VС’s View On Fintech And B2B Payments Infrastructure Startups

Because there are already so many articles about fintech and payments infrastructure, this one was written in the style of a personal blog entry. With the purpose of sharing VC perspectives on fintech infrastructure and market landscape. It may appear that this field is already congested at times. To some extent, this is correct — most BaaS solutions overlap. However, there are tons of use-cases and these startups continue to solve different challenges. This article should be useful for entrepreneurs who want to embed fintech into their businesses or VCs who want to invest in this area.

Challenger banks have recently trended in FinTech. It’s been a segment at the top of many investors’ and founders’ minds. When I first embarked on my VC journey, challenger banks were where I felt I should spend my time. After months of investigating, I was further excited about investing in the so-called “shovels” or infrastructure layers. So, that’s how the research on the embedded finance space started. As the result, this deep dive rewarded Runa with three great investments: HUBUC, Union54, and Method Financial.

First of all, let’s start with the definition: fintech infrastructure is a combination of startups that empower banks to go digital and enable other startups to launch fintech products. Essentially, SaaS for banks and so-called embedded finance providers fall into this category. Here’s a quick rundown of financial infrastructure clients’ use cases:

And in the last 15 months fintech infrastructure has become a truly hot topic, with a slew of funding rounds:

Why is it gaining popularity?

Most VCs are more comfortable with investing in B2B businesses because they are less capital intensive, more predictable, and manageable. On the other hand, everyone wants to get a piece of a trillion-dollar pie we call the financial industry. So fintech is always in the investor’s mind. Guess where the fintech and B2B models collide? Right, in the fintech infrastructure space.

Fintech infrastructure startups were founded long before “embedded finance” became a buzzword — e.g. Runa invested in core banking software provider Mambu almost 10 years ago. But the truth is that the rapid development of this space started just a few years ago. Acceleration of this field is tightly connected with the growth of challenger banks which started leveraging this type of software themselves and stimulated competition in the financial sector.

While challenger banks were the driving force behind “embedded finance” at its inception, non-financial organizations are now pushing this vertical forward. As can be seen, a16z General Partner Angela Strange foresaw this future 2.5 years ago when she stated that every company will become a fintech company. In 2021, the number of announced rounds for BaaS and embedded finance startups more than tripled, while these keywords were cited as many times in the first three months of 2022 as they were in all of 2020:

What are the main challenges fintech infrastructure startups are addressing? In 99% of cases, this is a BUY versus BUILD situation when you need to release a feature or a product fast while in-house development is getting too expensive.

Neobanks were among the first to adopt fintech infrastructure products, as previously indicated. The reason is simple: building your own banking backend and obtaining a banking license is almost impossible for an early-stage company. Today in the EU you may select an E-Money license provider, use Mambu core banking, add BaaS software on top, construct your own design and frontend, and you’ve got yourself a bank! Challenger banks, on the other hand, tend to construct more and more components of the stack in-house over time. However, there are always specific parts of the fintech stack that you must outsource at first, such as stock trading, which necessitates additional components that you can obtain through DriveWealth or Upvest.

The phenomenal expansion of new digital banks caused existing banks to be concerned. Because of cumbersome processes and 50-year-old legacy software (much of the banking stack was created in COBOL in the 1970s and 1980s), it’s difficult for most incumbents to launch similar products. This is where entrepreneurs may help, from providing white-label solutions to developing a new full-fledged core banking system. For example, startups excel at helping banks to use various forms of loan origination technologies to go online.

Finally, non-financial firms are the primary drivers of embedded finance and the BaaS market today. Large corporations seek a piece of the massive financial industry pie. They can generate new high-potential revenue streams and increase customer retention rates by launching fintech products. Marketplaces, for example, may begin to offer loan services to merchants they partner with. Big B2C companies can start issuing cards to their users. Expense management software providers can easily add corporate cards with specific spending rules to their portfolios.

The other popular use case is embedding fintech into vertical SaaS solutions. The common problem of vertical SaaS is the market size. The number of possible clients is limited, so increasing revenue per customer is the greatest strategy to expand the market. Fintech-enabled vertical SaaS products usually have better retention as far as they start covering the payment flow of the business.

Market landscape overview

Let’s take a closer look at the competition for BaaS and embedded finance firms. Competition and the market landscape are becoming recurring questions for most VCs as more competitors enter the market. Each startup is unique, yet there are certain similarities between them. Looking at the problem–solution aspect of the market landscape is the best method to grasp it. What is the main issue that these startups are attempting to address? They introduce fintech products for non-financial institutions, including the procedure of issuing debit cards as an example.

How was this issue previously resolved? Companies did not usually launch fintech products, but if there was a genuine need, they would have to do it themselves. To issue debit cards before BaaS businesses, you’d have to sign numerous contracts, pay set-up costs, integrate all of them to play along with each other and your own backend, and then make sure all of these components work properly together:

• EMI issuer
• Card processor
• Card manufacturer + packaging
• Card Fulfillment provider
• KYC provider
• AML provider
• E-wallet or IBAN issuer
• Hire in-house compliance personnel and MLRO

Today, the company can get everything in one box with a friendly interface to create its own rules on top. Despite most startups attempting to solve the same problem, they are all approaching it differently and with distinct use cases in mind. Each BaaS company will be able to issue cards, open accounts, process payments, provide KYC and AML compliance, and implement spend controls. The biggest distinction is in the specifics of which portions of the stack the firms have created in-house versus which are outsourced — third-party E-Money licenses and card processing are particularly frequent (e.g. from Marqeta). This is why examining a BaaS startup’s gross margin is critical, as it reveals how much of the product is actually developed by the company.

Another intriguing observation is that some embedded finance startups operate similarly to venture capital firms: you establish a portfolio of customers (mainly startups), and if one of them performs very well, you all grow together. Marqeta is the best example: according to the IPO prospectus, Square accounted for 70% of its sales.

Finally, the new hero and favorite of VCs in 2022 — B2B payments!

The topic of B2B payments appears to be the new trend in 2022. Today’s market necessitates the same revolution as B2C payments.

It’s critical to understand the differences between B2B and B2C payments before considering disruption in B2B payments:

• Negotiation part — compared to B2C, where the purchase is made in a matter of seconds, there is a discussion of the price, contract terms, etc.
• Payments cycle — there is usually at least 14 days gap between signed contract, invoice, and real wire of money. This makes the user experience very different from instant purchase when we speak about B2C payments.
• Willingness to risk — when it comes to a payment of $100,000 or more, you are unlikely to be open to new startup solutions and are content to make the payment the old-fashioned way.

But what are the major issues that entrepreneurs are attempting to address? The user experience comes first: financial teams all across the world must manually create invoices or enter invoice data into banking systems, which takes a long time. The other issue is cash gaps, which are caused by the payments cycle, which causes sellers’ cashflow to be unhealthy.

Startups commonly handle the first difficulty by using a combination of OCR (optical character recognition) and scraping tools. They recognize invoices, enter the required data into the system automatically, and complete the payment. For most venture capitalists, this way of solving the problem does not appear to be a significant disruption.

The second issue is usually remedied by incorporating BNPL capabilities, which is an excellent solution. When payment is made with a corporate card, it works nicely. But, in most cases, corporate cards are only used for minor purchases, and the finance team must still go through the old-school process for large sums.

It appears that OCR and scraping are only short fixes for the problem, not long-term solutions. New payments and invoice rails, where the invoice becomes digital and data flows automatically to your payment provider, should be the actual disruption.

This new field requires a specific driver, which potentially could be the rise of B2B marketplaces. There is an interesting correlation between these two terms:

Conclusion

As more businesses transition to fintech, banks will face increasing pressure. So bank software could finally take off, and if they decide to invest more resources in infrastructure solutions, the industry will become quite intriguing. Former challenger banks, such as Monese, are also beginning to provide BaaS products. Will it grow more widespread?

With a sufficient amount of investment and the brightest brains in the world focusing on developing new and better ways to design fintech products, there should be a lot more disruption in this field.