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Submerging Payments, Part II

Matt Harris —  September 14, 2015 — 4 Comments

Not much more than 100 years ago, the ice industry was a major component of the US industrial economy, contributing $660MM (in today’s dollars) to the GDP and employing 90,000 people, more than the total population of good-sized cities like Albany, Atlanta and Nashville. In the early part of the 20th century, ice went through what appeared to be its “disruption” (probably Ye Olde Techcrunch called it “FrostTech” or something at the time), where the industry shifted from natural ice (literally, I sh*t you not, chopping blocks out of lakes and shipping it coated in sawdust) to manufactured ice, made in industrial scale factories.

Sadly for the ice industry, that was not the disruption they should have been watching. What ended up eviscerating the ice industry was the advent of in-home refrigeration. Refrigerators weren’t invented to make ice, but they made ice on the side, as it were. More importantly, they obviated the need for purchased ice by doing the job of ice, which is to say, cooling food, much more efficiently. I can only imagine the self-satisfied ice-trepreneurs who moved gracefully from lake chopping to managing ice factories, smugly speaking at business schools about how they recognized that “they weren’t in the ice harvesting business, but rather in the ice provisioning business”, until they realized that they were actually entirely out of business. The key idea here is that the ice industry didn’t get disrupted by technological innovation that changed how they did business; the industry essentially went away as a result of their value proposition becoming subsumed in an entirely different value chain.

Which brings me to the payments industry. All kinds of market participants “buy” payments today … consumers make a payments purchasing decision when they choose a card (or cash, check or bitcoin); retailers buy payments when they select a merchant processing solution; governments and non-profits buy payments when they make decisions about what tender types they will accept and via what providers; and in the B2B context, both buyers and suppliers face off against the payments industry when they decide how to settle their bills and accept payments against invoices. Industry participants (issuers, acquirers, processors, lockbox vendors, etc) have been chipping ice out of lakes for years, and are newly wary about these new ice factories (mobile phones, EMV, NFC, blockchain rails, etc) that are springing up in various pockets of the industry.

Those new enabling technologies miss the main point, the real disruption that should be terrifying the incumbents, which is that fewer and fewer market participants are making any kind of payment decision at all. Over time, consumers won’t say “I’ll choose the card that has the best mobile interface”; they will choose Uber (or Apple Pay, Paypal, etc) and whatever funding mechanism they selected at inception will just fire away. God help the ISO that tries to get the attention of a retailer who has selected Booker (or Shopkeep, Revel, etc) as their ERP system; that merchant has already lit up payments within the software that runs their business. Governments and nonprofits will similarly turn a deaf ear to payments companies, having leveraged fundraising software from Evertrue (or Abila, Blackbaud, etc) or built General Ledger integrations into peerTransfer for cross-border payments. Businesses, having selected Billtrust (or Paymetric, Delego, etc) for their invoicing and AvidXchange (or Taulia, Chrome River, etc) for their Expense and Payables Management, will have no need or interest in speaking with traditional cash management and lockbox vendors.

Elegant, integrated and cloud-based software is submerging the payments business, and stripping it of its value. We at BCV have invested in a number of companies along this theme, including Billtrust, Booker, Chrome River, Evertrue and peerTransfer.  Today we’re announcing a large investment in AvidXchange, alongside Foundry, NYCA, TPG, KeyBank and other industry notables.  AvidXchange is the leader in AP automation solutions for the middle market, and has quickly built a substantial commercial payments business that provides additional value to their software customers.  Mike Praeger and his team have been ahead of their time in recognizing that controlling data and workflows creates a unique opportunity to monetize payments volume, and we’re excited to help them take it to the next level.

Many existing payments companies are already partnering with our software companies, and others, but many are ducking their heads in the sand. To those ice harvesters, I quote my 7 year old daughter: Beware the frozen heart.

Comparisons Are Odious

Matt Harris —  February 27, 2015 — 2 Comments

Growing up, I wasn’t popular in the conventional sense (and by the conventional sense I mean having friends and such). As a result, I spent a lot of time reading. Mostly it was epically nerdy science fiction (Heinlein, Piers Anthony, etc) but there were a few conventional writers I liked as well, embarrassingly including Judy Blume. Somewhere in between her kid stuff and her adult stuff (if you never discovered WIFEY I feel sorry for your loss) was the adolescent classic TIGER EYES. While it now seems hard to imagine YA fiction without a dystopian future plot, trust me, this book was good. Two salient points: a)my now wife was the model for the cover art on the book (!); b)there is a reoccurring quote that I’m using as the title of this blog, “Comparisons are odious”.

I’ve been running “comps” for 20 years now, since I started at Bain Capital in 1995. For the uninitiated, comps are a list of similar (specifically: comparable) companies that are theoretically useful in determining the proper valuation ranges for an investment you are thinking of making. Eg, “Yeah, I know paying 10 times revenue seems high, but Workday trades at 14X.” Or, “How can you pay 10 times revenue for Tesla when Ford trades at 10X earnings?!” I’ve never really understood the logic of this type of analysis, and I’ve actually become convinced it’s the diametrically wrong guide to use as an investors. Given that we hold our investments on average for 5-7 years, shouldn’t we do the opposite of what Mr. Market is doing at any given moment? Comps are a popularity contest and rarely durable.

If at any given moment, horizontal saas companies trade at a premium to vertical saas companies, what are we to make of that? Presumably investors believe that the TAM (total addressable market) benefits of broadly applicable software trump the sales and marketing inefficiencies. Suppose it becomes clear that, at scale, vertical saas companies have 500 basis points of additional margin due to structurally lower go-to-market costs … don’t we think revenue multiples will expand, on average? Surely we can anticipate changes in the conventional wisdom of this sort over a multi-year hold period. (If you have any doubt about the likelihood of this, let me remind you that cardiologists have recently reversed their position on cholesterol and are recommending people eat eggs every day. To my long list of regrets I now add every single egg white omelette I’ve ever had.)

If anything, low multiple comps can be a draw to a segment, in that they usefully point out that the incumbents are doing something fundamentally wrong, to wit:

  • Lead gen companies typically trade at low multiples because their customers (or users) are transitory and bounties fluctuate cyclically. Credit Karma flipped this on its head, in that they have loyal users who trust them to recommend, in context, a broad variety of pre-approved financial products. How are the lead gen comps relevant to Credit Karma?
  • Issuer processing companies trade at 15-16X EBITDA (a high multiple, by the way, on a relative basis). Google bought TxVia, a prepaid issuer processor, for [A BIG NUMBER] X Revenue… TxVia and Google both saw how mobile wallets were creating a new use case of account based consumer financial services that had nothing to do with traditional prepaid.
  • Debt collection service providers trade at poor multiples historically, as befits a cyclical commodity service with regulatory overhang. To an entrepreneur like Ohad at TrueAccord, that’s the opportunity … he can do it better, and flip the model on its head. Should we value TrueAccord in the context of the traditional comps?

The relevant thing about comps, ultimately, is not the revenue or EBITDA multiple levels themselves, but the implicit logic behind them. If an entrepreneur can build a company that challenges the traditional economic logic of a segment, they are likely on to something big.

On Prepaid

Matt Harris —  August 14, 2014 — 7 Comments

My friend Dan Schatt recently published a great book called Virtual Banking (incidentally you can buy it here). Dan was kind enough to ask me my thoughts on the prepaid space, which I have always felt poses great opportunities for entrepreneurs, and great risks for incumbents. I contributed the below essay, which found its way into book, alongside great content from Dan, Renaud Laplanche from Lending Club and many other thoughtful folks.

Until recently, there were three types of payment cards, and each of them stayed pretty much in its place. Credit cards and debit cards were issued by banks, the former to provide transactional lending (pay later), and the latter to provide access to a current account (pay now). Prepaid cards, the new kid on the block, were still largely a gifting vehicle, but increasingly also included a general‐use, open‐loop reloadable version. These cards were a stored value account purchased either fully loaded or where value could be added through various load mechanisms (pay before).

But now that old triumvirate is crumbling. In particular, the prepaid card has rebelliously left its historical place as either a gift card or a card of last refuge for the underbanked, and has now entered the mainstream. This development poses many risks for community financial institutions, as the prepaid architecture gives rise to all sorts of entrepreneurial competition. That said, prepaid is also a significant opportunity to broaden product lines and modernize customer‐facing applications without massive changes to core processing systems. How financial institutions grapple with, take advantage of, or succumb to prepaid may determine their relevance in the coming decades.

What do we mean by prepaid, and why is it so disruptive? The trade association for prepaid cards, the Network Branded Prepaid Card Association (NBPCA), defines prepaid cards as a “non‐credit payment option,” 3 a classic example of the fallacy of defining something by what it is not. The organization does go on to usefully enumerate the largest categories of prepaid card: General Purpose Reloadable (GPR), Payroll, Incentive, Healthcare, Government Disbursement, and Gift. This inability to define prepaid is a general problem, and the NBPCA provides a version of the most common type of answer: It isn’t a bank account, it isn’t a credit card, and here’s a list of examples of what it can be.

The problem with this definition and all of its variants is that they are quickly becoming dated. How is a prepaid account different from a bank account, when it comes with paper checks, automated teller machine (ATM) access, and Federal Deposit Insurance Corporation (FDIC) insurance? How is it different than a credit card now that companies like Insight Card Services and AccountNow offer hybrid products with a short‐term lending component?

These product distinctions (checking, savings, line of credit, credit card, etc.) have always been driven by regulators and bank technology vendors, not by consumer preferences in any event. The prepaid architecture is allowing them to collapse into a single account structure, with many diverse features, making the definition of prepaid as what it is not now impossible. As the categories of prepaid multiply out from the six listed earlier, into Travel, Expense Management, Insurance, and Digital Content, among many others, defining prepaid by example becomes long‐winded at best.

For the purposes of this chapter, there are two important characteristics of a prepaid card or account (in general, I will use prepaid card, but it’s important to note that increasingly prepaid accounts won’t need an accompanying card):

  • Prepaid cards reduce the financial institution to the role of commodity utility, allowing an independent program manager to design and market the product, as well as manage customer interactions.
  • Prepaid cards have limited transactional interaction with core banking systems, in that they create an account structure that sits atop a single pooled traditional debit account. Individual transactions hit against this intermediary account structure, which in most all cases is more modern, flexible, and feature‐rich than a core banking system.

The combination of these two factors has allowed the prepaid card to be the primary vector by which entrepreneurial firms have entered the consumer financial services arena, threatening territory traditionally monopolized by banks and credit unions. These firms are redefining what can be offered to consumers and small businesses and, in doing so, shifting the basis of competition.

The latest wave of innovation in prepaid is focused on capturing the primary account for consumers, which had historically been a combination of a demand deposit account (DDA) and a savings account, almost always held by a “local” bank or credit union. Obviously, the term local when discussing financial services is fraught, given that the four largest banks control approximately 40 percent of household banking assets from central headquarters locations, but it has historically been the case that the majority of consumers chose their primary bank based on branch location, so if a Chase branch is the closest to your home or work, it is your “local” bank. Because of this dynamic, the consumer banking industry became largely a real estate play. The national banks went on a branch‐building spree, aiming to become the bank of choice in the cities and larger towns, and truly local financial institutions took comfort in the knowledge that so long as they were a convenient option in their trading area, they would get their share of deposits.

Prior to the smartphone, it was difficult for any nonbank to challenge this physical reality except on the basis of offering high interest rates for savings accounts or CDs. It is telling that the latent threat to financial institutions was always Wal‐Mart, and, in fact, prepaid partnerships with GreenDot and American Express enabled that latent threat to become very real. Wal‐Mart always had the real estate, and the prepaid architecture has allowed them to offer financial products, with a geographic density far greater than any branch network. That said, Wal‐Mart’s customer base and brand positioning are such that the customers they are siphoning off from traditional financial institutions are generally the unbanked and underbanked. The graver threat, from a customer profitability perspective, are what are often called the “neo‐banks”— nimble, entrepreneurial firms that are leveraging the prevalence of the smartphone to convince customers that physical proximity no longer matters.

Who are these neo‐banks? The most public examples are Simple and Moven, but the prepaid architecture is so straightforward and flexible that many more are just launching or in formation. Perhaps the example that proves the point most dramatically is Card.com. Card.com has created prepaid debit cards that are as fully featured as most bank accounts, and are cobranded with dozens (heading towards hundreds) of micro‐affiliates.

Effectively, you can get a “bank account” that shows the world your affection for Gay Pride, Garfield the Cat, Frida Kahlo, or The Walking Dead television show, among many others. While it’s easy to dismiss these as trivial, many banks had the same reaction when MBNA launched its affiliate model in the credit card industry, only to find itself thoroughly outflanked.

This proliferation of neo‐banks has been enabled by technology. As mentioned, the core innovation that enables mainstream adoption of branchless banking is the smartphone, but there are companion technologies that are just as instrumental. The primary category of innovation is around account opening. Traditionally, account opening was almost entirely done in a branch, as much of it had to be done in person. Companies like Jumio and Andera have now enabled Web‐based account opening, and even phone only account opening, leveraging electronic signatures. Once the account is open, technology from Mitek and others enable mobile remote deposit capture, so that checks can be loaded into an account without a branch or even an ATM visit. One by one, the reasons to visit a branch are being demolished.

In the first instance, this seems largely like a threat to community financial institutions (FIs). Not only do you have the “big four” marketing into your base, but you have national branchless players trying to poach your customers.

But let’s imagine the possibilities whereby community FIs can leverage these trends and capabilities to their benefit. The fact is that most community FIs have been offering relatively plain vanilla product because they are dependent on their core system vendor to provide them functionality, and none of the large vendors are exactly dynamic. Community FIs need to consider ways they can leverage the flexibility of prepaid technology to innovate and move more quickly.

One opportunity is generational. The demographics of credit unions and local banks are not promising for the future; to be blunt, they skew old. Unless these financial institutions can survive as the bank of choice as the wealth and locus of banking activity moves from one generation to the next, they will become increasingly irrelevant. Prepaid is one weapon in that fight.

It makes a perfect teen product, given its natural limits on overspending and the ability to add parental controls. Its useful for parents with children away at college, allowing them to load money for expenses as needed. In either of these instances, it becomes an opportunity to convert the child/ recipient into a primary account owner over time. In particular, the community FI can leverage the relationship with the parent to offer credit to the next generation, with the parent as guarantor. At that stage of life, anyone who will offer credit becomes a student’s best friend.

Another significant opportunity is within the small business segment within a community FI’s trading area. Although there are some neo‐banks now getting started to serve the small business population, no one has critical mass. These small companies are hard to reach, and frequently value their relationship with a local bank (or, less frequently, credit union) as a source of credit when needed. Small businesses have a variety of needs that prepaid can solve quite elegantly. More and more employers are offering health savings accounts (HSAs), based on prepaid technology, to their employees as an alternative to traditional health benefits. Prepaid cards can provide a less expensive alternative to paper checks for small businesses that employ the underbanked. Many industries that employ salespeople use prepaid cards as a sales incentive program; local banks are in a great position to provide this technology to small businesses. One area where prepaid has already started to make an inroad, largely driven by a PEX Card, is in the expense management area. This, too, is a product that could be logically distributed by community FIs.

If the community FI has both a solid consumer base and good relationship among the local small business community, there is an opportunity to capitalize on the opportunity presented by linking those two groups via prepaid. The economics of traditional debit, post Durbin, do not allow for bank‐funded rewards programs to generate new accounts or create loyalty.

That said, a community financial institution could leverage its relationships with local retailers to create a merchant‐funded rewards program, which helps them to drive traffic to their stores and creates a distinctive product for the bank or credit union. Further along this theme, the FI could create a specialized gift card, leveraging Restricted Authorized Network (RAN) technology to limit the spend on the card to local retailers. Again, a distinctive product for consumers that provides unique value to a financial institution’s small business customers.

As has been articulated throughout this book, new innovations in financial services are both opportunities and threats for community financial institutions. Prepaid is a dramatic example of this important point. Small banks and credit unions have traditionally survived and thrived based on their local relationships and physical footprint; the prepaid architecture has unleashed the entrepreneurial energies of dozens of new and compelling branchless competitors, who challenge long‐standing relationships and make geographic density irrelevant. Prepaid also provides a vector for innovation for community FIs themselves, enabling them to partner with entrepreneurs to create and offer cutting‐edge products to local customers who otherwise would lack awareness or access to these innovations. It is critical to recognize that there is little time to ponder this issue; the competition is on the move, and the only question is: will local banks and credit unions be as well?

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Trends in payments innovation.

Yeah, I’ve done it … this blog basically consists of a slideshow.  Obviously we know what comes next:

Listicle
24 signs that you may be a Fintech nerd

Click bait
The founder of twitter started a payments company … and you won’t believe what happened next

Quiz
Answer these question and find out what kind of chargeback you are.

And so on.

In fact, I pulled this deck together to brief the board of a large, global payments company on what’s been happening in the start-up payments community over the past 12-18 months.  It’s a little sparse and works better with a voiceover, but I thought it was interesting enough as kind of a survey course syllabus to post for comment.

Trends in Payments Innovation

Race to the Bottom

Matt Harris —  May 5, 2014 — 4 Comments
I don't always invest in commodity products, but when I do, I prefer not to lose all my money.

I’d like to think that the vast majority of the investments we make are in companies whose products and services are not commodities, and not subject to the brutal forces of commoditization.

In those cases, we are looking at markets where companies can win based on product differentiation, or where what they are doing is very hard and/or protected by intellectual property.  That said, the broadest definition of what we as venture capital investors do is invest in disruption, and certainly one of the vectors of disruption is through commoditization.  So while backing a company about to be commoditized is, well, stupid … backing a company that is doing the disruptive commoditizing can be exciting (despite some recent commentary to the contrary.)

Exciting, and terrifying.

Particularly terrifying if you don’t have a gameplan; without one, you may succeed at chowdering an industry’s margin structure without creating any value.  Through trial and error in this field of endeavor, I have found four general models that can work.

1. Be the lowest cost provider

One of the sneaky elements of our investment in Simple (fka BankSimple) was that, while the common perception was of a company leveraging awesome mobile-first design and zero fees to acquire and delight customers, the actual key was the ability to serve customers far more cheaply and hence more profitably than banks.  The customer acquisition stuff worked also, which was nice, but in fact the way to make money in the DDA segment (a commodity) is through disruptively low costs.

Another segment purportedly running this playbook is the “peer to peer” lending community (Merely writing that phrase makes me want to tear my hair out.  While it’s kind of delightful to imagine a multi-billion dollar hedge fund and a near-prime borrower as “peers”, it’s not exactly accurate.) I’ve seen a ton of charts detailing the “cost to serve” advantages of these companies.  My issue with this analysis is that, of the meaningful elements of the cost bar of a lending  business, at least three (cost to acquire, cost of credit losses and cost of capital) far outweigh cost to serve.

The one thing we know conclusively is that these lenders have a stratospherically higher cost of capital than their bank competitors, who leverage their nearly free deposits for liquidity.  Alternative lenders who can create durable advantages in customer acquisition and/or underwriting will create value; merely being low cost in terms of operations will not be sufficient.

2. Lock up differentiated distribution

In the relatively near future, most retail investors will have their money managed using algorithms that solve for market returns, properly allocated across asset classes, rebalanced tax efficiently and optimized for minimal fees.  This will be hideously disruptive for stockbrokers and other corrupt money managers, but will it create value for the disrupters?

There are a whole crop of new companies who are steadily building Assets Under Management using this new model.  The challenge is that the classic “cost to acquire vs. lifetime value” math is almost always upside down when you are providing a service that is, by definition, undifferentiated and focused on lower costs.  The winner(s) here will be those companies who get introduced to their customers for free, either through harnessing viral growth (has not yet happened in this category, though Robin Hood is showing signs) or figuring out a high volume channel.

3. Serve the previously unserved (and ideally previously unserveable)

Square has had a tough time in the press recently.  They have gone from a $10B IPO candidate to a lost cause/acqui-hire in a 3-4 months, on no news.  This says more about the state of financial punditry than it does about Square.

PayPal figured out something fundamental 15 years ago, which is that while most underwriting models start by saying “no”, it’s smarter to say “yes” to nearly everyone and then throttle usage on the backend.  In this way, you enable faster growth and accumulate the necessary “bads” to train your models, all the while managing losses through tightly gated credit limits.  High delinquencies, but low severity.  Square adapted this methodology to merchant underwriting, and in doing so enabled millions of merchants previously shut out of electronic payments to get in the game.  At various times in their lifecycle, they have been over-valued, but those who now dismiss them do so at their own peril.  Their recent moves, to tack back from their experiments with Starbucks and p2p remittance towards a more robust value proposition for small merchants, represent a doubling down on what made them special to begin with.

Merchant payments has never been a particularly interesting business.  Retailers fundamentally don’t care who provides their payments, and will ultimately largely view it as an embedded feature of a commerce system.  But Square’s landgrab in a previously unserved segment may provide them with sufficient escape velocity to make their optimistic investors look smart, particularly when combined with a legendary founder and a world class team.  And I’m enough of a contrarian to have their back now that the world has turned against them.

4. Change the game

This is the one in a million shot, and ultimately why most of us do what we do. Once in a career, maybe, you get a chance to back a team that is turning a commodity business into one that creates huge value for customers and for the company.

Merchant payments is a commodity?

 Well, what if you also have the cardholder information, and can disintermediate the visa/mastercard model by creating an “on us” transaction.

Remittances are a commodity?

How about turning cross-border cash transfers into cross-border commerce, and enabling immigrants to pay bills, top up mobile phones and create gift cards for free, instead of getting gouged on fees.

Factoring is a commodity that can’t scale?

What if you had comprehensive information on when the buyers would pay their bills, and could turn a risky transaction into a riskless transaction.

All of these are big bets, and none of them may pay off.  But the juice is surely worth the squeeze.