Cash advancers

Homeowners defaulting on loans. Storied financial institutions crumbling overnight. Whispers of not just a recession, but an all-out depression.

With hair-raising stories like these, you’d think venture investors would be running from any deal that’s even remotely related to financial services. But financial services startups are now attracting more venture money than they have in the past five years. VCs invested $233 million in 22 financial services companies in 2007, their largest bet since 2002, when they put $128 million to work in 31 such companies, according to a VCJ analysis of data provided by Thomson Financial. And this year is off to a strong start, with another $190 million invested in seven financial services startups as of mid-April.

Those numbers are a far cry from the amounts invested during the tech bubble. Investment peaked in 2000, when 151 dot-com financial services startups raised a combined $2.8 billion. Many of those investments failed. Over the past 10 years, at least 80 such companies with a total of $1.1 billion in VC either filed for Chapter 7 or Chapter 11 bankruptcy or went out of business, Thomson reports.

Despite past failures, VCs continue to invest in the sector because it’s such a huge component of the economy. Financial services such as payment cards, trading exchanges, lending operations and bill payment represent more than 20% of overall GDP. Moreover, the financial services market is the leading sector for IT spending, with some $200 billion going toward technology projects annually.

“I look at financial services and see plenty of areas that traditional banks are not going after,” says Christopher “Woody” Marshall, a managing director at Trident Capital. “There are huge pieces of this market that can be addressed by small companies with differentiated solutions.”

Unlike Web 2.0, where you can have 30 companies doing the same thing, in financial services you’ll see a significantly smaller number of competitors.”

Jeffrey Crowe

VCs believe the industry is experiencing a new wave of innovation—spurred by trendy technologies such as Web 2.0 and social networking—that’s disrupting business as usual and leading to the creation of new and improved financial products.

“If you go back to a company like Intuit, you see how the first wave of technology dramatically enhanced the way people interacted with their finances,” says Tod Francis, a managing director at Shasta Ventures. “In the second wave, PayPal came along and revolutionized the way individuals exchange payments.”

Francis believes he’s hit on the next great wave with his investment in Mint Software, a money management website that lets consumers consolidate all their credit card and online banking transactions in one spot. He says Mint is an improvement over traditional banking sites because it allows consumers to better track and understand their spending habits over many different accounts and credit cards.

Mint, which in March raised $12 million in second round financing led by Benchmark Capital, also takes advantage of new Web platforms, such as personalization and social networking to save consumers money. For instance, the service leverages an analytics engine that can compare and contrast your spending with people living in the same general area. If you’re paying $89 for cable, and the average price in your neighborhood is $69, the site will let you know and even offer coupons from a competing provider.

Mint competes against a host of personal finance startups that have also raised new venture rounds, including Wesabe and SpendView, and angel-backed Buxfer (see table).

The un-banked market in particular represents a tremendous opportunity. Somewhere between 20% and 30% of the population does not have an official bank account.”

Chris Sugden

Other notable recent deals include Covester and SocialPicks, which have fused social networking and stock picking, and AccountNow and IPP of America, which offer services to consumers who don’t have bank accounts.

“The un-banked market in particular represents a tremendous opportunity,” says Chris Sugden, a general partner at Edison Ventures who participated in IPP’s latest $20.5 million round. “Somewhere between 20% and 30% of the population does not have an official bank account.” The goal, Sugden says, is to leverage technology to provide these consumers with valuable services equal to what regular banking customers would receive, such as the ability to pay bills online.

VCs also see interesting opportunities around the transition to electronic trading. Technology is allowing startups to play in areas that were once the exclusive domain of large banks. Online trading, for instance, has quickly spread beyond equities to other asset classes such as foreign exchanges. 3i and VantagePoint Venture Partners did a $116 million round for Gain Capital in January, following a $100 million investment in Oanda last September by a consortium led by New Enterprise Associates.

Naturally, not all VCs are enamored with financial services. In fact, some firms steadfastly refuse to invest in the sector. The biggest reason is the highly regulated nature of the industry.

“Some of the companies in this sector have regulatory requirements that vary state by state and country by country,” explains Jim Mills, a managing director at VantagePoint. Mills notes that regulations are not always clearly defined. Plus, they evolve constantly and can ultimately place additional costs on the business.

I look at financial services and see plenty of areas that traditional banks are not going after. There are huge pieces of this market that can be addressed by small companies with differentiated solutions.”

Christopher “Woody” Marshall

What’s more, many financial services businesses are subject to laws such as the Patriot Act, which impose requirements for client identification and to prevent money laundering, adding to the cost of compliance.

“Most VCs hear the word ‘regulation’ and immediately run in the opposite direction,” admits Jeffrey Crowe, a general partner at Norwest Venture Partners. Nonetheless, Crowe has participated in one notable financial services deal, a $10 million first round for Lending Club, a person-to-person lending site.

Unlike other VCs, Crowe believes the glass is half full when it comes to compliance. “If a startup can successfully navigate the regulatory issues, it quickly establishes a very powerful barrier to entry,” he says. “Unlike Web 2.0, where you can have 30 companies doing the same thing, in financial services you’ll see a significantly smaller number of competitors.”

Another issue financial services investors must contend with is that such startups may attract criminals who want to defraud them. “PayPal almost went out of business early on when the Russian mob figured out how to defraud them,” notes Trident’s Marshall, who is an investor in AccountNow. “If you have money flowing through your system, you’ll also have people trying to take it away from you.”

Marshall’s advice: Make sure you back a team that understands the industry inside and out. Also, be patient, because growth in financial services is typically slow and steady. If you get the formula right, he adds, you’ll eventually be sitting on a recurring revenue business that spits out money like a slot machine.

Some of the companies in this sector have regulatory requirements that vary state by state and country by country.”

Jim Mills

What about competition from big financial institutions? Crowe says they may not necessarily pose a threat to startups. Take a company such as Lending Club. The nascent person-to-person lending market is not even on the radar screen of large players because it’s so tiny compared to, say, credit card lending, which is now a $980 billion business in the United States alone.

“Person-to-person lending is not even one-tenth of 1% of credit card receivables,” says Crowe. “The market has a long way to go before larger institutions even think about dedicating resources here.” Still, he believes if Lending Club scales quickly—which is a distinct possibility in the current economic environment—it’s likely to catch the eye of a large institution looking to enter the market quickly through acquisition.

Of course, the biggest fly in the ointment is the subprime debacle. How this crisis will ultimately impact venture investments in financial services—and almost every other sector for that matter—is still unclear.

“Sure, some financial services startups could have trouble given the recent events around foreclosures,” says Marshall. “Then again, some could actually benefit.”

Such as? Marshall says AccountNow, a provider of prepaid debit cards to consumers, is poised for rapid growth.

“As more people get into trouble, they may lose their credit cards and bank accounts,” he says. “Prepaid is a perfect solution for people who no longer have access to credit. We have not seen a tidal wave of activity yet, but things could get a lot worse before they get better.”

Leave it to a VC to find a silver lining in even the darkest of clouds.