As private market dynamics continue to evolve, there is a shifting focus towards unit economics, cash flows, and the path to profitability. In addition, Private Equity and Venture Capital investors continue to see a burgeoning opportunity to generate incremental value at both the portfolio company and fund level through integrated payments.

It comes as no surprise that the world is changing. All around us, software companies are changing our everyday experiences -- from the way we shop, to what and when we eat, and how we all stay connected.

As the digital world continues to merge with the physical one, innovative technology companies strive to solve for nearly every use case, building products and services that are seamlessly integrated. Just twenty years ago, some of the most successful software companies did only one thing exceptionally well. But leading technology companies of today recognize that to win and continue winning, they must do many things exceptionally well.

One of the most significant changes today’s leading technology companies are giving their attention to is payments — and this presents a significant opportunity for investors.

We won’t belabor the “traditional” approach to value creation for private market investors, but in general, we have seen this process unfold in three steps:

• Buy: capital is sourced and put to work

• Restructure: often in the early stages of an investment, there are strategic opportunities to generate incremental cash flows and enterprise value (e.g., expense management, synergies, economies of scale, etc.)

• Sell: after the value has been created, an asset can be sold at multiples of invested capital

While there are nuances to this formula across asset classes, we see this as a high-level heuristic to traditional value creation. However, we see a paradigm shift taking place. In particular, during the restructuring process, a new playbook can be implemented by investors. This involves formulating a payments strategy to drive incremental cash flows and value.

In short, how can you, as an investor, find ways to capture as much net revenue from payments as possible (to highlight the opportunity at hand, I’d suggest watching Finix CEO Richie Serna’s Payments Layer Cake webinar). Using this approach, payment processing is turned from an operating expense into cost of goods sold, and software companies add net new revenue to the top line. Moreover, companies can also create superior user experiences and reduce churn, leading to higher customer lifetime value (LTV) in the process.

We see a world where rethinking your payments strategy should be a core tenant of your value creation strategy! Without this approach, software investors are leaving value on the table.

At a macro level, there are a number of reasons why this approach is gaining so much momentum, but the most critical theme is software and payments have become integral components of the investment landscape.

When analyzing private equity deal flow from the past ten years, ample dry powder continues to fund deals across the asset class. However, the pace of non-software related deal flow has ebbed as most of the economy has moved from analog to digital. This trend has become more pronounced recently as digital transformation has become increasingly important — and the pace of this acceleration has increased significantly.

When looking at software-related deal flow, this shift is apparent:

In 2010, only 5.5% of PE deals were allocated to software transactions, whereas 17.3% of PE deals in 2019 were software-focused. Moreover, there’s a reason to believe this trend will only continue. Based on data from the St. Louis Federal Reserve, software only represents 1.9% of private fixed investment as a percentage of GDP. There’s ample room for growth as software continues to become a core component of the broader economy:

There are many reasons why we see an increased focus on software-related investments across private equity. Still, it’s hard to argue the benefits of contractually committed recurring revenue at nearly zero marginal costs.

To augment the statistics above, we also see another exciting trend. Based on this year’s Global Private Equity Report, from Bain & Company, payments deal count from 2006-2019 far outpaces any other sector. Payments-related deals are outpacing technology and financial services by ~250bps and are well ahead of all sectors, which are experiencing a slight contraction of the observed time frame.

There’s a really good reason why we’re seeing this trend take place…

In short, payments are generating superior returns compared to other verticals. Given the potential upside of owning payments, we only expect this trend to continue going forward. Simply put, the rise of both software and payments are two trends that can’t be ignored.

What’s even more exciting about software and payments is the two have converged — and this convergence creates a new opportunity for investors. In addition, we believe we’re only in the early stages of this process, so there are endless opportunities for value creation if you know where to look:

We’re already starting to see other leading indicators of this convergence across integrated payments deal flow. In fact, through April, corporate activity has already outpaced all of 2019, and VC activity has also seen a significant uptick. For example, Global Payments has made seven integrated payments acquisitions, including Heartland, Active Network, Advanced MD, PayPros, RealEx payments, TouchNet, and TSYS. Also, PayPal has earmarked capital for similar investments and has also executed six deals, including Braintree, HyperWallet, iZettle, Paydiant, and Zong. Investors across the board are becoming more interested in the integrated payments space!

But this doesn’t tell the whole picture. In short, payments are integrated, but they’re still not woven into the product stack, which we’ll cover later in this post. However, software and payments are often valued much differently in the public markets. This is an obvious statement, but what we see is when software and payments are combined, there’s a new opportunity for multiple arbitrage.

At Finix, we believe pure-play payments companies face a much more challenging road ahead. Finix is enabling the next generation of software businesses – a combination of software and payments! But let’s first unpack why this is the case. We’ve already discussed the benefits of SaaS business models and their stable recurring cash flows and high margins – often reasons why investors will pay a premium for these assets. Moreover, typical SaaS businesses will add new customers, and if value is provided, existing user bases start to expand. This can be a large TAM depending on the market and vertical, but there’s a new opportunity to expand this TAM.

Enter payments. By embedding payments within your product stack, there’s an opportunity to expand your TAM beyond traditional ARR – and in some cases multiples of the software company’s initial TAM. A great example is a company like Mindbody. Yes, they can generate significant revenue by licensing software to yoga studios, but what’s even more powerful is the ability to take a percentage of every yoga mat and purchase made by consumers. When monetizing payments, software companies can capture a percentage of the total transaction volume and add another layer of revenue. On top of that, software companies are now capturing data-rich transactional-level detail. This new data provides new insights that lead to upsell and cross-sell opportunities. The TAM continues to expand, and this creates a fundamentally different company. We’ve already seen companies starting to do this. For instance, Shopify added payments functionality in 2013, and now a bulk of merchant solutions revenue is payments – in fact over half of the total revenues — can be attributed to payments. 

Most of all, we’ve seen investors take note of this strategy. Based on the BVP Nasdaq Emerging Cloud Index as of May 12th, Shopify’s forward revenue multiple is 35.1x — and is only exceeded by Zoom! This is the paradigm shift we see – more companies that leverage payments to drive growth and value – and at a premium compared to typical software and payments businesses. To end this section, we also see a new era of “verticalization” across SaaS that is primed to capitalize on this shift. In this next generation of SaaS, we see a world where more companies will unlock value through payments.

These vertical SaaS companies provide front end omnichannel solutions and back end applications for every aspect of a business (e.g., inventory, people management, reporting, analytics, etc.). These same vertical SaaS companies can weave payments into the company's fabric to provide end-to-end solutions and captivating user experiences. Ultimately, investors have an opportunity to generate incremental value and returns — and this has just begun!

Since we've touched on thematic content to set the stage for payments monetization, it's critical to outline the different paths to maximizing payments monetization. While there are multiple paths to monetization, not all paths are created equal.

To better understand these options, it's helpful to know how payments distribution has evolved. Moreover, this evolution is critical because distribution often dictates growth.

Initially, merchants would go to their local bank and establish a merchant account. Over time, the direct model would start to play a role as newer players started to offer merchant services. However, under both models, it became increasingly difficult to onboard more small and medium-sized businesses (SMBs) without a much larger salesforce. This constraint ultimately led to the rise of the Independent Sales Organization (ISO), which enabled a decentralized approach to providing merchant services. This new salesforce enabled traditional incumbents to onboard more SMBs, while also incentivizing ISOs by providing a residual for deals referred. Eventually, we would see the rise of the payment facilitator (PF) model. This was the most drastic shift in the distribution model because software companies could now completely own the merchant onboarding experience. The PF would dictate everything from sub-merchant underwriting to reporting. Ultimately, both the ISO and PF business models can be seen as derivatives of the integrated payments model previously discussed, with the ISO model being the 1.0 version and PF being the next logical step. However, while the ISO channel continues to grow below market rates, PFs and other software-enabled channels are growing at 2x the market. While the nuances of these business models may seem trivial — they are particularly important when developing a strategy that maximizes payments monetization.

Today, there are ~11K software companies that are leveraging an ISO model to monetize payments. They are effectively only a referral partner for a payments company, and as a result, only capture ~20-80% of total net revenue. However, when these same companies evolve into a payments facilitator, they effectively take full ownership of payments — an incredibly important distinction. When becoming a PF, software companies not only capture 100% of net revenue, but they also take full ownership of the customer experience. For example, Lightspeed POS, a point-of-sale and e-commerce software provider based in Montreal, went through this transformation, and the upside was noticeable. Previously, Lightspeed leveraged several ISO partnerships to monetize transactions, but eventually transitioned to a PF, and their net take rate increased ~2.6X as a result. In short, Lightspeed successfully transitioned from being a referral partner to becoming a payments company.

While there are a number of quantitative reasons to become a payments company, it’s critical to also highlight the qualitative aspect of owning payments.

On top of new revenue streams and improved unit economics, software companies also can deliver an enhanced user experience. This includes faster onboarding of sub-merchants, control over pricing, full control of the funds flows, and portability across processors. Also, detailed transaction-level data allows for opportunities for additional upsell/cross-sell opportunities. All of this leads to reduced attrition and increased LTVs -- and further driving value creation for investors. To illustrate this point, it’s helpful to take a look at the broader merchant acquiring landscape. While attrition varies by channel — and averages ~15% — attrition is meaningfully reduced as company’s take more ownership of their payments. This reduced attrition becomes even more powerful under the “acquire once – sell many times model” since you can continue to expand your current user-based and deliver incremental value.

Simply put, we see a significant shift taking place. Software companies are moving from a world of partially monetizing payments, to one where they maximize payments monetization and deliver superior user experiences. All of this leads to reduced attrition, higher LTVs, and incremental value creation for both software companies and investors who capitalize on this paradigm shift.

We’ve covered a lot of ground so far, but at Finix, we often face this inevitable question from investors — when should software companies bring payments in-house? While the following criteria are not intended to be prescriptive, we tend to look at the following factors when working with investors and companies to formulate a payments strategy:

What’s important to note above is the friction to owning payments have been dramatically reduced with payments-infrastructure companies like Finix. Before the introduction of companies like Finix, the process of owning payments was a daunting and tedious task. However, Finix provides a team of experts to help with the steps to become a payment facilitator and delivers seamless software solutions to manage technical integrations.

If you’re interested in learning more, the Finix team is here to help you formulate your payments strategy and identify a path to maximizing payments monetization.