Verticalization of payments is real. Cowen’s Restaurant Report gave us a glimpse into this trend through a survey of a few hundred merchants. Boston Consulting Group’s Global Payments: The Interactive Edition similarly predicts that by 2027, software vendors will represent $154 billion of North American payment revenue – that’s 54 percent of the total revenues for those of you keeping count.
And why not? Payments is massively commoditized, provides no real value, and has effectively zero cost of goods. So every software company and their dog should offer payments processing if they can.
But once you get into the weeds you realize how complicated payments processing can be. Not because it needs to be complicated, but because incumbent providers want it to be complicated to defend their commoditized payments moats. It’s the same reason Visa and Mastercard have hundreds of interchange rates for card types: because if nobody knows what the hell is going on it’s harder to question pricing.
Enter Payfac-as-a-service (PFaaS).
PayFacs, or payment facilitators, are the new-age payments entities. Square, Toast, Stripe – these software companies all became payments facilitators to drink from the payments processing fountain. The card networks – Visa and MasterCard – saw PayFacs as an opportunity to transition non-card volume onto their networks, where they would earn their respective fees. Thus the networks forced the rest of the payments ecosystem to accept this new model of merchant processing.
PayFacs are all the rage because you can onboard merchants quickly and often command greater processing profit. Traditionally, a payments processor would need to collect business information from a merchant, assess risk based on that data, and tell the merchant if they were accepted. This could take weeks. PayFacs instead become certified with acquirers directly as a master merchant and assume the risk of whatever merchants they themselves onboard. PayFacs have their own risk assessment tools but the verification process is faster and thus less rigorous than traditional methods. PayFac downsides are that a data breach or faulty analysis of merchant risk could be financially ruining. This is a great article explaining how PayFacs work if you’re so inclined.
Still, being a PayFac is cumbersome. According to Richie Serna, CEO and co-founder of Finix, one such PFaaS provider, PayFac sponsorship and compliance are non-core to nearly every software company – and they take material resources: sales personnel to handle payment pricing, operations personnel to manage the payments business, a robust support team, and risk management folks. “If you want to be a PayFac it typically takes two to three years of development,” Richie explains. “You need to build connectors to KYC (know your customer) entities and maintain compliance. It can take upwards of 15 engineers, and engineers aren’t exactly cheap.”
Via companies like Finix, software companies have become PayFacs much faster. “Our average onboarding rate is about two months though we have some partners who have done it in as fast as two weeks.”
Finix is one of many PFaaS providers. Others, like Infinicept, Payrix, and Amaryllis, are following the general trend on unbundling, albeit specific to payments. Yes, you could build your own payments business, but it’s almost certainly cheaper, faster, and more convenient to punt the responsibility to someone who does it for a living. “It’s more cost efficient for almost every software company to look at PayFac as-a-service,” says Richie. Lightspeed, which recently chose Finix to enable Lightspeed Payments, is a POS company processing $13B annually, but even they realized it was more prudent to partner than it was to build out payments capabilities themselves.
There are subtleties that make a big difference. For instance, how will you handle card present and card not present? Lightspeed had to do both since they have physical and online retail locations. Finix made compliance with their business model much easier.
Richie Serna, Co-founder Finix
FiveStars, a loyalty company that has since become their own PayFac via Infinicept, gave the thumbs up to the process as well. “We looked at all the PayFac players and ended up choosing Infinicept and have been very happy with the choice. Infinicept’s deep expertise on the payments side is incredibly helpful, too; it only took us one full-time employee to go-live, and one full-time employee to underwrite risk by leveraging the Infinicept platform and their expertise,” attests Matt Doka, FiveStars co-founder. “As an example, First Data sent a top guy to do an on-site underwriting review after we were set up. He booked eight hours and was out within 90 minutes. He said our underwriting systems and processes are what he, as a compliance guy, dreams he had on every one of First Data’s PayFac client sites. And we did all of this with effectively one additional full-time employee.”
There are tens of thousands of software companies that would benefit from becoming their own PayFacs. The model might even make sense for larger merchants with franchisees, too. According to Richie, Braintree started as an ISO but then they matured into a PayFac. “There’s no reason to think large merchants who became their own ISOs couldn’t benefit similarly.”
These PayFac-in-a-box models are also intelligently priced. While payments companies are garnering ~4x revenue multiples, companies like Finix and Infinicept sell SaaS subscriptions. Instead of taking basis points on a transaction, which is the classic dumb-dumb payments mindset, the SaaS model gets them an ~8x revenue multiple. That’s called arbitrage for all you payment bros out there.
The growth of the PayFac business can be a bit of the snake eating its own tail, however. “PayFacs ride on the traditional merchant acquirer rails but they’re cannibalizing to the processor,” shared a confidential source.
Processors don’t make nearly as much revenue from their PayFac partnerships as they do from their own, direct acquiring. For example, an acquirer might make 30-40 basis points plus bogus fees from their direct merchants. And because those merchants are on the acquirer’s paper the acquirer owns them. Via a PayFac model we might make 2-7 basis points per transaction. As more and more merchants logically select commoditized payments from their software vendors, merchant acquirers are going to see their revenues erode.
Confidential payments source
The acquirers most likely to see their revenues fall would be those with large card-present business lines, like restaurant and retail. We built a table to compare the revenue and margin opportunities for acquirers in conventional card-present situations (i.e. retail and restaurant).
The flip side of this is two-fold: PayFac business lines are, theoretically, higher margin, and PayFacs should bring net-new transaction volume to the acquirers. “Due to the limited amount of work required to set up and maintain a PayFac business unit as an acquirer, you can do more with less. At Mercury Payments we had something like 700 employees servicing 80,000 merchants,” shares an anonymous source. “You could support the same number of sub-merchants with about 20 people on the PayFac team.”
Todd Ablowitz, co-founder of Infinicept, also reiterates the idea that PayFacs will drive a lot of net-new processing to the acquirers that have open lines of PayFac business. “For emerging electronic payments categories, such as business to business, government payments, etcetera, it’s truly new payments. In 2010, 10% of all donations were electronic (at that time it was a $277B industry). I would bet that it’s more than half today. In 2010 India had very few merchants processing cards. Today India has 5M merchants processing cards, making it number three in the world. In both of these examples nearly all of that net-new volume came from software companies that were also PayFacs.”
Boost Payment Solutions, a B2B payments provider in 32 countries, backs up Todd’s claim. 98% of their B2B transaction are net-new on the payments rails according to Dean M. Leavitt, Boost’s founder and CEO. Dean defines the B2B payments Boosts supports as invoice-based, accounts payable spend, not “walking plastic”. We wondered why anyone would use a card for B2B transactions when wires, checks, or ACH transfers are much cheaper. “Our median all-in transaction cost is less than 2%, and a large percentage of businesses offer 2% early-pay discounts which offsets card costs. People often ignore the costs of managing remittances but plastic makes it easy, and it’s why we’ve not had a single chargeback in our company’s history.”
Where does this go? We see several paths, but none of them particularly good for merchants or innovation.
On the first path, acquirers with substantial exposure to card-present merchants increase fees to PayFac platforms. Todd thinks there’s still enough competition in the acquiring market that if one acquirer did raise rates its PayFac portfolio will just move elsewhere. “There’s nothing preventing the PayFac from moving their entire sub-merchant portfolio to competitor,” says Todd; but we’re not so sure the industry wouldn’t just collude. We are talking about an industry where materially increasing prices for no justifiable reason is appallingly celebrated.
On the second path, the acquirers – since they hold all the money, relatively speaking – buy the software and PayFac platforms and ratchet rates after the fact. Large tech companies have been buying disruptive upstarts for years, and it’s a well-honed strategy when a thorn digs itself into your side. It would certainly explain Global Payment’s acquisition spree of software companies, who wants to convince markets that they deserve a software multiple.
Yet payments processors have proven to be one-trick ponies: they turn the payments crank to meet numbers and squelch any whispers of innovation. Even if they own a software company it doesn’t mean they actually know how to run one; we’re talking about organizations that don’t know how to appropriately allocate capital to R&D because, well, payments processing needs none. Acquirers can make more money through rate increases than they can with sweating innovation – so there’s been no culture to support the latter. Sure, you can M&A software all day, but if you have no inclination to support what you’re buying it will end up as a failed experiment.
Unfortunately for the market, acquirers have all the money, and they thusly make the rules. Until someone materially disrupts interchange true innovation in payments will be fleeting. So become a PayFac while the getting’s good, because the processors will shoot this horse in the head as soon as they find their guns.
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