In part one of this essay, I discussed how fintech was moving from being a business model unto itself, to being an ingredient used in other technology businesses. This is what we refer to as the fourth platform, joining Internet, Cloud and Mobile in the modern technology stack. In Part 2 we will discuss why this is happening, and give some early examples.
Benefits of embedded financial services
When you look at the benefits of this embedded financial services model, the first point is obvious: as a technology founder, you’re already going through the hard work of acquiring customers, and as a result you have created the opportunity for a zero customer acquisition cost cross-sell. But the opportunity goes well beyond that basic business logic.
Having these financial functions integrated with software enables new functionality, leveraging the persistent connection to move beyond transactions to relationships. We’ve already been trained to conduct financial transactions inside of software applications (think payments inside of Uber), so if you’re utilizing software to run your business, using that same software to get paid and make payments is logical and more natural than going to your financial institution to do so. These relationships are data-rich, which leads to smarter cross-sell, prequalification and massive risk reduction. The monetization opportunities are not only large, but actually meaningfully larger than the original software opportunity.
As with most financial innovation, the first subsector to evolve is payments. When you look at payment card volume in the United States, for example, eight percent of it has migrated to what we call integrated payments, that is, merchant payments that are sold and managed through software companies as opposed to traditional payments companies. That portion is growing at two times the rate of the overall market, and analysts estimate it will hit 40 percent in the medium term. Why?
Take Shopify, a $36 billion software company that helps small businesses get online and setup e-commerce sites. You could think of it as shopping cart software. But at this point in time, the majority of its revenue comes from payments and that proportion is increasing. If you look at its website, you can see our thesis in action: zero CAC natural cross-sell, instant set up (most payments companies have to underwrite their merchants for risk, which takes time and hassle), novel functionality integrating settlement process and data into existing workflow, and then obviously additional revenue/enhanced monetization.
There are similar stories at many of our own portfolio companies. When we invested in AvidXchange four years ago, it was a majority software company, but by next year it will be 80 percent payments. Zelis Healthcare, which recently combined with RedCard Payments to form the next-generation leader in healthcare payments optimization, will scale from 20 percent payments to 40 percent payments in the next few years. We recently invested in Finix, the leading company enabling software companies to become payments companies.
In certain segments, the innovation has come in waves. For example, take the rental payment market, which started with old school payments companies like FirstData, then progressed with Fintech 1.0 player, ClickPay, and now to the fully-embedded model, Cozy. However, our bet is that companies like SmartRent represent the next generation, with an even deeper integration.
SmartRent sells and installs home automation hardware into rental buildings, and uses that as a methodology for getting widespread and persistent connectivity to tenants in the form of its app. This year, it will incorporate rent payment into the app, and as soon as next year will sell renters insurance. SmartRent is the logical evolution of insurtech companies like Lemonade — zero CAC, integrated into its own smart lock and leak detection system for a persistent data-rich connection and novel functionality, and with excellent incremental monetization.
Within lending, we’re starting to see some early examples of embedded fintech. For example, we’ve seen the rapid rise of the payroll advance lenders. This type of loan recognizes that workers are paid in arrears, and have a balance of worked hours that can represent, in effect, collateral for a loan. This began with the 1.0 versions, like Dave, which finds borrowers through marketing channels and attempts to underwrite their hours worked algorithmically. This has quickly evolved to where modern software-driven payroll companies like Gusto can offer this functionality through their employer’s customers, reducing CAC to zero, increasing data-richness and validity through their ownership of the payroll system, and adding another leg of monetization.
Our portfolio company Wisetack provides an API-driven infrastructure for software companies to add point of sale lending to their offerings without becoming lenders themselves. Lambda School, ostensibly an edtech company, has leveraged an innovative financing product called an ISA, creating unprecedented alignment between the school and its students. If SoFi is a classic Fintech 1.0 company (digital student lending!), Lambda is an early example of a technology company leveraging fintech as a platform.
In the insurance sub-sector, this trend is just getting started. We see companies like Tomorrow, Freewill and Trust & Will building beautiful software to enable charitable giving or end-of-life document creation, and monetizing through financial advice and life insurance. Technology-enabled companies like Tesla and Quip are looking to better monetize their customer bases and further validate the efficacy of their products by bundling insurance. If the car reduces accidents, or the toothbrush reduces cavities, it creates an economic surplus that should be reflected in cheaper insurance.
Where do we go next?
If the analysts are right, and 40 percent of the payments industry will move to an embedded model, and if we stipulate that lending and insurance will reach, say, 20 percent each, then this fourth platform shift — whereby fintech underpins all software companies — will be the big one.
At a five times revenue multiple this transformation will create $3.6 trillion of value. I’ll happily acknowledge that the internet is a big deal, sure. Cloud, mobile, great. But to put things in perspective, those three platforms together produced just under $3 trillion of value for founders, venture capitalists and everyone involved in the startup ecosystem. But we think, and the data clearly suggests that the opportunity in front of us now is even larger.
With the potential to create an entirely new landscape across technology, financial services and across every segment of the economy, we believe that every founder should be trying to figure out how to get ahead of this transformation and figure out their essential role in this next great platform shift. We look forward to partnering with you to do so.