If you’ve ever had the opportunity to pitch investors you must paint a massive, billion-dollar opportunity. Usually this level of success cannot be delivered via one core product itself. Instead, it’s typically delivered by creating customer relationships with a simple product and expanding out from there. You can look at Facebook’s conquest for messaging and picture sharing, or the entirety of Google X.
For some businesses this is totally doable. For others, the idea of a platform is less realistic. They’re either missing the cultural requirements to attract and empower innovators, or they’re limited by their own business model, sometimes by no fault of their own.
In the POS and payments spaces, we’ve seen a remarkable increase in activity over the past few years. Investors are catching on that 90% of commerce is still transacted in brick and mortar. This is a world starved of data, insights, and transparency. The size of the market and dearth of solutions has all flavors of opportunists licking their chomps.
But I’m have a hard time understanding the financings as of late. Many cloud POS companies are raising large amounts of money and I cannot determine if the financing is predicated on a large, future merchant base, or if there’s a “platform” play.
The “large merchant base” thesis is worrying. Brick and mortar is very nuanced. Take restaurants, for instance. The POS solution that works for a small pizza shop won’t work for a fine dining chain. And the staying power of solutions is a continual battle. The market sees an inherent 25% annual churn, meaning every year a quarter of your clients drop dead. Without successful sales it’s hard to imagine market share staying flat, let alone avoiding a fatal decline.
We can look at a company that succeeded under the merchant base thesis to learn a little more. Micros POS sold to Oracle for over $5B. Their market share? ~ 60K restaurants in a domestic universe of 600K (note: I do not adhere to the NRA’s counting method, which includes your daughter’s lemonade stand). Expanding further, Micros boasts 300,000 retail customers in 140 countries – including the 60K restaurants. There are 3.8 million retail locations in the US alone according to the National Retail Federation.
Micros, then, was a 35-year old POS company that had penetrated single digit percentages of the physical world. They also had a drastically different business model that earned substantially more revenue: tens of thousands for the POS software and hardware, $200/hour for support and ancillary services. In fact two thirds of their revenues were from services, which cloud POS companies do not charge for. Here’s a link to Micros’ entire 2013 10K; relevant screenshot below.
In the spirit of the “large merchant base” thesis, let’s dissect Toast’s recent fundraise. Toast publicly announced that it has grown to 1,000 merchants over two years, spending $7M along the way. They’ve raised a Series B of $30M for growth. For a typical $30M financing, you’re looking at a post-money valuation of ~$100M. So each of Toast’s merchants is “worth” $100K today. Let’s assume a continued aggressive growth rate where Toast adds another 2,000 merchants per year. In two years, they’ll be at 5,000 merchants. I have many issues with growth potential in a very crowded cloud POS market using an expensive direct sales model, but we will ignore this for now.
In two year’s time, each of Toast’s merchants is valued at $20,000 assuming the $100M valuation doesn’t change. This merchant economic still feels outrageously high considering Heartland bought Dinerware and PCAmerica at a value of $500/merchant, nor is it considering the more mature POS feature IP of Dinerware and PCAmerica.
Well, if the “large merchant base” thesis isn’t about the value of each merchant, maybe it’s about the POS revenue generated. Toast charges $100/mo for the core POS with free support and updates. Toast does offer some additional bolt-ons for increased fees, but I don’t want to get ahead of myself here: let’s assume the merchants don’t buy any of them.
If we can agree that merchants churn 25% annually, the average life span of a merchant is generously 2.5 years. At Toast’s current billing rate of $100/mo, they can expect $3,000 in lifetime value per merchant at a rate of $1,200 per year. At 5,000 merchants, Toast earns $6M a year. So even if Toast’s valuation in two years remains unchanged at $100M, that’s still ~17x revenue multiple on 5,000 merchants.
Okay well neither of these comparisons seem to hold any financial logic under the “large merchant base” thesis. So what the hell is going on?
It’s my belief that Toast, along with other cloud POS companies, sees the POS as a platform play. With open access to data, there are a myriad of solutions that can quickly plug and play with the POS, and the POS company can take a cut of each one. If a merchant previously paid $20K for a POS system and is now only forking over $1,500, there seems to be a pretty large delta of available funds. At face value this is logical, and correct. But the model will fall apart under the current approach.
I’m unconvinced any POS provider successfully builds their own bolt-on offerings or platforms alongside their core POS. Unlike the online worlds of search and social, POS is not inherently a high margin business. There’s the dirty work of sales, feature improvements, and support that limit margins. This keeps available funds for bolt-on product development to a minimum.
It’s also hard to compete with companies that do one or two things really well who aren’t in the business of selling POS, too. Is Revel going to build a better CRM than Salesforce? Shopkeep a better loyalty tool than FiveStars?
I’m really not trying to pick on Toast, but if we look at their add-ons page I see their online ordering and delivery product staring me right in the face. Is Toast going to build a better ordering product than OLO, who has raised over $60M to do one thing really, really well? And what about consumer eyeballs: is Toast going to bring as much marketing value to ordering as a Grubhub? Grubhub is an antiquated technology platform requiring fax machines, but it works because they offer consumer exposure. How can Toast generate the same consumer platform value as a Grubhub? Do I want a separate ordering app for Toast’s 1,000 restaurants? Methinks not.
Previous POS companies that have tried their hand at building non-core products have suffered: when was the last time you downloaded a POS app to transact with its merchants? Micros and NCR have offered plenty of bolt-on solutions but few customers use them because they’re expensive relative to 3rd party options; POS companies have large expenses to simply run their core POS business and they pass those costs onto their merchants in their bolt-on products. Realizing this, Micros and NCR went so far as to build walled gardens to ensure that their solutions were the only approved choices available to their merchants*, but in a twist of irony this has helped spur the rapid growth of cloud POS.
Success has come when companies recognize their core strengths and play to them. FirstData, in an effort to do more with its data, hired Palantir to build Insightics. It then used its distribution muscle to deliver value to tens of thousands of merchants. Similarly, TSYS partnered with Womply. Womply built and sold a product directly to TSYS merchants, and TSYS provided the data it had from hundreds of thousands of merchants to make the product possible. If POS companies took this approach they could focus on their core product while earning revenue share from best-of-breed third party bolt-ons and platforms, all without burning crucial, limited funds on R&D.
Unfortunately I’ve seen very little in this line of thinking from cloud POS providers. It’s possible that cloud POS is taking a short-term layover, and they’re establishing business processes until they must focus hard on their future. But it gives me pause when POS providers are branding themselves as the “all-in-one” solution. I understand that you need to tell investors that you’ll do everything. In the low-margin POS industry, it’s scary if you actually believe it.
* Micros and NCR require their merchants to pay laughable prices for integration modules, like AlohaConnect, in order to use many third party applications. AlohaConnect was last priced at a meager $1,500… or the cost of an entirely new cloud POS system.