ESO's Monthly Start-up

June 2023

Challenger Banks Finding Current Economic Environment… Challenging

There are a couple of black clouds looming over the economy right now, one of the most notable being the current state of the banking sector, specifically, regional banks. With the failures of SVB and First Republic, consumer confidence in smaller banks has been shaky, and trust has been moved firmly to larger establishments. The SPDR S&P Regional Banking ETF (KRE) is down almost 30% year to date while large national banks like JP Morgan Chase (up ~3%) and Wells Fargo (down ~3%) have been less impacted.

Regional banks aren’t the only ones in the banking industry struggling through this economic cycle, and challenger banks and FinTechs in general are beginning to feel the heat as well. Former high flyer Chime has recently been plagued with a revenue slowdown as they too contend with the limits of bank disruptors. Chime was running red hot during the pandemic, boosted by fresh government stimulus checks and low interest rates that allowed them to add new customers. During 2021, Chime’s revenue rose to $1 billion after tripling to $600 million in 2020. However, during the first quarter of 2023, Chime’s revenue rose only 27%, to $305 million, from the same period in 2022. At the same time, the company lost $45 million on an adjusted EBITDA basis.

What are the headwinds facing both regional banks and FinTech challengers? Most concerning, is the current interest rate environment. In a rising interest rate environment, banks suffer from decreasing net interest margins as the cost of borrowing increases. While larger banks can offset this compression partially with volume, smaller banks really struggle to compete in this environment. While FinTechs, and more specifically neobank challengers, are impacted by increasing costs of funds as well, they have an additional issue to contend with: lack of diversification of revenue streams. While bank’s are able to offer loans with rates that capture additional yield in a higher interest rate environment, challenger banks typically make most of their revenues through interchange fees. These are transaction fees that the merchant’s bank account must pay whenever a customer uses a credit or debit card for a purchase. This means that while neobanks might have a cheaper customer acquisition cost, their life time value amount significantly trails that of traditional financial institutions due to not being able to offer loans. This paradigm may be slowly changing, as neobanks begin to try and tap into additional income streams (last year, Chime began offering loans of up to $500), but they still have a ways to go.

The final and arguably largest battle that smaller banks and fintech’s will be facing is increased security and fraud risk. While large banks have both the capital and man power to devote a significant amount of resources to security, smaller banks and challenger banks do not have the same level of resources. As such, they are more vulnerable to cyber attacks and fraud.

The SVB and First Republic failures have hurried along a bank consolidation process that has been in the works for decades now. Bank challengers will have to figure out ways to not only increase their profitability, but also gain the trust of consumers that have been made increasingly aware of the risks of the banking system.

Why this matters: The current state of the banking system has implications for the larger FinTech ecosystem as a whole. FinTech companies, like the smaller regional banks, need to contend with competition from large financial institutions that are continuing to grow and expand their technology capabilities. In order to survive in this current landscape, FinTechs will need to continue to take market share and revolutionize, while placing an emphasis on profitability. Safe to say they likely have their work cut out for them as long as the market remains as is.

Tips of the trade

A section where we provide helpful tips for anyone with stock options or shares at private companies.

Exercising in a downturn: A buying opportunity?

Since we began our newsletter in late 2022, we’ve written a bunch on the recent downturn in the private markets. Whether it is the abundant layoffs, lack of liquidity (both through IPOs and secondaries), or slowing revenue growth, companies are feeling adversity in 2023: and so are their valuations.

After raising at sky high multiples in 2021/2022, things have come back down to earth, especially for the cash burning grow at all costs tech sector. Many of these companies are still burning just as much cash, without the rocket ship level growth rates. This leads to layoffs in order to preserve capital, and markdowns in valuation.

While exercising in this market may seem ill-advised, it actually presents a unique opportunity to purchase stock options at a lower cost for 2 reasons:

  1. Exercise taxes are lower due to drops in Fair Market Value (409A).

  2. Exercise cost in some cases is lower as options are repriced to the new 409A value.

Now as always assuming you do your homework on the company’s health and believe in its future, this lower cost of acquisition can be highly beneficial for employees. By avoiding taxes on the exercise, optionees can ensure more of their money goes directly to buyer shares, as opposed to paying taxes on an unrealized paper gain. Additionally, if things turn around and the IPO window opens once more, private valuations won’t remain in the basement for long. Exercising now can lock in that lower valuation before the market has time to recover.

Further benefits include unlocking Golden Handcuffs for improved flexibility in this challenging market and starting the clock on Long-Term Capital Gains.

Again of course it is important to look at the exercise as an investment and consider all other opportunities you have on the table (including simply investing in public stocks). However, while valuations may be down for the time being, if/when things do turn around, prices may move up quickly closing the window to exercise cheap. That being said, we’re not confident that prices soar up anytime soon. However, with the recent rally in the public markets coupled with some potential near-term IPOs, there is hope for a brighter future on the horizon.

Financing your option exercise can be expensive and a require a large capital outlay. Feel free to reach out to us to discuss your options for partnering with ESO to exercise your options risk-free.

The ESO Fund does not provide legal, financial, or tax advice.

Layoff Slowdowns Continue into May

Layoffs have continued to slow from a peak in January. May marked the 4th straight month of layoff declines, with numbers for both companies with layoffs and total employees laid off down 85% and 71% respectively from January. Both are down roughly 30% and 10%, respectively, from April. Total layoffs for the month were led by Cerner and Sabre, laying off 3,000 and 1,100 individuals, respectively.

Why this matters: Continued slowing in layoffs is signaling that we may be near the bottom in terms of tech layoffs. However, with continued uncertainty in the banking industry, as well as some continued large layoffs from bigger players, it is too soon to say if we are making our way out of the woods, or if there is more bad news to come here.

Brought to you via layoffs.fyi

Secondary Market Sentiment: a local max?

The graph below displays the ratio of buyers vs sellers for a given month on the private secondary market. Months with more buyers than sellers are displayed in green while months with more sellers than buyers are displayed in red. All data pulled from Zanbato, the below list does not imply completed transactions, simply intent to either buy or sell shares.

Despite a rally YTD in many public stocks through the first 5 months of 2023, secondary market sentiment remains firmly negative with May featuring the highest number of offers to sell since we began tracking the data. Bids are up compared to prior months so there is still likely closing activity in the market. It will be interesting to monitor how private company sentiment tracks the public market as the Fed slows their rate hiking process going forward.

Why this matters: We’ve mentioned it in the past, but the main disconnect between the public and private markets is liquidity. As long as the IPO (and M&A) windows remain closed, private stocks will struggle to rally back to their previous highs. The good news is companies are set to test the IPO markets at some point in 2023 (see more in our May Top Ten below). If those IPOs are successful, we should see a number of subsequent IPO filings.

Public Multiples Check-in: "Yesterday's Price is not Today's Price"

Declines in multiples have softened further as the S&P has continued its rally into May and is currently on the verge of a bear market exit. Investors are betting on continued economic strength (as supported by a robust May jobs report) and a pause on further interest rate hikes by the Fed.

Cryptocurrency has continued to see the largest multiple expansion, growing from a median 2.4x to 3.4x year over year as cryptocurrency continues its rally as well. However, we are expecting a contraction here in June as the SEC has gone through with lawsuits against Binance and Coinbase. Healthtech experienced a small gain year over year as well, with multiples expanding from 2.5x to 2.8x.

Why this matters: While the S&P and Big Tech’s rally in the previous month have been encouraging for multiple recovery, there are still many uncertainties surrounding the sustainability of this rally. Fears largely surround continuing stubborn inflation, as well as the impact of the US being in a higher interest rate environment for the long term. Start-ups will have to figure out how to continue operating under the new “normal” of fundraising money being harder to get their hands on. Later stage start-ups will be under the most pressure, as maintaining the valuations they raised at in 2021 is going to be extremely difficult in this environment. We have already begun to see more debt financing, structured financing, and down rounds, and believe these will continue as we get further into 2023.

May's Top Ten:

  1. Fanatics has moved closer to an IPO, hiring Meta’s head of investor relations. While an IPO is not on the immediate horizon for the company, the new hire of Deborah Crawford signals the company is starting to get its ducks in a row. Fanatics achieved a $31 billion valuation after a $700 million raise in December 2022.

  2. Klayvio has thrown its name in the hat as a possible contender to IPO this year, as they have confidentially submitted paperwork with U.S. regulators for an initial public offering. While no IPO terms have been laid out yet, the company is considering a raise of at least $750 million in the listing. As of its last financing round in 2021, Klaviyo was valued at around $9.5 billion.

  3. In what looks like to be one of the biggest biotech IPOs in 2023, drug developer Acelyrin announced the pricing of its initial public offering of 30,000,000 shares of common stock at a price of $18 per share. Gross proceeds from the offering are expected to be $540 million.

  4. To close out our IPO news for May’s Top Ten, Cava, the fast-casual Mediterranean chain, filed to go public through an initial public offering this month. While the company is currently not profitable, net sales increased by 12.8% last year.

  5. AI continues to control the narrative in the VC world, and Bessemer has been leaning into it hard. The VC fund has decided to drop $1 billion on AI startups. Other VC funds have followed suite with similar commitments, with Sound Ventures announcing a $240 million fund dedicated to AI, Salesforce Ventures with a $250 million AI fund, and Lux Capital with a $1.15 billion fund.

  6. While AI is the new Silicon Valley darling, the previous ones (AV) is struggling. Most recently, autonomous delivery startup Nuro is in the midst of a restructuring that will result in layoffs and shift resources away from commercial operations and toward R&D. Nuro has raised $2.13 billion over the years is hoping to extend its runway further to contend with a tighter fundraising environment.

  7. Elon Musk stans were rejoicing this month after learning that yet another Musk company has made headlines with positive news this month. Neuralink has announced FDA approval of in-human clinical studies for its brain implant device. The implant aims to help patients with severe paralysis to regain their ability to communicate by controlling external technologies using only neural signals.

  8. Continuing on the AI note, Anthropic completed a $450 million round in May from investors such as Google and Spark Capital. The latest round brings Anthropic’s total funding up to nearly $1 billion. Sources put the current valuation at nearly $5 billion.

  9. The second largest funding round of the month was completed by ElevateBio. The company announced a $401 million Series D financing to help enable expansion and scale the company’s cell and gene technology platforms, end-to-end capabilities, and therapeutic pipeline. The round was led by AyurMaya Capital Management.

  10. New Jersey-based cryptocurrency lender Celsius has announced it will be bought by a consortium called Fahrenheit. The company filed for bankruptcy in July 2022 when the crypto sector was rocked by trouble at big players Terraform Labs and Binance.

Why this matters: As you have probably noticed in this most recent issue, more and more of our top 10 is starting to involve start-ups moving toward an IPO exit. We hope that in upcoming months, we will have even more IPO and acquisition news to share.

Startups that are still hiring!

Open positions are per the company's website.

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