Investable companies should have a combined revenue growth rate and profit margin of at least 40%.
Over the past decade, the rise of the fintech industry has fueled remarkable innovation, placing powerful technological capabilities that otherwise might have been out of reach into the hands of companies and consumers.
For companies, the fintech boom has also created something else: risks, in the form of complexity in their technology stacks. Large companies today sometimes rely on scores of fintech partners who provide an array of capabilities. These products are often deeply integrated—and sometimes shoehorned—into companies’ often sprawling technology architecture.
Companies’ symbiotic relationship with fintech is providing real benefits. Within corporate tech platforms, fintech products are playing an increasingly important role in internal operational systems and customer-facing platforms. They are used to solve niche operational and technology problems, and provide sexy new features to customers.
However, the integration of third-party technology also comes with some costs. In monetary terms, fintech tools tend to be affordable on the surface. However, the total cost to “plumb and service” these applications within an evolving technology stack is often unknown, and usually, understated. Perhaps even more important are the risks associated with companies’ growing reliance on fintech providers, many of whom are small, nimble entrepreneurs with a dream. When a company integrates a fintech solution into its technology architecture, it’s making a bet that the provider will be there in the future to support the application. When fintechs fail, the ramifications can be profound.
Reliance Creates Risk
There are real world examples. The failure of Synapse Financial Technologies this spring provided a dramatic demonstration of the risks this type of reliance can create. Synapse, a banking software company, helped connect online nonbank lenders with licensed banks. When Synapse filed for bankruptcy, some customers of the online lenders were cut off from their funds.
Because the Synapse collapse directly affected consumers, it received significant coverage in top-tier media outlets like the Wall Street Journal and the New York Times. Although much less attention is given to financial problems experienced by other fintechs in the business-to-business space, the consequences of these companies failing can be equally painful, and the magnitude even greater.
The failure of a fintech provider whose applications have been integrated into noncore technology systems can disrupt internal and customer-facing systems, causing significant delays and expenses as the company fixes the problem. For applications that have been used in core systems, the collapse of a fintech partner can cause massive damage to the business overall. The bug in CrowdStrike’s server software last year disrupted airlines, banks and retailers, leaving a massive scar on their businesses. The entire business world learned invaluable lessons from the crisis, which fortunately ended up not being caused by an international cyber breach, as was initially feared.
Taking A Fresh Look At Fintech Partners
Companies are well aware of these risks and have developed vetting processes to judge the financial strength of potential fintech partners. However, in light of current conditions in the technology sector and financial markets, I believe many companies need to modernize these review processes.
In the years before the Fed started hiking interest rates, money was cheap. Fintechs in that era had access to huge amounts of funding at historically low rates. Cheap capital helped fuel the fintech boom, but in those “go-go Covid” days, lenders and investors were much less discerning about the quality of the companies that received funding. Some fintechs leveraged nearly unlimited access to capital, with no earnings. Many are now barely getting by.
In this environment, I’m advising clients to do two things. First, wherever possible, partner with large, well-established technology vendors with diverse product lines and revenue streams. Second, go back and reevaluate the financial sustainability of every one of the partners you work with to ensure their businesses and balance sheets are built to survive not just the current conditions, but any swings in the macroeconomic environment.
Business Sustainability And The Rule Of 40
The purpose of taking a fresh look at existing technology vendors is to measure the short-term financial stability and long-term viability of fintech partners. When explaining the purpose of this new round of reviews, I often use the example of the “Rule of 40” as a heuristic for the type of strategic assessment I’m recommending. The Rule of 40 was created by venture capitalists investing in the Software as a Service (SaaS) industry. It states that investable companies should have a combined revenue growth rate and profit margin of at least 40%. Companies that top 40% most likely have sustainable businesses. Companies short of that threshold might be investing too much in growth, or they might have other problems that could eventually threaten cash flows. In either case, a combined metric lower than 40% is a red flag for risk.
It’s important to note that the Rule of 40 was created specifically for software companies. For companies in other industries, the exact equation might be different. Even in software and closely related technology, I think there are variations. For example, in companies less than five years old, it’s not uncommon and not necessarily unhealthy for combined percentages of revenue growth and profits to fall below 40% due to the need to acquire customers and otherwise invest in growth.
The exact percentages, and even the precise equation itself, are less important than what the Rule of 40 looks to measure: the sustainability of the company and its business. The goal of this analysis is to look beneath the surface to identify strategic shortcomings that might be masked by seemingly strong capitalizations or rapid growth.
Identifying such strategic weaknesses before they cause a crisis can save companies from significant disruptions, delays and costs. Going forward, assessing the long-term sustainability of existing and potential technology partners will become a critical ability for companies as they rely on fintechs for an expanding number of functions in their increasingly complex technology platforms.
