Now that a wave of vertical SaaS companies include payments as a feature, the next wave of differentiation will come from those that become payment facilitators.
Some brief education: historically, businesses that want to process credit card payments have to open a merchant account with something called an acquiring bank, which underwrites the fraud risk of the business and relays transactions to the bank that issues the credit card. To open the account, the business has to convince the bank that its transactions won’t carry a disproportionate risk of fraud and chargebacks. In order to do so, business owners (or founders) have to provide detailed financial information, potentially even having their personal credit reports probed for abnormal behavior. Once the account is open, the business can use any number of processors to take credit cards as payment and the acquiring bank charges a transaction fee.
Fast forward to recent history, and payment facilitators (aka payfacs) emerge. A payment facilitator acts like an acquiring bank without actually being one. The facilitator opens a merchant account and creates sub-accounts for businesses that process payments through it. In return, the payfac takes on the role of underwriting merchant risk and assumes some fraud liability. Because of the risk associated with becoming a payfac, not many technology companies have explored it. But, a couple did and have consequently become household names: Stripe and Square.
In the meantime, though, SaaS companies have been busy building software for specific industries. Mindbody, for example, started as a scheduling system for yoga studios. But because it’s hard to build a moat of defensibility around a list of features, the next evolution of these vertical SaaS companies added the ability to process payments natively. As a salon, for example, you can accept payment directly through StyleSeat. When launching these capabilities, though, the companies mostly built on top of Stripe or Square. The consumer’s credit card would be processed by the business, the SaaS company, the payfac, and the merchant bank, with each entity trying to take a few basis points in fees. The result is a SaaS product that offers expensive payment terms, limiting the ability to make a profit by processing transactions.
Now, however, vertical SaaS companies are getting wise about payments and looking to become their own payfacs—a trend that excites me as an investor. By eliminating the existing payment facilitators, a new breed of companies can recapture the fees previously taken by Stripe or Square. In effect, they’ve become Stripe for their own customers. Since another payfac isn’t around to charge transaction fees, the SaaS company can scoop up additional profit while also providing better payment terms than competitors. And since becoming a payfac is a difficult process that can take years to complete, there is inherent defensibility. Newer fintech entrants, Payrix and Finix are helping companies become their own payfacs and kick their Stripe habit. Companies can thereby defeat competitors with superior payment terms that can’t be matched quickly, giving the payfac a substantial period of time in which to become an entrenched market leader. This is a trend I think will drive a whole new wave of vertical SaaS unicorns.