to bell the investor cat that was totally assuming a 100 bagger by 2025?
Survival as a Strategy
Ok, so what’s my smartypants, armchair consultant advice? It’s stupidly simple. Survive and conserve capital. Now’d be a good time for these fabulous ventures i.e Revolut and Monzo to ignore the pundits, have a heart to heart with growth gurus, and just survive for 2021. A big pivot now and a simple vaccine could make the pivot looks stupid. Keep going as usual, accumulate losses and investors might flee. To be honest that’s exactly what Monzo are doing right now and T S Anil coming from post crisis Citigroup is totally the man for the job.
This type of fine chopping and slicing is what the guys at McKinsey (not much understood or liked on twitter) do so well. Someone needs to start from top to bottom and allocate costs to products and regions. Then entire regions and products have to go. Note that Starling and Oaknorth have not invaded the US whereas Revolut and Monzo have. How hard is that market with local competitors like Cashapp, Venmo, Paypal (let alone the 6000 banks)? Kinda hard. How big is it? Very very big i.e. marketing, compliance and distribution costs add up quickly. Now if you don’t conquer the US, China, India, Brazil or all of Europe, can a VC turn a neobank into a 100 bagger? No, not really.
Then cost has to be squeezed from marketing gimmicks (hot coral?), partnerships, property, marketing, … cofffee, cookies, team drinks… (remember working in a bank post crisis?) but there’s no point in squeezing pennies from line items if pounds are being burnt on regions and entire products. The chopping board has to be apple-sque where Steve jobs cut 100+ product categories into 5 as his first task after his return.
Yeah, that turtleneck wasn’t all innovation. Contrary to popular belief, Steve was all execution in his second innings and he did pay attention to costs. Tim and Jeff have been doing exactly the same.
Neobanks will too. It’s all part of the startup lifecycle.