Changing how Main Street businesses bank

Patrick McKenzie (patio11)

So-called “embedded finance” has been a hot topic in fintech circles in the recent past. I’m fairly excited about it personally, as someone who has run small businesses before and never been wowed by the service received from the banking industry. The services were expensive even for commodities, the customer support was meh, the onboarding experience was legendarily broken, and the UX of the website and mobile apps was a decade or more behind the times.

Almost no SaaS company I used had these problems.

There are various pitches for embedded finance for consumers (you can sort of cast BNPLs in that light if you squint a bit), but the big pitch for embedded finance is: the SaaS platform your business runs on can arrange financial services for you, which will feel bank-like but better.

It is now time for my usual disclaimer: this is quite relevant to my professional interests. I work at Stripe, which has products for platforms to offer financial services and cards to their users. That said, my opinions are my own opinions, as always.

Why is SMB banking underwhelming in general?

So a good first-pass model for the behavior of banks is that there are some things they do which are lucrative and some things they do because they are the traditional business of banking. Experiences for the first category of things are often really, really good.

Issuing credit cards to retail users, for example, is an extremely lucrative business. The bank will often pay you to use the product. You can sign up for it at 2 AM in the morning. You can be approved in less than a minute without talking to anyone. The mobile app is (if not a heartbreaking work of staggering genius) reasonably functional. If you have any questions you can call the number on the back of the card and get a responsive answer very, very quickly from a human if necessary.

Banks also bank small businesses, but many do this out of a sense of societal obligation. This is sometimes organic from the culture that is banking. This is sometimes out of a more explicit quid pro quo. Society grants banks an exclusive license to engage in a number of extremely valuable activities, such as making consumer loans and funding loans with deposits. In return for this, society (and, specifically, banking regulators) demands a number of things.

One price of admission: you must have some offering for a customer who comes in and says “I just opened a laundromat… what happens next?”

Every entrepreneur who opens a laundromat is providing a valuable service to their community and should be celebrated. However, from a bank’s perspective… this is not the most exciting client in the world to have. A full accounting of why is outside the scope of this post, but some of the issues:

KYC (Know Your Customer): The bank will need to spend expensive staff time getting intimately acquainted with a business which is likely somewhat informal and less-legible than regulators expect it to be.

High servicing cost: The laundromat will have frequent dealing with coins, which are annoying and costly for banks, and which are likely under-monetized for a variety of reasons (this is often something society expects banks to just take care of because, after all, we gave them stewardship over money and coins are money). The laundromat will, likely, consume quite a bit of staff time on an ongoing basis.

Low revenue potential: The laundromat’s primary value to the bank is as a source of cheap deposits, but it will never deposit a lot of money; most of what it earns every month will go out the door.  The laundromat does have credit needs but the bank mostly cannot serve them profitably, because the nature of the business is risky, the business is informal and illegible, the entrepreneur likely does not have legible credit or assets or earning power outside of the business, and the bank does not have any computer program that can spit out a decision at 2 AM for seven cents but rather needs to have expensive human underwriters spend expensive professional time on a business which will probably not consume enough services to justify that time.

This is not a unique failing of banks! If laundromats had to hire top-flight engineering consultants to build internal software to operate their businesses, those consultants would have very similar issues servicing them. Which is why laundromats mostly don’t do bespoke software development.

They instead snap into SaaS, which love their business and can service it profitably.

SaaS platforms are rewriting the operations of small businesses worldwide. This is a very the-future-is-here-but-not-evenly-distributed trend; businesses which many technically inclined people would describe as “legacy” and “not tech-forward” will almost all run on software. It is going to happen much faster than consensus estimates.

Some SaaS companies will also become major financial services providers.

SMB-focused platforms are moving into financial services

Take Shopify, for example, which supports more than two million merchants, the vast majority of which are Main Street businesses which happen to exist at least partially on the Internet. (Shopify is a customer of my employer and is also a very large publicly traded company; all of the facts about their business can be sourced from their public reports.)

Their core business, historically, has been providing SaaS to let businesses that could never hire an engineer still have a competent web front-end. The vast majority of their customers pay less than $50 a month for this.

Shopify’s brief is to make their merchants more successful at selling more things to more customers. Payments is a large and growing portion of their business now, but at the core they’re a software company, and programmatic money movement is a very, very interesting capability for a software company to have.

The nature of payments has historically been that money moves from a customer through some pipes coordinated by a competently-executed software platform into a bank account before the business can actually use it. That last hop introduces delays, costs, and a lot of friction.

Many businesses which use Shopify eventually treat it as the nerve center of their business. It’s a special case of a pattern we see often in more vertical SaaS: “morally an ERP, in addition to the thing more commonly associated with it.” The view into the business exposed by the dashboard and things linked on it is the best legible reality of the business, as far as the owner is concerned.

The hop into the banking system necessarily causes that view of the business and the actual reality of the business to diverge. Reconciling them causes a lot of pain for the managers, for bookkeepers / accountants, and for anyone (banks, tax agencies, potential acquirers, etc) who need to understand the reality of the business.

If Shopify arranged for the provision of financial services, this final context-shedding hop would not be necessary. And so now they do: the offering is called Shopify Balance (which is powered in part by Stripe Treasury). It does the things a business wants to do with money, like spend it, hold it, and send it, but does them more natively in the Shopify context than if the business had to build an ad hoc underspecified version of half of it to interface with the bank on the corner.

Why is this structurally innovative?

It's probably fairly intuitive that most SaaS platforms will ship better software than most banks, but banks can (and do) publish some pretty amazing software. It is just far more incentive compatible for a platform to do it than for a bank to.

One reason is concentration of their customer base. Small business banking is, by necessity, a very, very broad offering. I previously ran several small businesses which banked (in part) with a large U.S. bank, chosen by the very sophisticated SMB owner process of “They had the branch in the food court where I went to college, many years ago, and so of course I walked into one of their branches and asked ‘Uh I think I am actually in business now, what do you have for me.’”

The bank helpfully offered my small SaaS company exactly what they would have offered a landlord, or a dentist, or a freelance copywriter, or a towing firm, or a budding e-commerce company. My business has very different needs from all of those. The bank knows this, because they are extremely intelligent professionals, and cannot act upon it. Society expects them to have a responsive offering for any licit business which walks in the door, and they have an offering, and it is what it is. They cannot customize that offering to exactly match the diversity of needs of any business in the economy. A hundred thousand engineers could not do that.

Their one-size-fits-none offering was relatively expensive. I paid $15 a month for basic business banking. The terms on the business’ credit cards were uniformly worse than the ones the same bank offered to me on my personal cards, despite the personal guarantee, and despite those cards being more lucrative for the bank structurally (due to spend levels and interchange rates). I’m a businessman and I don’t begrudge them their prices, but… I’d happily have moved to a better, cheaper offering.

SaaS platforms don’t have to serve everyone in the economy. They can make very large businesses off of a very small subset, and make their products sing for that subset. Shopify (presumably?) doesn’t have to worry too much about dentists or landlords.

Banks are able or willing to make some services free because they support the rest of the business (for example, the aforementioned coin management). SaaS platforms have the same capability, and because financial services are so sticky, platforms are often willing to “give them away” along with their base offering. BigBank had a five-prong test to waive the $15 a month fee for basic banking; Shopify will happily staple a free card to every new account.

Many small businesses are extremely sensitive to their cash cycle. The few days it takes payouts to land and become spendable are a frequent source of managerial headaches. With tighter integration between the platform handling money collection and the first place the money is spendable, that delay can be almost arbitrarily short.

BigBank has no system in place to see “OK if you just had a purchase on your website then probabilistically you should receive $48 in four days so, hmm, modulo credit risk and cost of funding, I should just advance you $48 to keep you happy”; Shopify and friends can build that. (Shopify offers next-business-day payouts to Shopify Balance.)

(There’s a fun sidenote about creating overlay networks on top of the existing financial system which I will have to cover some other time, but the backend of how this works is fractally interesting.)

How does this make business sense for platforms?

Platforms are rapidly becoming the OSes of businesses running on them. In some ways, I think of them as akin to franchising systems. A typical franchisee is simultaneously a provider of capital, labor, and entrepreneurial skill. The franchise’s operating document and systems attempts to increase their entrepreneurial capabilities by walking them through the huge list of things that they’re suddenly responsible for, from hiring to taxes.

SaaS platforms are evolving in this direction, where their software, services, educational offerings, and similar provide much of the infrastructure that a franchise does, but at wildly lower total take rates and for far less capital investment.

Adding financial services makes all of their offerings better. It makes them stickier. It can even make businesses more effective in a scalable fashion, and given that the platform indexes on the aggregate success of their users, figuring out e.g. “X% of our users and a disproportionate number of underrepresented founders report access to capital is holding them back; what can we do to solve that?” shows up on their dashboards very quickly.

There is also a direct revenue model for the platforms. One major component is interchange on the businesses’ card spend. For reasons which will be obvious to you if you’ve read previous installments of Bits about Money, the cards will be invariably issued by a Durbin exempt institution.

Just like interchange allows one’s suppliers to bid down one’s cost of capital, interchange also allows one’s suppliers to bid down one’s cost of compelling SaaS services.

This dynamic is extremely underappreciated in most popular discussions of interchange, by the way. Interchange historically moves the cost of credit from the purchaser to the business servicing them, by compensating the card issuer such that they can afford to offer credit at lower cost. This is the core engine of BNPLs; in the limit case extending credit can be free to the user of it. Businesses partially pay interchange specifically because they want their customers to come back more often and buy more and offering cheap credit does that.

An SMB’s non-SaaS vendors should in expectation be thrilled that their SMB customer is using a SaaS platform. It makes that SMB more likely to survive. If that SMB thrives it will buy more of their stuff. The SaaS platform and embedded finance team up to essentially make this subsidization happen automatically, without needing to walk anyone through the internal logic.

So does this cut out “the banks”?

No, mostly it takes advantage of specialization of labor in banking. Most embedded finance products heavily involve regulated financial firms, often including banks. Some are specialty players who have a core competence in this sort of thing, versus banks which have SMB banking in the same division as retail banking but also have e.g. ten thousand people working on capital markets, a wealth management division, etc.

(A plug: the annual report of any bank you use is fascinating reading. If you’re not familiar with how to read them, start with First Republic Bank, which is about as straightforward as a bank can be, and then after you’ve figured out what “simple but large” looks like compare that to any of the large money center banks.)

Banking services can be very bespoke on the high end, which probably seems unbelievable to a laundromat. Wall Street won’t return your calls, let alone negotiate terms with you. But a large enough aggregation of small customers without requiring building out a nationwide branch network is very interesting to even the largest banks in the world.

This can be a have-our-cake-but-eat-it-too for stakeholders in society who care intensely about exactly how money moves around. Large investment banks and money center banks are maximally legible to banking regulators. Smaller speciality banks are still, at the end of the day, banks. The diverse panoply of regulated financial entities stays regulated.

There are some people who would be very worried if “tech companies” ended up holding the money, for a variety of reasons that I mostly disagree with but can at least intellectually understand the underpinnings of. Embedded finance offers an interesting compromise solution: “tech” gets a detailed understanding of customer needs and paints the pixels; regulated entities sign up for the usual list of responsibilities and will respond with alacrity to any inquiries.

There is a potential that this is the best of both worlds. And even better, it’s a choice: the traditional small business bank account is still abundantly available. Walk into almost any branch in the country; they probably have a small business offering. But now they have to earn your business, which is better for everyone.

This trend is very, very early

Although fintech geeks have been quite enthusiastic about embedded finance for a while now, this trend is still very early. One reason why the above writeup is a bit North America centric is that offerings here in Japan, as well as much of the world, are still rather anemic. That is changing rapidly, though.

Core infrastructure takes time to build. Consumers of core infrastructure, though, can expand at the speed of software. Many people think SMB owners are set in their ways. You are welcome to share this observation with your SMB owner of choice over the messaging app on their smartphone and see whether they agree with it.

I think people underrate how fast product cycles and adoption curves will move in this segment, and I think that is also true of most people who are professionally involved in making it happen. The product possibilities are much better than existing alternatives and the channels for selling them already exist. This avoids the frequent bugbear in consumer fintech, which is that it becomes a cost of customer acquisition game against some of the best funded and most savvy marketing teams on the planet.

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I write about the intersection of tech and finance, approximately biweekly. It's free.