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Journal of Payments Strategy E-mail: *E-mail: - - Ashley Paston Ashley Paston is an investor on the Bain Cap ital Ventures team, focusing on payments and financial technology. She previously worked at McKinsey 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, acquir ers required certain documentation (eg last Growing below market Growing above market 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. Figure 1:Distribution of bank acquirers in the USA Source: Huang, T. (2019) J.P. Morgan: Payment Processing, 10th edn, Capital IQ, available at: Five to ten years ago, there was a nota ble shift in the preferred distribution model from legacy ISO-driven to technology-led sales (integrated payments 1.0), as merchant acquirers recognised that software com panies 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 Mer cury 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 merchants enterprise resource planning (ERP) and customer relationship manage ment (CRM) systems. Similar to the legacy - - - - Software as the future of payments distribution Page 228 ISO model, Mercury would refer business back to Worldpay, and ultimately to a mer chant acquirer (eg Chase Merchant Services, BAMS), who would need to underwrite the merchant. This shift towards integrated pay ments 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 mar keted its products through a network of more than 700 VARs. 2 Another prominent example of this trend was Vantiv/Worldpays US$1.65bn acquisition of Mercury Pay ments in 2014. - - - - The press release embodied the industry movement towards integrated payments, with the deal rationale reading as follows: Vantiv is strategically focused on strength ening and expanding its traditional mer chant and financial institutions businesses and continues to invest in strategic partner channels, including integrated payments. The acquisition of Mercury accelerates Vantivs growth in the integrated payments space, which is expected to increase sig nificantly over the next several years. - - - 3 Since then, First Data Corp, Global Pay ments Inc, Total System Services and Worldpay have collectively spent approx imately US$10bn on acquisitions to boost their integrated payments efforts. - - A decade later, the integrated payments 1.0 model is no longer novel. Merchant-ac quiring 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. - FINTECH 2.0 As integral players in day-to-day mer chant activities, software companies are in - a unique position vis-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 embed ded 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 compan ies 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 monetisation Software companies increasingly view fully integrated payments functionalities as com plementary to their platforms. A payments offering not only enables software companies to capture a larger portion of the econom ics of a given payments transaction, but also comes at nearly zero customer acquisition cost, as it is a logical cross-sell to their exist ing customer base. - - - As one of the early players in the FinTech 2.0 era, Square ( en) 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. 4 The advanced software offers features such as advanced analytics, loy alty 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 per cent, nota bly above the small business MDR average - - Paston and Harris Page 229 - (approximately 2.30 per cent) (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 per cent. How ever, given the increased risk associated with SMEs (Squares core market) as well as the incremental value Square provides to its end customers, Square earns approximately 1.05 per cent in net spread. 5 Figure 2:US merchant discount rate snapshot Source: Huang, T. (2019) J.P. Morgan: Payment Processing, 10th edn, Capital IQ, available at: 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 com pany would refer its merchants to third-party payment processors and receive a revenue share of the payment processing economics. Lightspeeds customers could choose either - to continue using their existing payments provider or utilise one of Lightspeeds rec ommended payments processing partners. For the 35 per cent of the customer base that used a referred partner, Lightspeed would receive a small percentage-based referral fee of approximately 0.25 per cent of electronic transaction volume processed (the 25 basis points was recognised into revenue at 100 per cent gross margin). 6 With Lightspeed Payments, Lightspeed will now capture sub stantially more revenue from its customer base. Pricing its solution at 2.6 per cent of the card-processed portion of its customers gross transaction volume (GTV), Lightspeed targets netting 0.65 per cent after accounting for network and interchange fees. Through integrating payments, Lightspeed will effect ively capture a net fee approximately 2.6 times higher than the fee received through payments partners. - - - Further, as Lightspeeds merchants scale (and their transaction volumes grow), Software as the future of payments distribution Page 230 - Lightspeed will directly benefit from the merchants growth. Beyond the rev enue boost, the payments offering is also anticipated to be accretive to Lightspeeds 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 per cent (using adjusted net revenue as the base), and the software and merchant services business can attain an EBITDA margin of 6 per cent by 2022 (up from 19 per cent 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). Figure 3:Lightspeed revenue projections Source: Chan, D. (2019) TD Securities initiating coverage: Lightspeed POS Inc.; empowering SMBs to move at the speed of light 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. 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 man agement. These software payment players have noted the inherent inefficiencies and monetary burdens that come with integrat ing 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 require ments. More importantly, these FinTech 2.0 players offer a fully-baked end-to-end solu tion in a vertical-specific manner crafting industry-specific solutions to best solve the unique pain points endured by florists, restaurants and spas. - - - - Mindbody (mindbodyon- is an early example of a company Paston and Harris Page 231 that stands out for its business manage ment and integrated payments software in the fitness, spa and salon markets. Mind bodys software includes scheduling, online booking, marketing (eg promotions), staff management, customer relationship management tools and POS integration. Further tailoring its product to its clien tele, Mindbody released a dynamic pricing functionality that helps its customers effect ively price classes based on indicated goals (eg maximise daily revenue, maximise class attendance). As fitness classes experience attendance rates between 4050 per cent, the value of an incremental attendee is substantial. - - 7 The data-rich nature of this software relationship provides tangible value to the end merchant. Furthermore, Mind- body can leverage payments data to help drive a given spas CRM system to target customers with appropriate offers. - - Lightspeeds offering for its restau rant client base is another example of the value inherent in a vertical-specific offer ing ( - - The Lightspeed Restaurant POS system provides restaurants with all the capabilities they require from the early stages of customer ordering to inventory restocking. Light speed Restaurant is specifically constructed to meet restaurants pain points. Specifi cally, restaurants face increased price-based competition, necessitating lower prices (and coinciding margin compression) and differentiated end-customer experiences (to attract and retain customers). Mer chants 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: 8 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). Menu management: Restaurants can lever- age the POS to better manage the various menu items (eg include photos of menu items, highlight relevant allergies, provide pricing information, surface menu specials). Order management: Restaurants can keep track of each customers 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. 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 inven tory 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 2540 per cent of a typical restaurants rev enue, and to ensure that they are making sufficient margin on menu items. - - 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 feed back that better enables the company to tailor and improve the product and contin ually 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 - - Software as the future of payments distribution Page 232 of Lightspeeds add-on offerings, Light- speed has been able to upsell modules easily. In 2016, only 6 per cent of customers had multiple modules. This percentage increased to 26 per cent by 2018. While Lightspeeds base package is approximately US$100 per month, adding all of Lightspeeds eight modules can translate to as much as US$500 per month per user. 9 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 provid ers (as it may not always select the softwares referred partner), then manage a cumber- some setup process with the selected pay ments provider. It is significantly easier for the merchant to purchase payments as a part of its existing software offering, as the mer chant has already implemented the software and is familiar with its features. Further, it is a straightforward process to set up and inte grate 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 th
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