Payments Ecosystem Part 3: Taking Payments
This is part 3 of a 4 part series on the Payments ecosystem. I plan on releasing one part per week for the next 2 weeks. Part 2 to this series is available here.
How can a Merchant Start Accepting Card-Based Payments?
Emmet’s dad, Mufasa, opens up a donut shop called Dad’s Donuts. Initially, he was just taking cash but realizes that he turned away a lot of customers because he couldn’t accept credit and debit cards. It seems like more and more people just don’t carry cash! Mufasa started looking into different solutions for accepting credit cards and saw a few options:
Use an ISO or Merchant Acquirer Directly
Mufasa could work directly with a Merchant Acquirer, such as Wells Fargo, to get a Merchant Account. If Mufasa doesn’t have a direct relationship with a Merchant Acquirer, such as Wells Fargo, he could go through an Independent Sales Organization (ISO) to establish this relationship. The Merchant Acquirer, in this case, Wells Fargo, then offers point-of-sale devices to accept card-based payments through its partners such as First Data. Going with a Merchant Acquirer directly will take a little more onboarding time but will provide a wider range of choice of hardware and software for the Merchant.
Key Term: Independent Sales Organization (ISO)
An ISO is granted a license to sell Merchant acquiring services from a Merchant Acquirer such as Wells Fargo or Chase Paymentech.
Use a Payments Facilitator
Another option, since he is just starting his business, is to work with a payments facilitator (sometimes referred to as a PF or PayFac) like Square or Toast to open a sub-Merchant account and get the point-of-sale device directly through them.
Key Term: Payments Facilitator (PF or PayFac)
This is a layer on top of a Merchant Acquirer. Payments Facilitators can typically onboard Merchants very quickly and offer out-of-the-box hardware and software to enable a Merchant to start accepting card-based payments quickly.
Donut Shop Is Just Getting Going: Use a Payments Facilitator
Mufasa has been making donuts for years using his mother’s recipes but only recently had the courage to open up a real donut shop. As with many entrepreneurs, there is a lot of uncertainty in if customers will like his donuts and whether he will be able to earn enough income to support himself and his business. Mufasa knows that customers are willing to pay him, but he doesn’t have enough history as a business to open up a Merchant Account directly with a Merchant Acquirer. This is why Mufasa opts to get a payments solution from Square, a Payments Facilitator.
Benefits of Using a Payments Facilitator
Cool Hardware
Mufasa really likes the option from Square because his cash register was pretty clunky, and he wasn’t able to customize it. Square’s register is able to accept card payments and also cash payments. Another benefit is that it can accept payments from Apple Pay and Google Pay, which he knows his customers like using.
Fast Setup
Additionally, the setup process for Square is really easy. He set up an account within minutes by providing Square some information online. This can be done because Mufasa’s donut shop would be considered a sub-Merchant under Square.
Fixed Pricing
He also saw that the pricing with Square was very simple, every swipe, dip, or tap would cost him 2.6 percent plus 10 cents regardless of if it was a debit card or credit card. This way, he can factor that cost into each donut. This is referred to as fixed pricing.
Managed Fraud
When a customer sees a transaction that looks inaccurate, they will often call their Issuing Bank to get money back; this is referred to as a chargeback. In this scenario, Mufasa doesn’t have to worry about a chargeback because the Payments Facilitator will provide Mufasa with tools to combat these chargebacks. Mufasa doesn’t need to do any direct follow-up with Visa or Mastercard or the customer in this scenario.
Other Services His Business Needs
In addition to accepting card-based payments, many Payments Facilitators offer other services and products that are specific to the company. Small retail businesses and restaurants like Mufasa’s donut shop need things that can help manage their inventory, offer receipts to their customers, and allow them to add new SKUs to sell.
Mufasa will also want some analytics that can tell him what his best-sellers are and times of heavy traffic in his store so he can staff it accordingly.
Drawbacks of Using a Payments Facilitator
Being a Sub-Merchant
While from the get-go, this didn’t matter so much to Mufasa, his donut shop is actually considered a sub-Merchant. Square is considered the main Merchant and already works with several Acquirers and banks to build a set of Merchant types. Mufasa’s business fell into the “Restaurants” category. Because Square services so many restaurants, this was a very easy business for Square to underwrite. The drawback here is that anytime someone swipes a card at Mufasa’s donut shop, the transaction history at the customer’s bank will always start with an “SQ*.”
Fixed Pricing Can Be Expensive in the Long Haul
While the pricing was very transparent with Square, it was a bit pricier than some of the other options out there. Had Mufasa gone with a Merchant Acquirer directly, his cost would go down over time as he sells more donuts.
Potential Funds Settlement Delay
If a customer buys a donut from Mufasa today (time = t), the network typically clears the transaction the following day (t+1). When this happens, funds settle with Square’s bank tomorrow (t+1), and then Square will perform a calculation taking their 2.6 percent plus 10 cents out of the transaction and then send the funds to Mufasa’s account at Square. If Mufasa would like these funds to go to his Wells Fargo bank account, then Square will send an ACH of this to Wells Fargo, which could take at least another day if not more (t+2).
How Do Payments Facilitators Make Money?
Most Payments Facilitators make money in two ways:
Revenue From Software or Hardware
Because most Payments Facilitators offer their own hardware, they make money off of the initial sale or sometimes lease the hardware. In addition to that, Payments Facilitators like Square and Toast offer other software and services like inventory management, payroll, and scheduling software. Additionally, Merchants can take working capital loans from some Payments Facilitators.
Revenue From Each Transaction
The major revenue source for most Payments Facilitators is the per-transaction fee. To make things simple for Merchants, Payments Facilitators typically charge a flat fee regardless of the type of card (in Mufasa’s case, he’s paying per swipe 2.6 percent plus 10 cents). On the back end, the Payments Facilitators are paying the card Issuers Interchange and the network’s network assessment fees. Additionally, they are paying their Merchant Acquirer the Acquirer fee. Because the Payments Facilitator is underwriting multiple Merchants under them as sub-Merchants, the transaction volume from all sub-Merchants is aggregated for the Payments Facilitator. With higher transaction volume, the Payments Facilitator is able to negotiate very low Acquirer fees.
The flat transaction fee that is charged to the sub-Merchants in most cases is higher than what the Payments Facilitator pays in Acquirer fees, Interchange, and network assessments, which is where they make their margin.
Donut Shop Experiences Explosive Growth: Moving to a Merchant Acquirer
Mufasa’s donuts became a huge hit, with a line that forms around the building in the mornings. He quickly realizes that he has passed $500k in annual transaction volume. That’s a lot of donuts! He has a conversation with his Square rep and they determine it may make sense for Mufasa to set up a direct Merchant Account. He now has to see what the benefits and drawbacks are of opening up a direct Merchant Account through a Merchant Acquirer.
Benefits of Using a Merchant Acquirer
Being a Direct Merchant
As a direct Merchant, Mufasa would be able to show the name of his donut shop in the transaction history of his customers’ accounts. There wouldn’t be an “SQ*” added to the front of the transaction as there would as a sub-merchant. He also would be able to control the exact Merchant Category Code associated with his business, which could help lower his Interchange rate.
He also won’t have a top limit of dollars he can transact within a year, which opens him up for growth. This is typically $500k for Payments Facilitators under the sub-merchant arrangement.
Hardware and Software Options
Mufasa’s can still use Square’s hardware and software, but if he wanted to, he could choose other products to help him manage his payments, inventory, and accounting.
Interchange Plus Pricing
By using a Merchant Acquirer directly, Mufasa has the option to use flat pricing as he had with Square or choose Interchange Plus pricing.
Interchange Plus works much like Emmet’s mocha example, where each swipe would incur an Interchange fee that would be a percent of the total transaction, a Network Assessment fee that is typically percentage based, and then an Acquirer fee that can be a percentage or a flat amount per transaction. Based on Mufasa’s donut shop’s Merchant Category Code and the type of card his customers use, Interchange Plus pricing could vary dramatically for each transaction, but overall, his costs should go down because he is doing some serious volume!
Typically, the Acquirer fee can be set up on volume tiers, meaning that this cost could go down based on the total monthly volume at Mufasa’s donut shop.
Faster Funds Settlement
With a direct Merchant account, Mufasa would set up a bank account with the Merchant Acquirer. Funds would settle with the network directly. Visa and Mastercard will take out any network assessment and Interchange from the transaction and leave the remainder for Mufasa’s donut shop. For example, if a customer buys a donut today, then funds will settle tomorrow in Mufasa’s bank account. The additional step of moving the funds to Mufasa’s Wells Fargo account via ACH is not needed.
The Merchant Acquirer would then bill Mufasa for their Acquirer fees at the end of the month or some pre-defined interval.
Drawbacks of Using a Merchant Acquirer
More Paperwork
Establishing a direct Merchant account typically requires a lot of paperwork, including things such as incorporation papers, audited financial statements, certificates of good standing, and so on. For Mufasa who just started his donut shop, he typically will not have all of this information.
Manage His Own Fraud
In this model, Mufasa would need to manage his own fraud. He would use the tools provided to him via his Merchant Acquirer to do this, but ultimately, he’s responsible for controlling this fraud and making sure his chargeback rates are at a controlled level.
How Do Merchant Acquirers Make Money?
Most Merchant Acquirers make money in two ways:
Revenue From Hardware
Since the primary focus of a Merchant Acquirer is to process transactions, its software and services are limited. They may have reseller agreements with point-of-sale manufacturers like Vantiv and First Data, where they would earn some commission. Alternatively, they could have their own hardware, where they would make a margin off of the hardware itself.
For some of the newer point-of-sale systems, they may have an app store where third-party developers can build apps. They could earn money from the app developers as well.
Revenue From Each Transaction
Most Merchant Acquirers are also Acquirer Processors, meaning that they have a direct connection with the card networks such as Visa and Mastercard. An Acquirer Processor has hardware from Visa and Mastercard in its data centers to process the transactions. This hardware needs to be connected to a very fast network connection so that transactions can be relayed from the point-of-sale terminal to the card Networks and then to the card Issuer and back in less than three seconds.
For this processing capability, the Merchant Acquirer is able to charge the Merchant an Acquirer fee, which is typically a flat fee or a percentage for every transaction. They may also assess fees when cards are declined or when a chargeback happens.
The Merchant Acquirer takes the Interchange from the transaction and sends it to the Issuer, and sends the network assessment to the network, so this is not considered revenue for them.
Donut Shop Gets Large Orders From Grocery Stores: Enter the Payment Service Provider
Mufasa’s magical donuts catch the attention of large grocery chains who want to offer his donuts at their retail locations. The grocery buyers want a place where they can put their orders in online and make payments on a monthly basis. This catches Mufasa by surprise because now he will need to open up a location just to service these large orders. Additionally, he doesn’t have the cash flow to allow for “net 30” payment terms. So, he starts looking at potential solutions.
Mufasa didn’t even have a website, so he sets up a quick website, and while he could easily add a few lines of code to his website and enable credit card payments through a payment gateway offered through Square or Stripe, he realizes that he needs to offer more ways to pay.
Buy Now Pay Later
Instead of traditional invoicing with “net 30” terms, he looks at “buy now pay later” options offered through companies like Affirm and Klarna. In this model, the buyer can opt to pay later, but the Merchant is paid right away.
For example, a large grocery store places an order for $10,000 and wants to pay in thirty days. On Mufasa’s website, instead of entering a credit card, they choose the “Buy Now Pay Later” option. When this happens, the “Buy Now Pay Later” provider sends money to Mufasa’s bank account typically the next day and then collects from the grocery store on whatever cadence they requested. For this service, the “Buy Now Pay Later” company typically charges Mufasa a percentage of the transaction, which is typically higher than what Mufasa would pay for credit card processing. However, this fee may be worth it in the interim to help manage Mufasa’s cash flow.
Payment Service Provider
The “Buy Now Pay Later” company is considered a Payment Service Provider (PSP). They are able to offer the “Buy Now Pay Later” service in addition to accepting credit and debit cards, and they are also able to offer payments through Mobile Wallets like PayPal, Venmo, and Alipay.
Key Term: Payment Service Provider (PSP)
A PSP is an aggregator of payment methods. It allows a website operator to get paid via debit cards, mobile wallets, and financing schemes.
This was very interesting for Mufasa because through one provider he’s able to get all of these payment methods online. He knows that if he ever wants to expand internationally or offer his customers additional ways to pay, his PSP can support all of that and funds settlement can happen through a single source.
An additional benefit to a Payment Service Provider is that under the hood, their payment gateway may connect to multiple Merchant Acquirers, offering Mufasa’s business redundancy and also the ability to operate internationally without him having to change anything on his website.
The final part to this series will be published on 5/26, please subscribe to my Medium page so you can be alerted when the next part is available. Also, if you would like to learn more about fintech, card based payments, payment networks, banks, and opportunities in payments, you may also purchase my book, “The Anatomy of the Swipe: Making Money Move” on Amazon.
