Formation and Access- 10x Your Take Rate!

We are seeing a new control point pattern we call “Formation and Access,” which may be the most disruptive pattern we’ve seen in Vertical SaaS since the introduction of embedded payments. 

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Formation refers to helping entrepreneurs start a business in a new field or spin out of large existing organizations to create their own standalone ventures. Starting a business is incredibly challenging. Daunting barriers like regulation and competition mean many people want to start something, but don’t know how to get their project off the ground. This is where a new breed of Vertical SaaS Vendors (VSVs) comes in, acting as accelerants by breaking down the barriers for merchants looking to found a company.

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Access is about solving key constraints in the new business by providing access to the key resources and relationships. Unlocking the right door for a founder can increase the speed of formation or increase the likelihood of the newly formed business succeeding. Access includes giving these new startups an advantageous position from which to reach customers, suppliers, and licensors. Doing so balances the scales against large players.

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If you can help with both, you can charge a merchant a lot of money! We see that Formation and Access VSVs are earning 10x the take rates of traditional VSVs.  This new breed is using this 10x economic rocket fuel to quickly take share and threaten to disrupt the incumbent vendor landscape. However, these Formation and Access VSVs need to resolve a couple of critical (perhaps existential) value proposition flaws to take advantage of this early momentum and build long-term sustainable platforms. 

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This essay will explain why we are excited about this idea and the potential pitfalls that founders pursuing it should be wary of.

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Formation

Let’s start with Formation. What makes it so special for the VSV? We know that merchants typically want a single point of accountability. Business owners are busy people running complicated businesses. For them, purchasing goods and services from a single vendor is preferable. It increases the speed and ease of the purchasing experience, and if anything goes wrong, there’s a single point of contact.

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When a merchant is buying for the first time, that desire for a single point of accountability becomes even more extreme. When an entrepreneur has an idea they’re excited about, they will want the “formation” service as soon as possible! They are desperately looking for solutions if you engage with them in the harried 0 to 1 of starting a restaurant, a web design agency, or almost anything else. You don’t need to convince them of the relative merits of your software; you just need to show them a solution that works right now. As long as a trusted brand provides the service, comes with the right integrations, and has a good price, merchants will just click buy. Note our case study on LegalZoom if you want to see this effect in action.

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The bonus is the zero or negative CAC. Offerings like Stripe Atlas charge $500 for business incorporation. Other incorporation services that deal with more complex regulatory or professional accreditation requirements can charge even higher amounts, sometimes pushing into the thousands of dollars. The key insight is that the fees you earn from the moment of incorporation can be more than enough to offset the CAC you spend for each of your customers!

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What Markets Are Well-Suited for a “Formation and Access” Strategy?

A market that is well-suited for a formation and access strategy is growing quickly (as most good markets to enter are). Beyond that, there are three unique characteristics that could make such a strategy work especially well:

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1. Markets where consumers choose products or services on the basis of the individual practitioner. The key question here is whether customers are more loyal to the individual service provider or to the larger brand that the service provider works for. In cases like mental health professionals, an individual therapist and an end customer form a connection that is an essential part of each transaction. People tend to be loyal to their therapist rather than to the larger brand or franchise the therapist happens to work for. This decreases the barriers for a merchant forming a new company because they can bring demand or a book of clients with them. This also increases the likelihood that new businesses using the VSV’s formation solution will succeed, as they already have an existing book of business to count on.

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2. There are limited returns to scale or high fragmentation in the market. This indicates that smaller operations can achieve some degree of success and that the market isn’t hostile to smaller players for a structural reason. If you’d like to see data on fragmentation by vertical, you can find that in our “Picking Your Market: Vertical TAM & Concentration” piece.

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3. There are bottlenecks to unlocking supply in a market where consumer demand far outstrips supply. If consumer demand consistently outstrips supply in a market, this could indicate either 1) that there simply isn’t enough supply or 2) an abundant latent source of supply exists, but some constraint prevents that source from entering the market. The latter is a strong case for a formation strategy—a VSV that enables new business formation and unlocks latent supply is best positioned to command superlative take rates. If the constraint were solved, this latent source of supply would convert into new businesses entering the market, which would fill the gap between supply and consumer demand. A key point here is that a latent source of supply needs to exist in ample quantities. One case study of this latent supply dynamic is in the medical spa (medspa) market. Consumer demand for medspa services like Botox has been growing, and an ample supply of Registered Nurses (RNs) in the US could potentially start new medspas to provide those services if the barriers to starting one were made smaller.

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This brings us to the ultimate mark of a great market for formation: the presence of a key constraint.

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Removing Key Constraints by Providing Access

Think of the key constraint as the most important thing that’s blocking a new business from succeeding. Why does David have such a hard time slaying Goliath? What does the scaled player have that a newly formed company doesn’t? Thinking about the answer will lead you to identify the key constraint. And then, when it is solved, the new business becomes “proforma equal” with the incumbent.

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The key constraint can be many things, ranging from finding customers to obtaining critical talent. Our writing on consumer and employee extensions covers a lot of this ground.

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But we’re finding that the platforms that are earning the superlative take rates are removing constraints that are extremely vertical-specific or esoteric. That is where the constraint presents the most pain and, therefore, where the profit pools are the most compelling.

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These vertical-specific constraints typically manifest in a few ways, all centered around the need for Access to a key resource:

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1. Access to Customers and Payors: Structural, vertical-specific cases sometimes gate access to customers. For example, therapy practices often face the constraint of needing designation as “in-network” by health insurance companies, which limits the number of potential customers they can access. If a practice gains designation, consumers are much more likely to become clients of that practice since they no longer have to pay out of pocket for the services. However, small independent practices find it very difficult to get giant health insurance companies to designate them as in-network. Companies like Grow Therapy, Headway, and Alma solve this problem by allowing practices to become in-network with certain insurance payors, thus increasing their access to consumers.

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2. Access to Suppliers: In some verticals, access to suppliers is essential, but getting those suppliers to answer your calls is challenging or costly for small independent businesses. The key constraint is not being able to access supplies. For instance, a medspa will need to be able to access a steady supply of Botox, a common injectable. However, buying requires certification and a six month waiting period, and it can be prohibitively costly if you are unable to buy in bulk as just an individual independent practice. A VSV can solve this with a Master Service Agreement (MSA) to provide merchants access to supply immediately, as well as aggregating the combined demand for supplies of all its merchants to negotiate lower prices with suppliers. 

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3. Access to Regulatory Solutions: Regulatory restrictions constrain new business formation in some markets. Staying compliant and fulfilling regulatory requirements can be challenging for individuals aspiring to become new owners in these markets. For instance, healthcare-adjacent VSVs provide services, like medical director matching, to help meet regulatory requirements for care or drug prescription.

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What is characteristic of verticals where key constraints like these exist? The main factor is market concentration. When the suppliers are concentrated, they have more leverage to limit access to their goods. This is the case in the Botox example above—there is only one original supplier in the US, and it can be picky about who it works with and has pricing power. Similarly, there are only a few large health insurance companies in the US, and so the same dynamic exists in the “access to customers” example listed above.

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You might find players across the value chain who have fat margins or slow processes—these are all downstream of them being scaled in a concentrated market, which gives them the leverage to price highly, earn bigger margins, and drag their feet on process. Often, markets operating primarily on legacy software are also indicative of key constraints or bottlenecks being present—the workflows through which business is done in those industries may have stayed inefficient, as a result of concentrated players stifling innovation.

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Challenges

10x take rates sound great, but what’s the catch?

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First, you’re dealing with customers just starting their journey–in addition to being uneducated about your product, they know very little about starting and running a business. For most software companies, your customer education is typically limited to how to use your own product. When you offer formation products, you have to educate your merchants on how every aspect of business works. This is not easy. For example, most Formation and Access vendors provide in-depth training as well as 1:1 expert coaching, all dedicated to teaching their customers how to successfully run their businesses.

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Second, a VSV pursuing this strategy will have to deal with lots of early churn and unfocused customer acquisition spend. You will really struggle to know which merchants will succeed or fail and inevitably invest in many that will go out of business in under a year. The new customers you acquire will not be established businesses that have been around for a while and have proven staying power; instead, by definition, they will be newly formed businesses that are fighting for survival.

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Third, high take rates tend to come under pressure over time. As the saying goes, “Your margin is my opportunity.” Conventional wisdom suggests that high take rates don’t persist forever as new players and startups compete away margins. Or, just as commonly, customers and suppliers realize how much you’re taking off the top and attempt to take more of the profit pool away from you. There’s also a graduation risk: companies may be willing to pay these large rates when they’re small, but when they scale, they’ll start examining your bill closely and look for alternatives. They may have formed their business through you, but as they scale and get to a more mature state, the formation services you provide become less and less critical to them, and they may become more and more averse to your high take rates.

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Whether it’s graduation risk or another Formation and Access competitor coming at you, you need to be thoughtful about how you can sustain value propositions (and thus take rates) over time. Ideally, you find value propositions that only get stronger as more customers come onto your platform. Some examples that remain strong beyond just the formation phase are:

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• ‍Value Propositions that Only Get Better with Scale
  • Buyer/Supplier Power: In an industry where the merchants are small businesses and their suppliers are much larger, a group purchasing organization (GPO) can be an effective offering, leveraging collective buying power to buy at lower prices and better terms. If executed well, a VSV’s GPO can drive serious volume for suppliers and remove the cost of selling and negotiating with thousands of merchants individually. And it gets better as you scale. Every time you add a new merchant as a customer, the aggregated negotiating leverage your VSV has with suppliers grows, and thus, your ability to negotiate larger volume discounts increases. The more significant your aggregate purchasing volume is relative to your counterparty, the more powerful you become in that negotiation. One other dynamic to note is that the more commoditized the actual item being supplied is, the more leverage you have. We write more on this in our supplier extensions piece.
  • ‍Data Advantage: Your offerings benefit from data or experience-driven learning. An example of this is claims management. Increasing your scale and getting more claims data under your roof allows you to make better predictions. The more you do it, the more you understand the process and the better the product is that you can offer to your customers.

• ‍Reputational Benefits: As your platform gets larger, your brand and reputation may also grow. You can leverage this growing reputation to boost your negotiating leverage and trust with suppliers, payors, and government bodies that are relevant in the value chain. If your platform becomes well-known for only working with reputable, well-trained, legitimate merchants, then that decreases the transaction costs that other entities incur to do business with you (think shorter KYC processes, lower monetary costs, less friction). Done well, your brand can become a marker for quality and excellence.
• ‍Relationship Benefits: Your VSV’s relationships with other stakeholders in the value chain can create long-lived benefits for your merchants. For instance, you don’t need to do a new negotiation every time for every new merchant on your platform–instead, you have an MSA with the relevant party. Also, having repeated interactions with and deep integrations with these important stakeholders can yield faster process times, higher quality of goods or services traded, and lower costs.

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We love these businesses not only because they embody the VSKP theory on steroids but also because they change industry economics. Most of all, they level the playing field for Davids to go out there and slay Goliaths.

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If you are building a company utilizing the Formations and Access strategy, please reach out! We’d love to jam on how we can protect and increase your take rate.

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