Fintech Compliance: A New Focus for Venture Capitalists in the US

With the rise of regulatory challenges in the fintech industry, companies are facing new obstacles when it comes to launching and expanding their operations. To overcome these hurdles, a fresh approach to compliance risk management is essential. Venture capitalists must now recognize the significance of prioritizing regulatory compliance capabilities as a key factor for long-term and sustainable growth. Ensuring compliance with regulations must now extend beyond mere policies and procedures; it must be an integral part of the ethos of fintech companies. 

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Strong Regulatory Headwinds

Global Funding has seen slippage for fintech ventures over the past year, in the Americas fintech investment dropped from $95.4 billion in 2022 to $78.3 billion in 2023, with the United States accounting for $73.5 billion in funding dollars. As venture appetite shifts from latter stage companies to pre-seed / seed fintechs it's important to understand the increasing headwinds battering this segment.  

From enforcement agency activities to barriers to strategic partnerships that are instrumental in  rapid growth strategies; it’s important for investors to be aware of these risks and ensure their fintechs have a plan for overcoming them.  Enforcement agencies in recent months have targeted compliance deficiencies related to Consent Order - Anti-Money Laundering (AML) laws, Consent Order - Third - Party Risk Management Program , and Consent Order - Fair Lending (ECOA).  

Remarks from FDIC Chairman Martin J. Gruenbard on September 20 2023 indicated agencies are seeking to pave roads that will allow for direct authority by agencies over nonbank financial institutions. In preparation for this inevitable state of increased oversight, fintech firms must adopt proactive compliance strategies to ensure their growth and survival in an increasingly competitive and regulated market.

Impact of Non-Compliance on FinTech Growth and Survival

The consequences of regulatory noncompliance for fintech companies are far-reaching and multifaceted, impacting not only their financial health but also their reputation and operational capabilities:

• Financial Implications:
  • Over 86% of fintech companies incurred more than $50,000 in compliance fines last year, with more than 37% paying over $500,000 1.
  • In response to the current temperature BaaS banks have raised the proverbial walls,many banks now require fintechs to have longer capital runways. In the past quarter we have spoken to several banks that require minimum funding of $2.5MM - $3.5MM to even be considered for an initial partnership conversation,and that is with or without active users (meaningful traction). 
  • A significant 60% of fintechs faced at least $250,000 in compliance fines in the past year, underscoring the hefty financial burden of noncompliance 2.
• Operational and Strategic Consequences:
  • Fintech regulatory noncompliance can lead to loss of top talent or premium talent shunning the organization due to risk of reputational harm.
  • Fintechs engaging in Banking-as-a-Service (BaaS) inherit the compliance issues of their partner banks and middleware providers creating heightened business continuity risk, as seen in BaaS players' decisions to abruptly pull out of the market 3.
  • Inadequate compliance programs can result in stunted growth or loss of value, highlighting the importance of robust compliance measures 4.
• Expansion Challenges:
  • Consent orders at the Bank level almost always include innovation and growth choke points that are not removed until the agency is satisfied with remediation efforts. This can mean for fintech, the speed of product evolution and product offering expansion can at times be several slowed and in some cases completely halted. 
  • Non-compliance can lead to diverted resources and an inability to perform as projected, ultimately resulting in missed growth milestones jeopardizing the viability of long-term success. 

These few points illustrate the real world impact compliance failure can have on a fintech’s ability to navigate the market and perform as predicted at the initial raise.

Strategic Importance of Compliance for FinTech Growth

In the dynamic world of fintech, compliance emerges not just as a regulatory requirement but as a strategic cornerstone for sustainable growth and partnership. Here's how compliance intertwines with the operational fabric of fintech companies:

• Foundational to Growth:
  • Compliance is integral from the outset, laying the groundwork for growth and partnership. It's not an add-on but a fundamental aspect of a fintech's operational strategy.
  • Direct communication with banks is pivotal for devising suitable compliance programs, ensuring fintechs navigate the regulatory landscape effectively
  • Embedding compliance into finance programs from the start can immediately identify and mitigate potential risks, safeguarding against future regulatory hurdles.
• Trust and Competitiveness:
  • Regulatory compliance bolsters trust among customers, investors, and regulators, serving as a testament to a fintech's commitment to lawful, ethical, and oftentimes, optimized operations
  • A well-implemented compliance program not only enhances a fintech’s trustworthiness but also its competitive edge, fostering innovation within the regulatory framework.
  • Despite the challenges, with 93% of fintechs finding compliance requirements demanding, the financial and strategic benefits of robust compliance programs are undeniable 7.
• Navigating Compliance Challenges:
  • Understanding the full spectrum of the regulatory environment, acquiring necessary licenses, and implementing comprehensive scalable systems are crucial steps for ensuring compliance.
  • Fintechs can navigate these challenges by deploying a multi-faceted approach leveraging subject matter experts with real world experience, automation tools, technologists, and strategist or building an effective compliance team, guided and approved by legal advisors to ensure the compliance program evolves with regulatory changes and product development.
  • Addressing concerns such as the financial cost of compliance and adjusting to regulatory changes proactively can unlock opportunities for improvement, notably through automation, enhancing efficiency and compliance robustness

Venture Capitalists' Growing Focus on Compliance

Venture capitalists (VCs) are increasingly recognizing the importance of compliance fintech and risk management in the fintech sector, especially in challenging economic conditions. This heightened focus is driven by several key factors:

• Prioritization of Compliance for Growth: In a down market, VCs and their portfolio companies understand that fintech compliance and risk management should not be sidelined but prioritized for sustainable growth 5.
• Influence on Investment Decisions: During the due diligence process, fintechs with robust compliance programs are perceived as less risky, making them more attractive to investors. This indicates that compliance programs significantly influence investment decisions.
• Foundational Requirement for Partnership: For VCs investing in financial technology startups, compliance is increasingly seen not as an afterthought but as a foundational requirement. This shift highlights the strategic importance of compliance in fostering growth and partnership, especially when considering the banks' preference for fintech partners that prioritize compliance.

Furthermore, the recent surge in attention towards fintech compliance startups, particularly regtech startups, underscores the sector's growing significance. Despite a general decrease in fintech funding since 2021, regtech startups experienced a record-breaking year in 2022, with deals amounting to $20.9 billion 6. This trend showcases the burgeoning interest and investment in fintech compliance solutions, marking it as a critical area of focus for VCs looking to capitalize on the evolving financial technology landscape.

Conclusion

The necessity for fintechs to navigate the labyrinth of legal requirements, from anti-money laundering laws to third-party risk management and beyond, underscores a transformative shift in the industry. Venture Capitalists, recognizing the integral role that compliance plays not only in securing the operational longevity of fintech startups but also in preserving their investment positions, are redefining the contours of fintech funding strategies.

As the fintech ecosystem evolves, its growth remains tethered to the ability for companies to align operational strategies with market conditions. Harmonization of risk mitigation and operational ambitions not only fortifies trust among stakeholders but also carves out a competitive edge in a currently restrictive market. For fintech firms and venture capitalists alike, the journey toward sustainable development necessitates embracing compliance as a strategic bedrock, rather than a regulatory hurdle. In navigating this path, the insights garnered here offer a blueprint for success. Should you seek to refine your foothold in this turbulent market, feel free to reach out to discuss your compliance strategy, ensuring your venture not only survives but thrives in the complex fintech landscape.

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