Embedded finance: the revenue amplifier

Last week, Shannon Scott (Global Head of Product at Airwallex) and I spoke on a panel about the $58B embedded finance opportunity. For startups that have found product-market-fit with their core value proposition, embedded finance can be a powerful avenue for further growth.

What is embedded finance?

Embedded finance is the addition of financial products like payments, lending or insurance to a non-financial software platform, such that it feels seamless to the customer. An example: construction project management software Procore allows their customers to pay subcontractors directly within their platform.

For startups, adding embedded finance can be a 2-6x revenue amplifier (e.g. Shopify’s payments revenue is 3x its subscription revenue, Toast’s financial services revenue is 6x its subscription revenue). 

In this article, I lay out the different ways embedded finance has been used by successful startups that have since become unicorns and how it can be used by early-stage startups today.

‍Marketplaces: owning the financial transaction

If you are the founder of a marketplace startup, owning the payments on your platform provides three advantages:

1. Improved user experience – both demand and supply participants can complete the transaction immediately. When a marketplace requires the participants to go off platform to pay each other, they introduce friction that may cause a user to reconsider the transaction and not carry it out
2. Increased revenue capture – marketplaces take a clip on top of the payments processing fee which can be as high as 2-3% in the US. They can also increase the take rate by bundling in other value-added services e.g. verifying authenticity of items, handling customer support
3. Increased stickiness – marketplaces can be the trusted intermediary that provides protections around the flow of funds if either side does not meet their obligations. This makes it difficult for participants to take the transaction off platform

Some of the largest unicorn marketplaces like Amazon, Airbnb and Uber can command hefty take rates of 10-20% by embedding payments and other value-added services into their platform. B2B marketplaces like Faire went one step further than embedding vanilla payments by offering trade credit. This was a key value proposition to small-to-medium retailers, allowing them to test new products in their shops risk-free for 60 days before needing to pay.

Vertical SaaS: solving your customer’s financial needs

If you are the founder of a vertical SaaS platform (e.g. construction, logistics, restaurants, healthcare), solving your customer’s financial needs provides similar advantages to those listed in the section above: improved user experience, increased revenue capture and increased stickiness. In addition, there are two other advantages:

1. Accelerated distribution. Embedding finance can be a powerful lever to disrupt the business model of incumbents. 
   • Borrowing a tactic from the gaming world: when Riot Games came onto the scene, they disrupted incumbents by making League of Legends free to play and monetising via in-game transactions.
   • Similarly with vertical SaaS, you can give away the software for free and monetise solely via embedded finance (e.g. payments that happen on your platform). Opensolar (vertical SaaS for solar installers) has done this to gain fast adoption in the market as a counterposition to its competitors Aurora Solar and ARKA who charge $1,500-3,000 a year per user for their software.‍
2. Improved risk assessment. By being the core platform your customer lives in, you have incredible context from the data you collect, allowing you to better price risk on products like working capital finance or insurance. Flexport (vertical SaaS for international shippers) saw natural expansion opportunities in embedding financial products like cargo insurance and supply chain finance.

The typical playbook for a vertical SaaS platform on the path to market leadership is:

1. Start with a wedge use case that is the #1 or #2 priority of customers in that vertical
2. Use this initial wedge to discover more and more pain points to solve for this customer
3. Layer on new product modules until your customer lives in your software for most of their workflows
4. Layer on financial products like payments or lending – at this point, solving your customer’s financial needs becomes a natural extension of your software as it allows your customer to complete their core workflows end-to-end  

Once you get to step 4, many vertical SaaS unicorns eventually see their transactional revenue completely outstripping the subscription revenue they get from the software. Shannon described this phenomenon succinctly during the panel: 

“... with subscriptions, you grow with the number of customers you have. With embedded finance, you grow with the transactions of your customers.” 

In other words, you directly benefit from the underlying growth of your customers. Mindbody and Shopify are two great illustrations of that:

• Mindbody started off charging a subscription for its fitness centre management software. 9 years after founding, 70% of its revenue still came from subscriptions. Now, ~20 years after founding, payments account for more than 50% of its revenue.
• Shopify, a platform for e-commerce retailers, made half of its revenue from subscriptions 10 years after founding while the other half was from transaction revenue. From 2016 onwards (12 years after founding), transaction revenue started to far outstrip subscription revenue (see Figure 1)

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When should I think about adding embedded finance to my startup?

A difficult question for a founder to answer is when does it make sense to add embedded finance? Even the unicorns in this space had very different journeys, with some like Toast and Mindbody integrating payments early and others like Shopify adding payments almost a decade later (see Figure 2). 

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It really depends on the problem and customer you’re tackling, the markets you’re entering into and your business model. Treat the following considerations as a rough guideline:

• If you are a marketplace, owning payments from the start is important
• If you are a vertical SaaS, how close is your initial wedge to a financial transaction of your customer?
  • If close, consider adding payments early
  • If far, consider building product modules that get you closer to that financial transaction (e.g. with Procore, the progression went from project management -> quality and safety tracking -> workforce management -> invoice management -> payment and insurance)
• If you are entering into the North America market, consider embedding payments in preparation as it is a lot more lucrative (interchange fees are less heavily regulated there so value capture is higher)

If you have additional thoughts or learnings to share on this topic, I would love to hear from you. Please reach out to lucy@squarepeg.vc

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