The Embedded Finance Playbook
Hey! For anyone reading my content, you’ve probably heard that I’m back to spending 99% of my time on fintech, where I started my VC career back in 2006. It’s been incredibly liberating to quickly pass on deals that are out scope as well as productive to “go deep” on specific areas of interest. I feel like I’m “playing offense”, more and “picking my plays” as opposed to reacting to industries where I lack experience or “playing defense”.
One of the most exciting areas of fintech that I’ve been actively exploring is embedded finance. I talked about it first when we announced our investment in iink back in November 2022, which has been one of our fastest growing portfolio companies since the time of investment. Given the pattern recognition associated with venture capital, it naturally leads to the question…
“Is there a playbook for embedded finance, that might help us find the next great company like iink?” (Stick around to the end, and we’ll explain how iink put up MVP numbers using the playbook.)
First, what is embedded finance? Tom Sullivan at Plaid offers a great explanation: “Embedded finance is non-financial companies offering financial products and services. It could be an e-commerce merchant providing insurance, a coffee shop app that offers 1-click payments, or a department store’s branded credit card. Effective embedded finance solutions meet the customer where they are with a financial option they need, whether that be a loan, payment program, insurance plan, or something else.”
So what are the other characteristics or performance attributes that we scout for in an embedded finance company?
1.Vertical niche — We really like companies and founders that start out with a specific customer and industry pain point in mind. Who better to build a solution than the practitioner who is dealing with the big problem on a daily basis? If a great solution already existed, they would have already adopted it, so we know we have a big problem in need of innovation.
2.Antiquated industries — We particularly like industry verticals that are large, yet antiquated, where technology can replace manual processes with automation. Ideal embedded finance solutions create a flywheel of faster time to value, increased revenue, and growing market share.
3.Customers are working capital constrained — In addition to savings, and more convenient payments, embedded finance companies can really thrive when the customer has a short term need for working capital and is willing to pay a premium or fee to access additional capital.
4.Loan Duration — In our experience, many businesses need short term financing, but some banks won’t entertain short term options due to their upfront costs. However, short term financing often generates greater yield than more mature, longer term loans. Smart embedded finance companies capitalize on this opportunity by automating the manual tasks and underwriting that are cost prohibitive to banks today.
5.Pricing — The best embedded finance companies know how to price their offering to create value for their customers and charge a fee that is lucrative for both parties. For an embedded finance company that offers a working capital solution, most customers don’t want to pay a 24% annual interest rate. However, if they only need access to one month’s worth of capital, perhaps they might pay a 2% monthly interest rate or “processing fee” to access the capital early. Effective pricing has an impact on virtually all aspects of the business, from market size and gross margin to lifetime value and scalability.
6.Spread. One of the biggest determinants of profitability is spread, or the delta between your cost of funds, and the rate you charge to “lend” or advance capital. More mature asset classes, which are typically longer duration loans, might only be as little as 0.25–1.0%. But if a company can access capital at 8% annually, and lend at 2% per month (or 24% per year), their spread is 16% contributing to greater revenue and gross margin.
7.Product Led Growth (PLG) Go To Market — Go to market is how a company plans to scale its marketing, sales, and customer success efforts. Some great companies follow the product-led-growth strategy, offering simple products or features to start, that might be offered in a freemium business model or with inexpensive pricing. Customers learn, try it out, love the experience, and come back for more!
8.Expandable Product — Following the PLG playbook, top companies listen to their customers and continue to add products, features, and services that add value, generate additional revenue, and increase customer usage and retention. Founders might start with automating paperwork, but then expand to offer accelerated payments, and then offer short term financing for those that want access to working capital.
In most industries, if paperwork and processes are still manual, there are probably all sorts of other functions that could be automated, including analytics, invoicing, workforce automation and scheduling, or even customer marketing. In this way, embedded finance companies might ultimately start to look like vertical SaaS companies, focused on a particular industry and providing the next solution to their core customer and industry.
9.Network effects — Network effects are a phenomenon whereby increased numbers of people or participants improve the value of a good or service. Early examples include the fax machine or internet…they have little value individually, but when others are on the same network it creates a medium for communication, exchange, and commerce. In tech, network effects are oftentimes the differentiator between a “nice business” and a unicorn. Companies that build platforms and networks that create additional value for all stakeholders by joining, are much harder for competitors to replicate, and create much greater value.
10.Category King Strategy — When you add up all the steps of the embedded finance Playbook, you have a strategy following the road to Category Creation. Product led growth -> Product expansion -> increased customer value and retention -> network effects leads not just to a “better” way of doing things, but a “brand new” way of doing things.
This is how you redefine an industry. And those founders and their investors have the potential to create both transformational businesses and exceptional returns.
Let’s tie it back to a real world example using one of our more recent investments iink payments.
Iink started out hyper focused on solving the problem of mortgage check endorsements after a large storm occurred (#1 vertical niche + #2 highly antiquated industry). The process of check endorsements was painfully manual and cost renovators time and money that could have been spent renovating additional homes. After automating the check endorsement process, iink started solving for their customers’ next problem — working capital (#3). If these renovators could access capital earlier, they could start working on a project and generate more revenue with high confidence of short term repayment from insurance companies upon completion (#4 duration). Today, iink’s core product of remotely endorsing and depositing checks requires only a $299 first time fee (#8 PLG), but they’ve continued to expand their product line (#7) which encouraged both increased revenue and network effects (#9) with new constituents. Specifically, iink’s product now not only benefits contractors, but also benefits insurance companies who pay for alternative housing during renovations and banks who want to ensure renovations are completed. Iink’s CEO and co-founder Tom McGrath, created the Advanced Funding and Pro products with a deep knowledge of yield and spread (#5 + #6 respectively), which translates to their consistent revenue growth month over month. Finally, by leveraging the embedded finance playbook, iink has an early head-start to become a category king (#10).
If you’re an early-stage FinTech company disrupting embedded finance solutions or an investor in the space, we would love to hear from you!
