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.