$5.5 Million for Neighborly: Proof that Fintech is Now a Bubble
Neighborly, a municipal finance startup that just raised $5.5 million despite the lack of a proven revenue model, offers more evidence that the Fintech boom has become a DotCom-style bubble.
At its founding, Neighborly created a crowdfunding model for civic projects. People who wanted to contribute to local infrastructure projects could donate to these initiatives on the Neighborly platform. Unfortunately, there are a couple of problems with this business. First, general purpose crowdfunding platforms like Indiegogo can be used to raise money for civic projects and have a lot more traffic.
Second, most of us already pay taxes, some of which are supposed to finance infrastructure. Having already been obliged to fund the government, most of us are unwilling to contribute more. The best evidence of the difficulty in getting people to donate to government comes from the US Treasury’s unsuccessful efforts to pay down the national debt with contributions. Despite soliciting contributions in Form 1040 instructions and online, the Treasury received only $1.5 million in donations toward its $18 trillion debt in the most recent fiscal year.
More recently, Neighborly “pivoted” away from crowdsourcing donations to selling municipal bonds to millennials. But, as Matt Levine (on Bloomberg) and Kristi Culpeper (here at Medium) have observed, millennials (adults under 35) are a poor fit for municipal bonds. Aside from tech workers in the Bay Area and other hotspots, most millennials have limited investable assets. They are struggling to pay off student loans and/or making ends meet with relatively low incomes.
Since municipal bonds are exempt from federal income taxes (and, in most, cases state and local income taxes) their yields are lower than taxable investments with similar characteristics. Municipal bonds are thus most suitable to investors in high tax brackets, i.e. those with higher incomes. This high income category tends to be disproportionately populated by older folks.
Moreover, investing in municipal bonds generally does not make sense even for high income millennials. Younger investors saving for retirement have a long time horizon; they are thus better off investing in equities which can be expected to outperform fixed income investments over long time frames. Although stocks may underperform bonds in any given year; they are unlikely to do so over the 30–40 year investment horizon millennials have. Also, tax exempt securities are a poor choice for tax deferred savings vehicles like IRAs and 401k’s - where millennials should be placing most of their investments.
Of course, there are times when high income millennials need to save for near term goals, like accumulating a down payment on a house. In these cases, the millennial investor is likely better off with a federally insured high yield CD available on bankrate.com as opposed to making a concentrated investment in a municipal security with a similar yield and some risk of default.
This problem could be ameliorated by another idea Neighborly is pursuing: municipal mini bonds. Today, most municipal bonds sell in denominations of $5000 — beyond the reach of many millennials. Neighborly has been inspired by AAA-rated Denver’s success in selling “mini bonds” with $500 denominations and has aspirations to facilitate similar deals. One reason for the success of the Denver bonds is that the city offered yields of 4.38% for nine year bonds and 4.89% for bonds maturing in 14 years — well above rates for similar maturities being paid by other AAA issuers. To the extent that the Denver model relies on overpaying investors, it won’t be able to scale once taxpayers find out that their money is being wasted on excessive interest payments.
Neighborly created its own mini bonds in California — but could only do so by building a Rube Goldberg contraption. The company bought school district bonds on the secondary market and housed them in a special purpose entity (SPE) which, in turn, issued securities backed by $500 units of the municipal bond. California law limits SPEs of this type to 35 investors, so a new entity would be needed each time Neighborly wanted to sell another $17,500 bonds (assuming all investors bought the $500 minimum). This means a lot of legal and administrative overhead to set up the entities and then subdivide the small coupon payments for each “mini-bond” owner.
Neighborly’s lead investor, Joe Lonsdale has suggested other directions for Neighborly including underwriting and rating municipal bonds. But these functions have incumbent players that benefit from economies of scale and barriers to entry. For example, rating agencies typically operate under an SEC license that is difficult to obtain. It is not clear just how a bunch of programmers operating from a house in Twin Peaks can gain share in these markets, let alone do so profitably.
Lonsdale, Ashton Kutscher and other Neighborly investors have a lot of money, and undoubtedly can afford the $5.5 million loss they stand to take on their Neighborly investment. But, as Kristi Culpepper correctly predicts: Neighborly will not disrupt the municipal bond market. And, at some point, VCs will realize that funding a bunch of bright young people to pursue a broad-brush idea without a coherent revenue model, is symptomatic of a market top. It is then that the Fintech bubble will burst.
