The Next Generation Of Fintech Is Here

Fintech is becoming a native component of the stack (both as a technology stack and as a business model), which means embedded fintech is becoming more prevalent than pure fintech.

To put it another way, we're investing in companies that use financial technology as an ingredient rather than as a primary business model.

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In the era of embedded fintech, Payments-as-a-Service ("PaaS") has emerged to provide a menu of packaged microservices that can be delivered through the cloud rather than a standardized all-or-nothing solution.

In other words, all the functional capabilities of a payments hub can be customized, packaged to order, distributed, and delivered via multiple media, significantly reducing implementation and onboarding times."

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The Current Landscape

Software companies today have three options for accepting payments:
1. Use the legacy ISO model: the ISV refers its merchant customers to a payment processor. Because the ISV does not take on merchant underwriting and compliance burdens and is not involved in the funds flow, this model is simple. However, the ISV lacks control over the payment experience (it cannot control which merchants are underwritten or how payments are disbursed) and it is not fully able to monetize its payment transactions (it only receives a referral fee).

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1. Partnering with a PayFac: the ISV processes payments through a PayFac. For the ISV, this model offers three key advantages: (1) greater share of payment economics than the ISO model, (2) faster merchant onboarding, and (3) greater control over payments. These benefits, however, come at a cost: (1) ISVs earn less than if they were PayFacs themselves since PayFac partners typically keep the majority of payment economics; and (2) ISVs are limited in terms of payment features they can offer because they are dependent on PayFac's product suite.

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1. Become a PayFac: the ISV becomes a PayFac by acquiring and aggregating payments for its submechants. PayFac offers several benefits to end customers: (1) faster merchant onboarding, (2) greater control over payment experiences, and (3) higher revenue share for ISVs. It is, however, possible to become a PayFac by hiring additional staff to manage legal, customer service, and engineering processes; (2) establishing payment system integrations requires substantial investment; (3) developing merchant onboarding and compliance procedures is expensive; and (4) managing risk monitoring, fraud prevention, and chargebacks on an ongoing basis.

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Our View Of The Payment Future

Ultimately, we believe multiple winners will emerge in the PayFac space serving a variety of fundamentally different customer segments.

At the smaller end of the market, PayFac will continue to dominate, as the economics of in-house payments flow make no sense for these customers.

With its considerable economic and customization advantages, the PaaS model that enables ISVs to become PayFacs will be more advantageous for larger customers.

A PayFac model that is able to cross the chasm from one side of the market to the other could change this outlook.

For example, TSGS is working on a "direct" product, which allows smaller software companies to take the first step toward becoming a PayFac without having to undergo the same underwriting, operational, and compliance burdens - effectively acting as a third-party PayFac on the company's behalf.

After the company reaches a certain size, TSGS migrates it to an in-house PayFac. As a result, players like TSGS are able to support customers' PayFac needs throughout their entire lifecycle, regardless of their scale.

Once they reach a certain scale, larger payment companies might also begin offering APIs to enable their customers to become PayFacs, but they need to be aware of the potential revenue cannibalization if their customers begin bringing more parts of the payments stack in-house.

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