A Primer on Payments Business Models

How Payment Companies Create Their Business Models

Any successful business, no matter the size, at its core has a business model that should provide the founders or owners with the most critical goal they were out for, Profit.

For some, it is as clear as day. Sell a product for more than you bought it for, including any labor, overhead, and expenses. Depending on your customers or clients, you would either be able to be left over with profits that range from 1% to 80%. Or quickly find out, you are losing money and need to pivot to something else.

However, in the payments industry, we have been able to take a relatively simple subject and turn it into one that is so complex, that the majority of the people in the industry still struggle with the concept to this day.

It seems very simple from a merchant perspective, who either gets quoted blended pricing (all-inclusive) or interchange++ (each component broken out and passed through, including the margin the processor makes).

But from a Payments company’s perspective, there are several components, we have to think about before selecting a given model and building a business on top of it.

To make sure that we have a foundation for breaking down the strategies that payment companies use in future editions of this newsletter, I wanted to start by giving you a Primer on Business Model Selection in the Payments Industry.

This is by no means everything, but hopefully, it has enough for us to understand the financial motives companies have, and how we can analyze and rationalize the sometimes interesting changes payment companies make.

Understanding Services

The first component of developing the business model has to do with the type of processing services you want to provide.

In the last few years, we have heard and seen many different variations including Gateway-Only, Full-Stack, Omni-Channel, Unified Commerce, and Embedded Payments.

But to make it simple, I have broken it down into two of the core intentions.

Pure Processing or Omni-Channel.

The reason I break it down into these two options is that it doesn't matter what kind of Marketing or SEO term you want to give it. A Payments company either provides a merchant with a Pure Processing solution to process payments Online (E-commerce) or Offline (Retail).

Alternatively, a Merchant could have decided to run both their Online and Offline businesses together, for which an Omni-Channel solution, combines the two ways of processing into one platform.

Pure Processing

Pure Processing means that a Payments company focuses on delivering its solution in one single way.

The core ability they provide is a Gateway or POS terminal, that through their technology stack, processes a Card-based or Alternative Payment Method (APM) transaction to Card Schemes or APM Providers.

This could be done in as little as 7 lines of code like with Stripe, or through a set of complex APIs, that require multi-week integrations the way that Adyen or WorldPay does.

As these companies matured and understood that merchants don't always have the engineering resources or time to implement complex APIs, we have seen plugins, payment links, platforms, or pre-configured terminals, help reduce or remove these complexities.

But at its core, it is still the same, a Pure Processing Payments company provides Merchants with the acceptance of cards and/or alternative payment methods.

Omni-Channel

Omni-Channel, means a Payments Processor that provides more than one Pure Processing capability.

Before the Internet, Merchants were mostly considered, stores that had one or multiple physical retail locations. As the demands of consumers have changed in the last two decades, there has been a growing trend of Merchants wanting to be available for their customers in every single way.

Originally, that required Merchants to find a Payment Service Provider, who would help them process transactions online. As you can imagine this caused a lot of friction, whenever customers had to deal with returns. So naturally, this created an opportunity for Payments Providers.

By developing a Single Platform that combined two or more different (channels) ways of processing a payment transaction, Omni-Channel was born.

Selecting to be a Pure Processor or Omni-Channel Payments company is a critical decision, as it determines where you put your efforts, how you spread your resources (financial and non-financial), and has a big impact on the eventual margin you can potentially get.

Understanding Pricing

The second component of developing the business model has to do with the type of Pricing you want to provide.

Payments Processing as we know it, originally started in the 1970s, when computer systems weren’t as advanced, to provide us with in-depth pricing data as we have right now.

So gradually, we went from Pricing Models that were applied post-facto on the statement, to nowadays being able to Predictively calculate fees on transactions, as computer systems have dramatically increased in compute and processing power.

So to keep things simple, I will explain the difference in Pricing, using just two variations, namely Blended Pricing and Interchange++. As I consider, any other variation of these to be ways in which, Payment companies are trying to increase complexity when they are trying to hide something.

Blended Pricing

The idea of Blended Pricing has been around since the beginning of processing cards. It's an All-in Fee that provides a very simple and clear two-part model, often consisting of a fixed fee and a variable fee.

The fixed fee, which can range from $0.01 to as much as $1,-, covers all the fixed components that the underlying service providers charge to the processor, and any fixed margin they would like to charge.

The variable fee, which is calculated by taking the gross processed amount and multiplying that against the percentage, covers the variable fees of the parties involved, as well as any margin the processor has built into it.

Due to the highly geographical nature of Card Payments, many PSPs have been providing region-based blended fees, where processing in Europe has a lower fee than if transactions originate outside of the EEA (European Economic Area).

Interchange++

For merchants who have grown in revenue, and finally meet the criteria to be awarded a dedicated Sales or Account Manager, the change that takes place, is the change in the pricing model from blended to Interchange+ or nowadays Interchange++.

The idea is simple, as Payments Processing for Cards consists of four parties, the three companies involved all have their way of earning on such a transaction.

Interchange: The Fee the Issuing Bank (who issues the credit or debit card) collects for providing the processing capabilities (this does not include interest on other fees the bank charges to the cardholder).

Scheme Fees: The Fees the Card Scheme collects from both the Issuing and the Acquiring Banks for developing and maintaining the scheme as well as processing and settling the transaction.

Acquirer Markup: The Fee the Acquiring Bank (the merchant bank) collects for providing the processing capabilities for the Merchant.

In the cases that the Acquirer is not the supplier of the Gateway or Terminals, an additional gateway fee and or processing markup can be charged.

Alternative Payment Methods

With Alternative Payment Methods, which can include global payment methods such as PayPal, Klarna, and Affirm, the fee structure tends to be similar to the blended pricing, as it often time charges a gateway fee and a variable fee for providing all elements of the service.

For a payments company, the choice between blended or interchange++ pricing is a combination of preference, the maturity of the merchants you tend to focus on, and the technical capabilities to properly implement them.

Understanding Attrition

The third component we need to understand is Attrition.

We have heard the statistics about the failure rate of Startups and Small Business, which often says, that 20% of new businesses fail within the first two years. 45% of new business startups don't survive the fifth year. 65% of new startups fail during the first ten years.

Often we don't think about the impact a failing business has on other businesses that are part of their ecosystem. Depending on the severity of the failure, this could be $0,- to potential damages in the millions, unless adequate measures like Rolling Reserves have been taken.

But the difference in Payments companies focussing on Startups and SMBs is the level of Attrition they will have to endure. For this category between 10 - 15% of "micro" merchants fail per year.

As they grow in size, and age, all the way up to Enterprise, that attrition number goes down to less than 1%. Often these are the once we hear about the most in the media, as they bring with them a loss of significant jobs and impact on an industry.

The reason this component is important, is that Payment companies who deal with higher levels of Attrition, need to account for that in their Service Offering and Pricing Selection.

Putting the Pieces Together

Now that we know the Services they can provide, the Pricing Models they can apply, and what type of Attrition they will endure, we have a foundation for understanding the business models they will form.

To do that, I have used the following formula.

Revenue Bracket x Market Size x Margin = Revenue Potential

Revenue Brackets

Depending on if you are focused on Europe, the U.S., Asia, MEA, or Latam, the majority of that market will always determine how big the Revenue Bracket is.

To keep it simple, I will use European examples to break it down.

• Micro Merchants: Less than €250,000.- in Annual Revenue

• Small Merchants: Between €250,000,- and €1,000,000.- in Annual Revenue

• Medium Merchants: Between $1,000,000.- and €50,000,000.- in Annual Revenue

• Enterprise Merchants: €50,000,000.-+ in Annual Revenue

Merchant Pool

Using the same categories, there are a total of about 23.4 Million businesses. Each of those businesses, depending on their Revenue would fall in one of those categories.

• Micro Merchants: 21.5 Million

• Small Merchants: 1.4 Million

• Medium Merchants: 200 Thousand

• Enterprise Merchants: 40 Thousand

Card Volumes

The total card volume in 2020 for example was €7.4 Trillion, which we break down based on the brackets they fall in.

• Micro Merchants: €550 Billion

• Small Merchants: €900 Billion

• Medium Merchants: €2.9 Trillion

• Enterprise Merchants: €3.1 Trillion

Expected Margin

As explained above, the Net Yield or the Margin is different based on the type of merchants. This is an overview of the Net Yield the brackets fall within.

• Micro Merchants: 70 - 100bps Net Yield

• Small Merchants: 25 - 80bps Net Yield

• Medium Merchants: 10 - 30bps Net Yield

• Enterprise Merchants: 1 - 15bps Net Yield

Total Revenue Potential

Based on the formula, Revenue Bracket x Market Size (Merchant Pool x Card Volumes) x Margin, we can calculate the Total Revenue Potential for each bracket.

• Micro Merchants: €5 Billion in Revenue

• Small Merchants: €5 Billion in Revenue

• Medium Merchants: €6 Billion in Revenue

• Enterprise Merchants: €1.5 Billion in Revenue

Market Share Potential

Added up, we can determine that the European Market in 2020 had about €17.5 Billion in Total Addressable Market (TAM) Revenue.

The TAM includes both Pure Processing and Omni-Channel Revenue.

To break down the Serviceable Available Market (SAM), the Payments company has to determine, which portion of the TAM, they could acquire based on their chosen Business Model.

And to make it even more "realistic" they would have to determine their Serviceable Obtainable Market (SOM), which is the percentage of the SAM, they could realistically capture.

Making a Decision

Using the above, we can determine for most Payment Companies, which focus they have. As you can imagine, each decision comes with its own Pro’s and Con’s.

If you decide to be a Pure Processor, focused on Micro Merchants, the Pro’s could be that you could generate higher margins, compared to Pure Processors focused on SME (Small Medium, or Enterprise) Merchants. Less need for complex sales processes, as simple integration, self-onboarding, and digitized customer service, would be acceptable by this target group.

The Con would be that you have to acquire tens or even hundreds of thousands of merchants, to generate any real revenues, as they only process revenues up to $250K per year, which at even 100bps, would mean a maximum of only €2,500.- per year in revenue per merchant.

On the other side, if you decide to be an Omni-Channel processor, focused on Enterprise Merchants, the Pro’s could be fewer merchants who despite a lower Net Yield, produce substantially more revenue per Merchant, with a smaller chance of Attrition.

But the Con’s would be that you will be required to provide support with complex integrations, account management, and continuously have to develop additional products to prevent them from moving their volume to a competitor.

Pivoting or Adopting Along the Way

Throughout the years, we have seen Payments companies who have had tremendous success, who are pretty much unrecognizable from the way they started out.

From Stripe starting as a Pure Processor with a Blended Rate to now transitioning into becoming an Omni-Channel provider targeting Enterprise merchants, which has driven them to also having to adopt an Interchange++ pricing model.

We have also seen Adyen, which started as an Enterprise-Only Gateway, move away from blended pricing to using Interchange++ when they became an Acquirer, and as of recently, trying to make themselves more open to merchants that they previously wouldn’t have entertained due to their revenue size.

How Will We Use This Going Forward

It would have been easy for me to jump straight into Breaking Down the Strategies of Payments Companies, without providing this Primer.

However, I believe understanding how Payments companies choose their business model, is crucial as it impacts pretty much all their Strategic Decisions.

Of course, there will also be Payments companies that have used Forex, Subscription Fees, Technology Fees, and Interest, as additional Strategies and Pricing Components to grow their business, which has dramatically impacted the direction of some of those companies.

Whenever they are relevant, I will be sure to highlight them separately and explain the impact they have on their Business Model.

But for now, all we need to understand is that all payment companies, either knowingly or unknowingly, start by determining their business model through this exercise first.

They:

1. Select the kind of Services they want to provide,

2. Select the kind of Pricing Model they want to offer,

3. Select the kind of Region they want to operate in.

So they can:

1. Determine the Revenue Brackets of the Merchants they want to serve, taking into account any Attrition that will occur.

2. Determine the Size of the Market they can address,

3. Determine the Card (or APM) Volume can potentially be processed.

To eventually:

Calculate the Total Addressable Market, the Serviceable Available Market, and the Service Obtainable Market.

Once they have done this, the numbers should speak for themselves.

Either their Service Obtainable Market is big enough, that it excites them, or they change the variables until it does.

Once this is established, they can decide to move forward by raising capital, building a team, launching their platform, and maybe one day, become Profitable.

Thank You for Reading, feel free to Like, Comment, Share, or Post on Your Socials, as I appreciate all the feedback I can get.

Dwayne Gefferie