Financial Technology, or “fintech,” is one of the fastest growing sectors in finance. In 2010, the total amount of funding raised by fintech firms was just over $1 billion dollars, while in 2018, total funding was around $40 billion. In 2018 alone, U.S. banks invested in 45 funding rounds of fintech firms, suggesting that banks are beginning to hedge their future by participating in such strategic deals. Non-financial services firms like Amazon and IBM have also invested in fintech firms, e.g., Amazon has invested in Bill Me Later, which itself was acquired by PayPal.
In a new paper, we addressed several questions raised by these investments. First, we examined the motivation of fintech startups in accepting investments from corporations and the effect of such investments on the startups’ future performance. Large public firms may invest in startups to obtain data, learn more about the startups’ business strategies and products, and launch competitive. For example, Amazon has invested in many startups and launched competing products. Banks also compete directly with fintech firms in the product market while providing key infrastructure to such firms.
Second, we analyzed the main motivation of U.S. public firms (corporate investors) to invest in fintech startups. Do these investments help improve the firms’ product market performance or are they merely empire-building exercises for managers? What are the determinants of such investments? Further, are the effects of such investments different for corporate investors in the financial services sector (which may have greater synergies with fintech startups, e.g., PayPal) than for other companies (which are unlikely to have high synergies with fintech startups, e.g., Amazon)?
We focused on the effect of corporate investment in fintech startups because the economic relationships of such investors and investees are fundamentally different from those of companies in other industries. Fintech startups compete with corporate investors (corporations in the financial services sector) contemporaneously in the product market by creating disruptive innovations. It is interesting to investigate whether fintech startups benefit from such investment or whether it is only the corporate investors that gain from investing in fintech startups (or neither corporate investors nor fintech startups benefit from such investment).
We obtained our data on fintech startups from the Venture Scanner database. We augmented our dataset with data from Crunchbase and VentureXpert. We used the National Establishment Time Series (NETS) database to obtain information on sales and employment of private firms. We used PatentsView to obtain data on patents and inventors. We also identified the corporate investors in fintech startups from the Venture Scanner database. We focused on publicly listed corporate investors for our second set of research questions and used the Compustat dataset to analyze their performance. For some of our analyses, we categorized such corporate investors as financial services versus non-financial services firms.
As to the first set of research questions, we found that the presence of corporate investors in various investment rounds of fintech startups is significantly and positively associated with a greater probability of successful exits of such startups, as measured by IPO or acquisition. Next, we showed that corporate investments have a positive and significant effect on the innovation output of fintech startups. We also showed that corporate investors help fintech startups attract inventors. Our results were economically significant, e.g., the presence of a corporate investor in at least one of the investment rounds leads to a 7.7 percentage point increase in the probability of successful exits of fintech startups.
To test whether our baseline regression (ordinary least squares (OLS)) results were driven by selection and value-addition by corporate investors, we controlled for the selection effect by using instrumental variable (IV) analyses to estimate the effect of value-addition by corporate investors. We used the change in aggregate sales of publicly listed firms in the financial services sector over the two years prior to the investment year as our instrument for corporate investment. The underlying intuition was that when the sales of publicly listed companies in the financial service sector falter, they are more likely to invest in fintech startups to arrest this decline. Our IV analyses showed that even after controlling for selection effect, corporate investment adds value to fintech startups.
Next, we showed that synergy plays an important role. The investment by corporate investors in the financial services sector is positively associated with successful exits, innovation output, and the hiring of inventors at fintech startups. However, investment by corporate investors in the non-financial services sector has no effect on the above outcomes of fintech startups.
As to our second set of research questions, we first showed that firms whose sales dropped tend to make investments in fintech startups in subsequent quarters.
We next investigated the effect of investment in fintech startups on the performance of corporate investors. We used a stacked difference-in-differences (DiD) framework. First, we showed that corporate investors in the financial services sector that made investments in fintech startups experienced an increase in their profitability and market share compared with control firms in the same three-digit industry code that did not invest in fintech startups. However, we did not find any such effect for corporate investors in the non-financial services sector. Second, we showed that such corporate investors experienced an increase in their market valuation compared with control firms in the same industry that did not invest in fintech startups. Again, we did not find such an effect for corporate investors in the non-financial services sector. Economically, we did find that such corporate investors experienced an average increase of 50 percent in their profitability and an average increase of 9.1 percent in their market share, respectively. Further, our dynamic DiD analyses showed that the parallel trend assumption is validated.
We conjecture that the benefits of synergies between corporate investors and fintech startups might occur through different channels. We hand-collected data on whether a corporate investment has led to a strategic alliance based on media coverage. For example, Visa Inc. made an investment in Square, which was then a startup, on January 10, 2011, and on April 27, 2011, there was a news article that mentioned the formation of a partnership between Visa Inc. and Square. Our empirical analyses suggested that strategic alliance formation between fintech startups and corporate investors is an important channel that helps corporate investors in the financial services sector to improve their product and financial market performance. We also investigated the second potential channel and did not find any evidence consistent with the hypothesis that corporate investors benefit from their investment in fintech startups through launching new products after learning about such products from fintech startups.
This post comes to us from professors Thomas J. Chemmanur at Boston College’s Carroll School of Management, Harshit Rajaiya at the University of Ottawa, Michael Imerman at the University of California, Irvine, and Qianqian Yu at Lehigh University. It is based on their recent article, “The Entrepreneurial Finance of Fintech Firms and the Effect of Investments in Fintech Startups on the Performance of Corporate Investors,” available here.