A World Powered by Payments

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SaaS entrepreneurs and investors are enamored with payments for good reason. We agree with Nick DeLeonardis, SVP GM of Fintech at Toast, when he said, “I think of the world as being powered by payments.”

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Embedded payments can create a seamless purchase experience for customers and dramatic optionality for Vertical SaaS Vendors (VSVs). It allows VSVs to uniquely position themselves as a point of trust, a point of depth, and ultimately, a point of data.

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Payments monetization also provides a game-changing financial lever. It can allow you to create additional go-to-market channels, target segments that otherwise might not be viable, or change how you extract value for your products. This is particularly true in SMB and Vertical SaaS. You can think of payments’ impact in three areas:

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Customer Experience 

It is a mistake to think of payments as an individual product. Instead, it is a lever by which you can transform the customer experience. If you enable a strong payments experience, onboarding can be streamlined, your checkout times can be faster, your average spend can be higher, and from a data perspective, there is a fantastic opportunity for recommendations and increased purchases. It’s a huge win.

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Customers expect payments to work quickly, efficiently, and securely. Enabling this requires more than just having a pretty UI. It also means making sure the software works in difficult circumstances. This can be in a deskless, industrial environment, or on nights and weekends when your merchants are busiest. Supporting these merchants means offering hardware or offline mode, having high levels of support for the VSV’s software, and having core dependencies for WiFi and internet connectivity. 

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These key ideas of resilience and reliability come from the way customers experience payments. When things work seamlessly, as the customer expects them to, it’s a positive experience on both ends. But when something goes wrong (like a network failure, settlement issues, losses from fraud, etc.), the way you deal with it has a huge impact on the customer experience. This is an important factor that can make building payments in-house a riskier move than going with a managed service.

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Payment Powered Expansions

Embedded Financial Services

Payments provide key data and money movement workflows, which can be leveraged into adjacent financial services like lending, instant deposit, issuance, and fraud. All of this should be in service of building a deeper customer relationship.

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Lending is a great example of this. When conducted alongside payments, it provides extremely low Customer Acquisition Costs (CACs) as the VSV leverages the financial trust and connectivity built through software and payment experiences (as well as expedited applications from prior payment onboarding). The merchant benefits from easier access and lower ongoing operating costs as payments data streams drive superior underwriting. Collections can also occur seamlessly through the payments flow, improving collection rates and reducing the servicing burden on the merchant. 

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Instant deposit is another service that delivers outsized value when built on a payments foundation. It is a valuable feature for customers who want to transfer money in real time across various use cases (e.g., p2p payment, immediate bill pay, or movement across accounts). Integrating instant deposits into payments offers a value-added service that boosts margins by providing you with incremental fees of 1-1.5% of the dollars transferred. 

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These services benefit you and the merchants, adding to the loyalty ecosystem and creating a flywheel effect. This ecosystem creates rich sources of data and higher dollar volume processing, which you then get to monetize or reinvest into your customers.

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CRM & Loyalty

A rich Customer Relationship Management (CRM) helps you to better understand your customer base and business. Payments coupled with a dynamic CRM approach – taking payments data to inform your customer base and the operational aspect – is a powerful way to amplify value. For more on this, you can read our essay on how payments and CRM systems intersect to impact Consumer Demand, including how to differentially charge for new versus existing customers and how to create more loyalty via your CRM.

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Executed correctly, a strong payments system will enrich the CRM and provide real time transactional data to a loyalty program. This data can power look-alike offers, display campaigns, or cross-sell recommendations directly in the purchase experience (or via email or text).

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Execution: Setting Up a Payments System

The bar for payments is far higher than other types of software. Customers will have ferociously high expectations for your performance. 

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There are many options for implementing payments. Some services, known as payment facilitators (or PayFacs) will set up the entire payments functionality for you by creating a "plug-and-play" experience. Other services will allow you to mix and match different payment components, so you get more customizability without having to do it all on your own. Obviously, the most options and customization come with owning payments completely in-house. To know which option is right for any given company, it is important to understand each option and what internal factors contribute to the decision.

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What Do PayFacs Do?

PayFacs, whether in-house or from a company like Stripe, manage payments systems from creation and set-up through onboarding and ongoing maintenance. The first step is being approved as a merchant account and assigned a Merchant ID (MID). This involves registering with an acquiring bank and proving the capability to underwrite sub-merchants. Your customers become sub-merchants within your MID; this aggregation simplifies the requirements for your customers and creates a stronger experience.‍

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Once that baseline is established, the next step is setting up the actual payments system. There has to be an integration with a payment gateway, which will connect your customer merchants to networks that process payments. You also need to develop an onboarding and underwriting process, which often includes specific policies like Know Your Customer (KYC) evaluations, Anti-Money Laundering (AML), Office of Foreign Assets Control (OFAC) checks, and creditworthiness. As with any service, these policies minimize risks to the underwriter of these merchants.

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Finally, PayFacs are responsible for ongoing operational requirements. This includes everything from fraud monitoring, to maintaining a Payment Card Industry (PCI) certification, to managing chargebacks, merchant support, and other day-to-day needs. Maintaining all of these elements is important for the customer-merchant experience and for creating the reputation of resilience and reliability that customers expect from a PayFac.

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What are the PayFac Options?

The different ways of setting up and managing a PayFac system can be divided into three general approaches: 

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• A plug-and-play solution with a company like Stripe that also provides natural expansion into complementary banking products
• A more customizable but still mostly pre-built solution like Finix
• The do-it-yourself approach

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Each of these options requires a different level of investment of time, money, and effort. They also provide varying levels of opportunity for monetization and other business perks down the line.

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The plug-and-play is a company that functions as a managed PayFac provider and offers you a full-stack payment gateway. Essentially, this option is the “easy mode” of payments setup because you don’t have to devote resources to an in-house build of the service. It is relatively cheap and set up quickly, with seamless connectivity into extension products and lower operational costs. 

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The tradeoff is that there are fewer opportunities for customization or monetization down the line, since the company selling this product takes a percentage of transactions and has more rigid payment structures. However, these companies can provide a feature-rich experience and a material amount of data visibility, so they are still a good option in many cases.

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Another option is a middleware for PayFac building. These companies still provide all of the elements of a PayFac for you, but in the form of Application Programming Interface (API) building blocks that you can put together however you like. The flexibility this provides is accompanied by a SaaS fee structure and fees for volume. The policy and implementation details are up to you. These services strike a middle ground between the plug-and-play of Stripe-type services and total in-house builds.

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The last approach is becoming a PayFac directly and building the payments system yourself. This in-house build option requires greater expertise in payments and a significantly higher investment in cost and time. However, the opportunities it provides for monetization and customer experience are also great.

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Logistically, the process of becoming a PayFac is not easy. There are fees attached to partnering with a bank and processor; building out onboarding and underwriting merchants is complex; and the operational burden of maintenance and compliance falls directly on you. You need to determine whether you require online-only payment processing, in-store only, or a mix, because that will impact whether you need to invest in custom hardware or card readers. You will also need to know whether or not to set up international capabilities, and if so, in which countries. Additionally, you need to decide which forms of payment you will accept—in addition to cards, there are payment forms like wallets and cryptocurrency in the ecosystem today.

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The positive of all of that setup is that you have the opportunity to maximize the margins per transaction, create a sleek, digital-first, integrated UX to streamline onboarding, and manage other customer experience or monetization customizations. That flexibility can allow a VSV to spread the fee burden across not only the small business merchant, but also to the merchant’s end consumers through a customer-side convenience fee.

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Which should you choose?

There is no easy rule-of-thumb for determining which route to follow when setting up payments. Leverage comes with scale, therefore much of this decision is determined by the economics of your business. You need to have a sense of what scale is possible, and the level of investment you are willing and able to make. It is important to understand the size of your TAM and your payments aspirations.

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Solutions like Stripe offer a very high ROI for incremental investment. Since Stripe is doing all the heavy lifting, you can have a very lean staff dedicated to payments. These PayFac providers have tremendous reliability and are feature-rich, which allows you to layer in fraud and risk, lending, and more along with payments. The alternative investment to get all those things into place is massive, creating limitations on customization and margins, especially with the Interchange Plus (IC+) pricing models. The most common approach is to start with this "easy mode" to get you in-market and learning. 

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Building a PayFac in-house requires a lot of upfront investment in expense, time, and skill, and the room for error with customers is very, very low. The reasons to do it anyway:

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• You have significant scale. PayFac costs are largely fixed, whereas managed PayFacs (e.g Stripe) charge on a variable basis. Large scale favors fixed costs/in-house build.
• Your merchants can’t or are unwilling to pay high payment fees. Some verticals can’t afford the margin structure to pay significant fees on payments (see merchant pricing below). In other situations, the merchants may have significant scale and are able to get access to low payment fees. In either case, you won’t be able to charge high merchant fees, so for a VSV to make a margin on payments, you may need to bring the PayFac in-house to minimize variable costs.

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In the chart below, you can examine some of the costs and staffing required for each option:

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Monetization of Payments

Payments can provide a high margin and highly scalable revenue source. The exact margins and scale depend on your particular payments setup, the processing fees, and the pricing models.

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Merchant Pricing Models

There are multiple pricing models out there, but the most common in the world of payments are IC+, flat rate, and tiered pricing. IC+ is the structure we discussed above regarding fixed transaction fees—a set percentage and fixed amount per transaction.

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Flat rate pricing has become increasingly common because it provides a simple and predictable cost to the merchant. Its structure is often similar to the IC+ structure (% + $0.XX per transaction), and you as the PayFac retain the margin risk around the different card and transaction types. Therefore, the rates are often quoted differently for card-present and card-not-present transactions, or for American Express.‍

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Tiered pricing is often used by Independent Sales Operations (ISOs) and legacy payments providers. It can be more predatory, as rates are based on opaque qualifiers that can drive up the net cost to the merchant. However, this gives you an opportunity to be a provider that is transparent and predictable, offering a lower-cost model.

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Economics

Net margins on payments for the VSV are the fee revenues from the merchant, subtracting transaction costs and other fees. Some of those fees, like network and interchange fees paid to issuing banks, are pretty much non-negotiable. These fees are typically a fixed percentage of a transaction plus a fixed amount (e.g., 10 cents) per transaction (like the IC+ pricing model). While interchange fees cover a range depending on the card type and how the transaction is entered, those ranges are pre-determined.  

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As a general rule of thumb, net margins before processing approach 100 bps at the high end. They will tend to be highest where transactions consist of a high volume of lower average ticket sizes, where the fixed part of the fee drives up the total percentage paid by the merchant, and in industries with a greater proportion of online transactions, since card-not-present rates are higher than in-store rates.  

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Processing expenses vary dramatically depending on your company size. Managed PayFacs and PayFac-as-a-service systems provide the benefits of program automation, faster implementation, and lower investment or operating costs, but come at a higher incremental cost over time. Managed PayFacs and PayFacs-as-a-service can charge as high as 90 bps for processing (although they can go as low as 10-20 bps at significant GMV scale).

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The ultimate net margin to a VSV can approach as high as 75-80%, or as low as 10-20 bps on a managed PayFac basis. If you choose to bring the PayFac in house, a VSV will get access to the ~100 bps of net margin before processing and paying any expense for running the PayFac. 

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