In the VC world, there seems to be a fairly strong bias against pitching your company by saying, “We’re like X, but for Y.” Most commonly, the “X” in the aforementioned sentence refers to Uber or Warby Parker (although there are some more colorful examples out there if you’re looking for ideas.) While the description may be a useful shorthand, detractors would argue being “X for Y” is indicative of laziness or derivative thinking on the part of the founding team.
In this post, I’d like to argue the contrary for one market in particular: payments. Said a different way, being “Stripe for X” is actually a pretty great business. If you can master the payments workflow of a particular vertical, you can build a great company — and that’s why “Vertical Payments” is one of our biggest focus areas for 2016.
The Vertical Software Premium
The case for vertical payments companies echoes that of “Vertical SaaS”, an investment theme that is pretty well-covered in the VC blogosphere, and underpins some of the great VC success stories of the past few years (Guidewire in insurance, Veeva in pharmaceuticals, Textura in construction, and Opentable in restaurants, to name a few). I’m definitely not an expert here, but the basic distillation of the thesis is as follows: Many niche industries are reliant on antiquated and often on-premises technology systems, and have yet to adopt the latest and greatest in SaaS due to a “club mentality” among technology buyers. While the horizontal players (e.g., Salesforce, Workday) have made progress and often have vertical-specific sales teams, being laser-focused on one particular vertical affords several advantages to the vendor.
These advantages start with the product design itself— by understanding a user and his / her unique workflow, you can strip away extraneous features and offer a software package that’s purpose-built, out of the box. Vertical software vendors often augment their products with industry-specific data sets as well (e.g., Costar in commercial real estate). Product focus feeds into another major benefit: greater sales and marketing efficiency, through focused sales efforts and word-of-mouth awareness within smaller buyer communities.
Altogether, the vertical focus yields a pretty meaningful business model advantage for SaaS companies, as demonstrated in some key financial metrics, averaged across a sample of 30 publicly-traded vertical and horizontal SaaS companies. As I’ll touch on in a moment, the Vertical SaaS theme provides a great analogue for payments businesses as well.
Enter the Payments Processing Conundrum
Payments processing has historically been a great industry, benefiting from a secular shift from paper-based transactions to card and electronic payments, alongside a widespread migration of buying behavior to e-commerce (which requires a card-not-present electronic transaction). The companies in the space also demonstrate high degrees of recurring revenue and strong margins (especially the card networks, which frequently run 50–60% EBITDA margins). However, it has become popular to say that payment processing is really just about moving bits of data, and that intermediaries are merely rent-seeking “dumb pipes” — consequently, the cost of moving money from point a to point b should be zero. While I wouldn’t go that far, it is undeniable that take rates in the payment processing business have declined over the past few years, due to commoditization, competitive pressure and regulations in the U.S. and the E.U.
Whether or not you believe in the promise of modernized, near-free payment rails (e.g., same-day ACH or even bitcoin), it is reasonable to believe that core payment processing margins will continue to compress over time.
Towards the “Re-bundling” of Payments
What we’re starting to see in response is the movement towards integrated (or as Matt Harris says, “submerged”) payments: the tight coupling of payment processing and the software systems that help consumers and businesses transact. Incidentally, I wrote a post a while back about the unbundling of the financial services value chain; this is a notable exception where the opposite is true.
In the horizontal merchant processing world, the benefit of this integration is simplicity to the merchant and end consumer. Take Square , for instance; from their S-1:
“ We deliver tightly integrated services using a full-stack development approach that combines product management, development, and design… The benefits to our sellers include fast, easy, and inclusive sign-up; simplicity; affordability; transparent pricing; fast access to funds; and the ability to take payments anywhere, anytime.”
Gateways like Stripe and Braintree are also great examples of the value of bundled payments, with easy-to-use APIs that allow app developers to slip transactions directly into the end user flow with just a few lines of code. In the processor space, Mercury has led the way in integrated payments, and other big processors have followed, with First Data, Heartland / Global Payments and others making large software buys to move upstream in the value chain.
Given that the leaders of the horizontal integrated payments movement are well-established, what’s exciting to me now is the potential application of this same playbook in specific verticals. Thinking back to our Vertical SaaS thesis for a moment, every single benefit of the vertical strategy holds true for companies that facilitate payments as well — from product focus to sales / marketing efficiency — and by tightly coupling software with payment processing, vendors can develop relationships with payers and payees that prove to be even more sticky over time. There are already some great success stories to which we can point, such as MindBody in fitness, Yapstone in travel & rentals, Emdeon in healthcare, and Flywire in higher education.
Flywire, an F-Prime Capital portfolio company whose first use case is helping universities process international tuition payments, is a perfect case study for the value of an integrated, verticalized payments strategy. The company solves a meaningful problem on both sides of the transaction: international students face a confusing and expensive experience when paying for their education from abroad, and universities struggle with the process of reconciling confusing wire transfer instructions to their accounting and student registration systems. By focusing on this very specific pain point, the company has grown rapidly and has quickly become the leading company in the space by market share.
Looking forward, one way to prioritize the vertical payments opportunity is a simple graph, with total dollar volume transacted on one axis and the complexity of the industry’s workflow on the other. The former describes the potential value from the payments revenue stream, assuming some take rate on volume processed, and the latter shows the potential value from the software revenue stream (note — this one is totally subjective, but in general, companies are willing to pay more for software that solves challenging problems).
The natural takeaway from this chart is a massive opportunity at the top-right, in healthcare payments (which is worth detailing in a subsequent post). But note also that even the bottom-left example, MindBody, is a venture-backed, public company with almost $100M in revenue and a $450M market cap — and there are plenty of other industries not even mentioned here that are just as promising. I look forward to seeing more companies tackle these markets in the future — and won’t think twice if they lead by saying, “We’re Stripe, but for X.”