Financial services startups attracting VCs

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, it would not be surprising to see venture investors running from any deal that’s even remotely related to financial services. But financial services startups are attracting more venture money than they have in the past five years.

Venture firms 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 an analysis of data provided by Thomson Financial. 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 have since 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, according to Thomson data.

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.”

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.

Tod Francis, a managing director at Shasta Ventures, 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 that 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. Mint competes against a host of personal finance startups that have also raised new venture rounds, including Wesabe and SpendView, and angel-backed Buxfer.

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. Online trading has quickly spread beyond equities to other asset classes such as foreign exchanges. 3i and VantagePoint Venture Partners participated in 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.

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.

A longer version of this story appeared in VCJ, a PE Week affiliated publication.