Originally published in the Journal of Payments Strategy & Systems, Vol. 13, №3 2019, pp. 226–236, © Henry Stewart Publications, 1750–1806
While the trend for leveraging integrated payments software (FinTech 1.0) offered bank acquirers a new channel to disseminate payments, the current wave of FinTech (FinTech 2.0) consists of software companies integrating payments into their core offering. FinTech 2.0 companies are able to capture more of the payment economics and offer merchants a better experience. While a software company can pursue multiple pathways to offer payments to its customers, the only way to fully capture the benefits of FinTech 2.0 is to become a payment facilitator (payfac). Thanks to the emergence of dedicated infrastructure providers, this is now much easier. This paper discusses the historical, current and future state of merchant acquiring distribution, the benefits of new-age software-based distribution models, and the options available to software companies to capitalise on payments in this new model.
Merchant acquirers play a key part in the processing of card payment transactions. Acquirers are banks or non-bank financial institutions that enable merchants to accept and process credit and debit card payments by acting as a link between merchants, issuers and payment networks. An acquirer provides authorisation, clearing and settlement, dispute management and information services to merchants. In the earliest days of merchant acquiring, bank acquirers such as Chase Merchant Services, Bank of America Merchant Services (BAMS), Wells Fargo Merchant Services and Elavon/US Bank would sell directly to large merchants (eg Walmart, Best Buy). While these bank acquirers still claim around 50 percent of the market today (Figure 1) [FN1], this sales channel has proven to be a less viable acquisition tactic for the small business market.
Consequently, merchant acquiring channels began to evolve beyond bank acquirers, leveraging various forms of independent sales organisation (ISO) including tech-led front-ends and independent software vendors (ISVs) as new sales channels. ISOs did not integrate into the software, but rather would serve as ‘feet on the street’ to refer small and medium-sized enterprises (SMEs) back to the merchant acquirers. Concretely, in the ISO model, a retail store would be approached by an ISO, which would sell that merchant a point-of-sale (POS) machine and introduce the merchant to a payment processor such as Global Payments Inc, First Data Corp or Worldpay (among others) to set up their back-end payment functionality. Due to the lack of software integration, merchants were unable to run sales analytics or monitor activity across sales channels; they merely were able to accept credit card payments. Before being able to accept these payments, though, a merchant would need to be underwritten by a bank acquirer. This process took weeks, or even months, to complete and placed a burden on both small merchants and the bank acquirers. To underwrite merchants effectively, acquirers required certain documentation (eg last three years of sales data), which merchants were unable to provide either due to a lack of internal systems to track such data or an insufficient number of years in business.
Five to ten years ago, there was a notable shift in the preferred distribution model from legacy ISO-driven to technology-led sales (integrated payments 1.0), as merchant acquirers recognised that software companies could serve as an innovative channel for payments sales. In this technology-led model, payments were embedded into the technology sold to merchants. Under this new integrated payments 1.0 model, the retail store would be approached by Mercury Payments, or more typically by one of its 3,000 POS software developers or value-added resellers (VARs). Mercury Payments would sell the merchant a POS device that would be integrated into the merchant’s enterprise resource planning (ERP) and customer relationship management (CRM) systems. Similar to the legacy ISO model, Mercury would refer business back to Worldpay, and ultimately to a merchant acquirer (eg Chase Merchant Services, BAMS), who would need to underwrite the merchant. This shift towards integrated payments 1.0 sparked a wave of consolidation in the space, catalysed by Global Payments’ 2012 acquisition of Accelerated Payment Technologies, an innovative provider of fully-integrated payment solutions for small to medium-sized merchants, which marketed its products through a network of more than 700 VARs [FN2]. Another prominent example of this trend was Vantiv/Worldpay’s US$1.65bn acquisition of Mercury Payments in 2014.
The press release embodied the industry movement towards integrated payments, with the deal rationale reading as follows:
‘Vantiv is strategically focused on strengthening and expanding its traditional merchant and financial institutions businesses and continues to invest in strategic partner channels, including integrated payments. The acquisition of Mercury accelerates Vantiv’s growth in the integrated payments space, which is expected to increase significantly over the next several years’.
Since then, First Data Corp, Global Payments Inc, Total System Services and Worldpay have collectively spent approximately US$10bn on acquisitions to boost their integrated payments efforts.
A decade later, the integrated payments 1.0 model is no longer novel. Merchant-acquiring distribution has continued to evolve, with distribution power increasingly shifting away from integrated payments 1.0, and toward software companies — a phase where software providers own payments.
As integral players in day-to-day merchant activities, software companies are in a unique position vis-à-vis intermediate payments. Most software companies today provide merchants with comprehensive POS or ERP solutions; however, merchants have started to show a proclivity toward buying payments services from the vertically-specific software companies already embedded within their organisations. Whether it be Shopify for e-commerce merchants, Housecall Pro for plumbers, Mindbody for yoga studios or Lightspeed POS for retailers/restaurants, these software companies are in an optimal position to incorporate payments into their offerings to unlock new monetisation avenues and improve customer experience.
Integrating payments allows for better monetization
Software companies increasingly view fully integrated payments functionalities as complementary to their platforms. A payments offering not only enables software companies to capture a larger portion of the economics of a given payments transaction, but also comes at nearly zero customer acquisition cost, as it is a logical cross-sell to their existing customer base.
As one of the early players in the FinTech 2.0 era, Square has exemplified the positive economic impact of masking the commodity nature of payments. Square offers a software app (along with free hardware) that not only enables payment processing for merchants, but also provides deep insights into their businesses [FN3]. The advanced software offers features such as advanced analytics, loyalty programmes, employee management, and marketing application programming interfaces — all of which deliver value that extends well beyond payment processing. This revolutionary value-add has enabled Square to charge a merchant discount rate (MDR) of approximately 2.92 percent, notably above the small business MDR average (approximately 2.30 percent) (Figure 2). Small businesses pay merchants a discount (MDR) on all card-based transactions, which covers interchange (that goes to the issuer), network fees (that go to the payment network), and the merchant acquirer spread (net revenue to the acquirer). Merchant acquirers, on average, earn an acquiring spread of approximately 0.50 percent. However, given the increased risk associated with SMEs (Square’s core market) as well as the incremental value Square provides to its end customers, Square earns approximately 1.05 percent in net spread [FN4].
Lightspeed POS is the latest pioneer in the space, rolling out Lightspeed Payments in January 2019. Prior to launching Lightspeed Payments, Lightspeed monetised payments through a referral model, whereby the company would refer its merchants to third-party payment processors and receive a revenue share of the payment processing economics. Lightspeed’s customers could choose either to continue using their existing payments provider or utilise one of Lightspeed’s recommended payments processing partners. For the 35 percent of the customer base that used a referred partner, Lightspeed would receive a small percentage-based referral fee of approximately 0.25 percent of electronic transaction volume processed (the 25 basis points was recognised into revenue at 100 percent gross margin) [FN5]. With Lightspeed Payments, Lightspeed will now capture substantially more revenue from its customer base. Pricing its solution at 2.6 percent of the card-processed portion of its customers’ gross transaction volume (GTV), Lightspeed targets netting 0.65 percent after accounting for network and interchange fees. Through integrating payments, Lightspeed will effectively capture a net fee approximately 2.6 times higher than the fee received through payments partners.
Further, as Lightspeed’s merchants scale (and their transaction volumes grow), Lightspeed will directly benefit from the merchants’ growth. Beyond the revenue boost, the payments offering is also anticipated to be accretive to Lightspeed’s earnings before interest, tax, depreciation and amortisation (EBITDA) margin. Using conservative estimates around research and development, general and administrative expenses, and sales and marketing expenses, TD Ameritrade estimates that the payments business can attain an EBITDA margin of approximately 70 percent (using adjusted net revenue as the base), and the software and merchant services business can attain an EBITDA margin of –6 percent by 2022 (up from –19 percent today). As TD anticipates payments to compose a larger percentage of gross revenue over time (generating up to US$88.2m/US$22.0m in gross revenue and net revenue, respectively, in 2022), payments will serve to move EBITDA into cash-flow positive territory (Figure 3).
Integrating payments allows software companies to add value to their customers
Beyond monetising payments, software payments players are better equipped to create value for their customers through (1) vertical-specific end-to-end offerings; (2) seamless merchant onboarding; and (3) ease of implementation.
(1) Vertical-specific end-to-end offerings
While most cloud-based software solutions today address a majority of the issues faced by SMEs, most do so in highly targeted capacities — addressing one pain point at a time, such as POS for physical location retailing, e-commerce or inventory management. These software payment players have noted the inherent inefficiencies and monetary burdens that come with integrating a handful of niche applications. Instead, these FinTech 2.0 players have introduced comprehensive solutions that seamlessly bridge online and offline businesses, while integrating front and back-office requirements. More importantly, these FinTech 2.0 players offer a fully-baked end-to-end solution in a vertical-specific manner — crafting industry-specific solutions to best solve the unique pain points that florists, restaurants, and spas endure.
Mindbody is an early example of a company that stands out for its business management and integrated payments software in the fitness, spa and salon markets. Mindbody’s software includes scheduling, online booking, marketing (eg promotions), staff management, customer relationship management tools and POS integration. Further tailoring its product to its clientele, Mindbody released a dynamic pricing functionality that helps its customers effectively price classes based on indicated goals (eg maximise daily revenue, maximise class attendance). As fitness classes experience attendance rates between 40–50 per cent, the value of an incremental attendee is substantial [FN6]. The data-rich nature of this software relationship provides tangible value to the end merchant. Furthermore, Mindbody can leverage payments data to help drive a given spa’s CRM system to target customers with appropriate offers.
Lightspeed’s offering for its restaurant client base is another example of the value inherent in a vertical-specific offering. The Lightspeed Restaurant POS system provides restaurants with all the capabilities they require from the early stages of customer ordering to inventory restocking. Lightspeed Restaurant is specifically constructed to meet restaurants’ pain points. Specifically, restaurants face increased price-based competition, necessitating lower prices (and coinciding margin compression) and differentiated end-customer experiences (to attract and retain customers). Merchants utilising Lightspeed have noticed a 20 per cent GTV improvement, driven by better end-customer experience and data-informed operating efficiencies.
Specifically, Lightspeed Restaurant POS offers [FN7]:
(i) Floor and table management: Restaurants can replicate their table and floor layout in the POS to enable staff to better manage and monitor tables (eg tables are colour-coded according to their status to alert staff when a table has been waiting too long for its bill, driving better table turnover).
(ii) Menu management: Restaurants can leverage the POS to better manage the various menu items (eg include photos of menu items, highlight relevant allergies, provide pricing information, surface menu specials).
(iii) Order management: Restaurants can keep track of each customer’s order, route the order to the kitchen, allow staff to modify or cancel existing orders and monitor the orders in progress, and then ultimately close out the order and submit it for payment — at which point the bill can be put on a tab, split and/or ultimately processed.
(iv) Ingredient management: Restaurants can keep track of the ingredients associated with a menu item, including quantities, cost and supplier information. This allows restaurants to closely monitor their inventory status, so that (1) they know when to reorder and (2) wait staff can be alerted, for example, not to sell any more lobster dinners when the kitchen is out of lobster. This also allows restaurants to closely track their ingredient costs, which can represent 25–40 percent of a typical restaurant’s revenue, and to ensure that they are making sufficient margin on menu items.
(v) Integration with delivery services: Restaurants can integrate with third-party apps that allow restaurants to handle orders from delivery services, such as Uber Eats and Door Dash.
With this integrated, highly useful platform, Lightspeed has become indispensable to its end customers. Further, as Lightspeed serves a specific market, it constantly receives feedback that better enables the company to tailor and improve the product and continually launch new, highly relevant features. These restaurant-specific features not only add to the ‘customer stickiness flywheel’ but also translate to higher average revenue per customer. For example, given the relevancy of Lightspeed’s add-on offerings, Lightspeed has been able to upsell modules easily. In 2016, only 6 percent of customers had multiple modules. This percentage increased to 26 percent by 2018. While Lightspeed’s base package is approximately US$100 per month, adding all of Lightspeed’s eight modules can translate to as much as US$500 per month per user [FN8].
(2) Seamless merchant onboarding
Software companies that offer integrated payments provide the following benefits to merchants:
· Merchants can purchase payments more easily: Historically, a software provider would set up its offering for a merchant and then refer that merchant to a payment provider to set up payments acceptance. The merchant would have to compare payments providers (as it may not always select the software’s referred partner), then manage a cumbersome setup process with the selected payments provider. It is significantly easier for the merchant to purchase payments as a part of its existing software offering, as the merchant has already implemented the software and is familiar with its features. Further, it is a straightforward process to set up and integrate payment systems through this channel, obviating the need to deal with a separate payments provider and the challenges that follow (eg necessary data reconciliation). As the sole provider of services to merchants, these software companies become the simple one-stop-shop for service and customer support. In addition to delivering a more seamless process for the merchant, the software provider is able to add to its top line, as this cross-sell effectively prevents drop-off in the funnel.
· Merchants are more quickly underwritten: In contrast to legacy payment processing providers that necessitate complex application forms, large sums of collateral, and up to six months of processing time for a merchant to be able to accept payments, software players with embedded payments are able to onboard merchants instantly. As one of the pioneers in the space, Square was one of the first companies to radically simplify the onboarding process for small merchants. The merchant was given an inexpensive POS (a dongle instead of a US$1,000 POS terminal), download the Square app, answer a handful of questions, and confirm the transparent pricing agreement. Within minutes, the merchant could begin accepting credit cards, and within one business day begin receiving payments. While Square should now be considered a quasi-legacy system (as compared with the vertically-specific software providers truly representing FinTech 2.0), it was one of the first to popularise the payment facilitator model that made this seamless merchant onboarding feasible. Previously, due to the high degree of associated risk, smaller merchants struggled to obtain traditional merchant accounts. However, under the payment facilitator model Square embodies, Square serves as the merchant of record for these smaller merchants. In effect, Square (and other payment facilitators) must underwrite each sub-merchant, as the payment facilitator becomes responsible for any risks (eg money laundering, illicit activity) these smaller merchants may engender.
· Merchants are better underwritten: While Square was among the first to popularise this model, the true FinTech 2.0 vertical-specific software companies that provide integrated payments are best positioned to further simplify the onboarding and monitoring process for small merchants. Software companies that integrate payments will not only have clear visibility into merchant payment activity, but also into merchant inventory fluctuations, staffing coordination and marketing campaigns. All of these data points will enable better underwriting and monitoring of sub-merchants, mitigating risk for the software company. It is not only the increased access to merchant data that allows for better underwriting, but also the vertical-specific nature of these software companies and the data privileges that position affords. In contrast to horizontal players like Square, vertical-specific software companies know which questions to ask that could further improve underwriting capabilities. For example, Mindbody’s software knows to ask a yoga studio questions about the different class packages it sells, whether yoga mats are included in those packages and other specific queries that impact revenue.
(3) Ease of implementation and use
Software solutions reduce technological complexities for merchants, from initial implementation to ongoing usage. These cloud-based solutions can be implemented easily. Before FinTech 2.0 players entered the industry, it would take merchants months to be able to accept payments. Square has enabled merchants to accept payments in minutes simply by handing them a dongle. Even for more vertical-specific merchants (eg restaurateurs, retailers, plumbers), the implementation process rarely requires much customisation as these software companies have been purpose-built to address the specific needs of these customer bases. Further, the cloud-based software providers are supported by a team of developers whose primary roles are to innovate and launch new applications, features and system upgrades to ensure the end merchant can remain competitive in its own industry.
The ease of use provided by these solutions has further accelerated merchant adoption, enabling any employee to operate the software (without extensive training) and allowing for seamless omni-channel management (eg for a retailer, online and physical store inventory can be synced in real time).
Getting to FinTech 2.0
To capitalise on the benefits of FinTech 2.0, software companies theoretically have three options: (1) pursue the ISO Model; (2) partner with a payment facilitator (payfac); or (3) become a payfac. However, becoming a payfac is the most effective way to capture the benefits of FinTech 2.0.
(1) Pursue the ISO model: This model is a glamorised version of integrated payments seen in FinTech 1.0. Under this model, a software company will refer its merchant customers to a payments processor. For example, Mindbody is an ISV that, in return for a referral fee, will refer its salons and spas to Total System Services. This model does offer certain advantages. Specifically, Mindbody is not involved in the funds flow, and consequently, does not take on merchant underwriting responsibility and the compliance burden that follows. On the other hand, this model hinders Mindbody from fully monetising its transactions, receiving a referral fee instead of a percentage of the transaction volume that flows through its site. Further, Mindbody lacks control over the payment experience. Specifically, an ISV has no influence over which merchants get underwritten or how payments are disbursed.
(2) Partner with a payment facilitator: Under this model, a software company partners with a payment facilitator to process payments. Stripe, Ayden, Braintree and Square are well-known examples of payfac partners. This model offers several benefits to the software company. First, the software company is able to capture more of the payment economics (as compared with the ISO model). Further, partnering with a payfac allows for seamless merchant onboarding and more control over the end-user payment experience. For example, unlike the ISV model that still requires weeks of merchant underwriting by payment processors, partnering with Stripe enables software companies to allow their merchants to accept payments instantly. Most importantly, partnering with a payfac like Stripe enables software companies to forgo the process of building out the infrastructure to become a payfac, saving the company both time and money. However, these incremental payment economics come at a notable cost, with the payfac typically keeping a majority of the payment economics (eg Stripe presently charges 2.9 per cent plus US$0.30 per successful credit charge). This becomes increasingly relevant as software companies scale past US$100m of gross merchandise volume, and ultimately pass on these fees to their end users. Software companies that leverage payfacs are also limited in terms of feature functionality (ie a software company is highly dependent on the payfac’s product suite). Shopify, for example, uses Stripe as its back end for payment processing. While there have not been notable issues to date, Jeffries’ Initiation of Coverage report alludes to the risk of relying on Stripe, stating ‘the margins of the business could also suffer if Stripe were to raise the negotiated rate for providing payment processing’ [FN9].
(3) Becoming a payment facilitator: Under this model, a software company like Club Essential (a unified suite of accounting/POS, website, online reservations and member marketing solutions specifically designed for country clubs), would open a merchant bank account and receive a merchant ID (MID) to acquire and aggregate payments for their sub merchants (in this case, country clubs). Country clubs are not required to register for unique MIDs, and instead, have their transactions aggregated under Club Essential’s master MID. Club Essential is the merchant of record for all of its sub-merchant’s transactions, and consequently, is tasked with acquiring and underwriting each and every merchant on its platform. This process enables Club Essential to reduce the complexity that its sub-merchants would face if setting up online payments on their own (ie spending time and money establishing relationships with an acquiring bank and payment gateway). In addition to providing value to Club Essential’s sub-merchants, the payfac model is beneficial to acquirers who now have access to a broader pool of merchants from whom they can accept payments without needing to undergo the costly and time-consuming process of signing merchants with low sales volumes.
This model best positions software companies to monetise sub-merchant transactions and create a differentiated service offering that creates stickiness with sub-merchants. Becoming a payfac allows software companies to earn the largest share of the payment economics, as compared with the other two options. For example, by shifting from the ISO model to become a payfac, Lightspeed expects to see a 2.5-fold improvement in payment take rate [FN10]. Further, by integrating payments functionality into a software company’s offerings, said company is better able to differentiate its product and add more value to its customers, driving customer stickiness. Of course, this model is not without its downsides. As the merchant of record, the payfac assumes the risk of its sub-merchants. As such, payfacs are responsible for [FN11]:
― controlling who is on the platform (and setting up an efficient and reliable onboarding processes);
― meeting know your customer, anti-money laundering and US Office of Foreign Asset Control requirements;
― auditing merchant activity on the platform to ensure high-risk activity is addressed quickly and successfully; and
― Payment Card Industry (PCI) compliance
While becoming a payfac will be the best way for software companies to capitalise on the benefits of FinTech 2.0, doing so has historically not been an easy feat. The setup process requires a serious time and monetary investment. To simply set up as a payfac, a software company could spend over two years and approximately US$4m [FN12]. Specifically, the company would need to negotiate and integrate with payment gateways (1–4 months; cost varies by gateway), validate level 1 PCI DSS compliance (3–5 months, plus US$500,000), build a merchant management system (6–12 months, plus US$600,000), develop a compliance programme and underwriting policies (12–20 months, plus US$800,000), and pay licensing fees (6–18 months, at a cost of more than US$1m in US and international licences)— and this is only part of the investment [FN13]. Millions more will be spent on ongoing costs such as merchant onboarding and monitoring, risk monitoring, fraud prevention, chargeback management, payouts routing, reporting and reconciliation, and more. Within the last few years, the industry has seen an increase in companies like Finix, Payrix, Amaryllis and Infinicept, which provide payments infrastructure/middleware — allowing software companies to capture the upside of being a payfac without all of the time and investment historically required.
As FinTech 2.0 continues to develop, payment companies are already fearing the next wave of competitors: dedicated software companies that will provide enough value that payments will become a commoditised feature for customers. For a snapshot of how this might work, it is worth considering the example of real estate rental payments. Cozy is a cutting-edge real estate payments software. Using the present framework, they would be described as FinTech 2.0. Cozy’s technology makes the renting and payments process simple and secure, and complements its payments technology with value-added features including property listings, rent estimates, rental applications and tenant screening. Cozy has leaped ahead of industry incumbent Click Pay (a FinTech 1.0 player), which only facilitates rental payments. In five years from now, however, players like Cozy (as it stands today) will struggle to compete with those FinTech 3.0 players providing comprehensive bundles that include payments as just one of dozens of offerings. An example of such a player would be SmartRent, a home automation company that packages and resells hardware to multifamily apartment units, offers a software as a service (SaaS) platform for property managers and tenants, and is clearly positioning itself to be a FinTech 3.0 player. Through its SaaS platform, SmartRent offers its tenants the ability to control smart devices within their apartments, set up ‘scenes’, create access permissions, access community boards, fill out apartment applications and make rent payments. For SmartRent, rent payments are only one small sliver of the value-add the company creates for its multifamily customer base; however, over time, SmartRent predicts that its tenants will only use SmartRent’s app to pay their rent. Ultimately payments will become table stakes to be integrated into all vertical-specific software offerings.
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(10) Sedar, ref. 6 above.
(11) Stripe (n.d.) ‘Payment facilitation’, available at: https://stripe.com/guides/payfacs (accessed 10th July, 2019).