At Square Peg, we’ve had a history of backing payment founders early in their journey and these companies have been amongst the best performers in our portfolio: Airwallex (cross-border payments), Zeller (payments processing for SMEs) and Finaccel (BNPL) to name a few. We also recruited our partner Pirunze Sabuncu, who formerly headed up Stripe in South-east Asia. Beyond venture, we also continue to invest in fintechs via our listed equity Global Technology Fund with an active position in dLocal (LATAM payment processor).

Given this history, we have continued to double down in the payment space. However, we are about to enter a period in the market that we haven’t seen in over a decade - a period of high inflation, rising interest rates and a very real chance of a recession. We wanted to share our thinking on what opportunities could emerge under these market conditions.

If you’re building a payments business, we’d love to hear from you. Reach out at lucy@squarepegcap.com. ‍

“Never let a good crisis go to waste”‍

There are, of course, significant challenges founders will face (covered well in Sequoia’s Adapt to Endure piece). However, we believe that for the best businesses, there has never been a better time to play for category and market leadership. Less well-positioned competitors who historically have grown at all cost rather than paid attention to unit economics will struggle and opportunities for consolidation/M&A at attractive prices will be more plentiful.

In particular, the fintech segment we remain incredibly bullish on is payments: both consumer-to-business (“C2B”) and business-to-business (“B2B”). With C2B, there is a huge opportunity to disrupt the underlying payments infrastructure. With B2B, there remains low hanging fruit in further payments digitisation and unifying a fragmented finance tech stack.

Payments businesses have historically been resilient in economic crises. High inflation does impact consumer spending but during the 2008-2009 GFC, there was a mix shift from credit to debit. On the B2B side, companies will likely reduce their discretionary spend but the vast majority of payments volume continue to go towards “keeping the lights on”.

‍How can C2B payment fintechs benefit from this environment?‍

In a high inflation or recessionary environment, merchants will face increasing pressure on their margins. When it comes to payments, merchants have to pay fees to the duopoly of Visa and Mastercard to use their infrastructure (also known as the “card rails”). In Australia, these fees have a regulated ceiling - merchants will pay roughly 80 bps for credit card transactions and 50 bps for debit card transactions. In the US, this isn’t regulated and merchant fees are even higher e.g. 130-350 bps for credit card transactions.  

Now, the combination of real-time account-to-account (“A2A”) payments infrastructure being built up across the globe (Australia’s is called NPP) and open banking regulation may finally lead to viable alternative rails to Mastercard and Visa. This will enable merchant fees to be driven down to almost zero.

The challenge for any payment fintech in this space however will be around driving consumer adoption and behavioural change. In Australia, this is even more difficult given the relative ease of contactless card payments at point-of-sale and use of wallets, BNPL or Paypal at an e-commerce checkout. But creating an alternative set of rails to Visa and Mastercard is truly the holy grail: today, Visa is worth $396B and Mastercard is worth $302B (as at 20 June 2022).

We can see how various players in the ecosystem are readying themselves for this A2A opportunity:  

• Visa and Mastercard are making A2A-related acquisitions as a hedge (Visa acquired Tink for €2b, Mastercard acquired Finicity for $825m)
• Large fintech companies are making a move into A2A (Plaid launching A2A payment program, Klarna and GoCardless partnering to allow BNPL pay in 4 using A2A)
• An increasing number of smaller fintechs are emerging in the space (Zepto raised $25m to facilitate international expansion of B2B payments using A2A, US player Banked raised $12m to build out its ‘pay by bank’ functionality, London’s Volt raised $23.5m to make available a global real-time A2A payments network through APIs, Lithuania’s Kevin raised $65m to enable A2A payments over point-of-sale terminals)

If merchant fees are driven down to zero, you may be thinking: how does any payment fintech in this space make money?

The answer is we’ve already seen the playbook i.e. those who use payments as the wedge from which they expand to capture more of the merchants’ spend. Stripe started with payments acquiring but then expanded into corporate cards, credit solutions, card issuing and banking-as-a-service. Similarly, Square started with payments acquiring but then expanded into POS, invoicing, banking services and credit solutions.

~40% of a typical merchant’s wallet is addressable for a payment fintech. Lending may be less attractive in the short to medium term as rising interest rates will limit startups’ access to cheap, wholesale debt funding. However, other adjacencies like spend management and payroll remain attractive.

This brings us to the part of the market we are really excited about: B2B payments.‍

How can B2B payment fintechs benefit from this environment?‍

While C2B payments have seen significant digitisation and innovation in the last 10 years, B2B payments have been more difficult to disrupt due to a fragmented tech stack and the need for invoice reconciliation. However, this is an attractive area to tackle: it’s an enormous market at $120T in payments volume that dwarfs C2B by 4x and there is low hanging fruit in terms of digitisation. About~60% of business payments across North America are still made through non-digital channels, i.e through cheques.

As merchants become increasingly cost-conscious in this environment, they will look to reduce costs in not only the B2B payment transaction itself but also the workflows that support these transactions (e.g. generating invoices, approving funds for disbursement).

For example, Airwallex simplified cross-border B2B payments as its initial wedge and has since expanded into multi-currency cards and spend management to help automate more of the workflows under the finance team. Some other interesting opportunities that might arise in the B2B payments space include:

• ‍Automated accounts payable and receivables: Plooto enables businesses to automate their accounts payable and receivable functions by unifying payments, processes, controls, and reporting under one platform. It also integrates with accounting platforms to automate the reconciliation of invoices. In a related space, Amaka is an exciting Australian start-up that specifically focuses on building these accounting integrations to eliminate manual data entry as much as possible.   ‍
• Virtual cards and expense management platforms: This is one of the fastest growing segments within B2B payments. Companies like Brex, Ramp and Divvy (acquired by Bill.com) have built full suite spend and expense management solutions that help businesses track spend much better while monetising through processing payments. Brex’s recent announcement that it would shift focus away from SMEs to larger corporates and its push into software to diversify its revenue reflects 1) a more urgent need for payment start-ups to increase share of merchant’s wallet beyond a race to the bottom for interchange fees and 2) a greater focus on unit economics.‍
• Tailored payment solutions for B2B marketplaces: There has been a rise in B2B marketplaces such as Faire. Emergence of such marketplaces require tailored payment solutions, which startups like Balance and Sprinque look to provide. Their payment solutions address the complicated transactional and workflow needs of marketplace participants.

Jim Barksdale(former CEO of Netscape) famously said “there’s only two ways I know of to make money: bundling and unbundling.” With the finance tech stack so fragmented between ERPs, payroll, accounts payable / accounts receivable reconciliation and spend management, a key theme we see emerging is the unification of these platforms to allow seamless transfer of data. This need is so acute that we are starting to see the emergence of players like Amaka which specifically build APIs between disparate systems to allow them to talk to each other.

For payment fintechs to have an effective wedge from which to expand and unify the finance tech stack, they need to have the following:

1. Context on the customer that others don’t have. This is a given when you have the payment transaction data of a business but it’s certainly not the only way to get context. Payment fintechs must also contend with software players that enter through a vertical e.g. Toast is dominating in the restaurant sector by starting as a POS solution that then expanded into online ordering, payroll management, inventory management and credit solutions. This speaks to the ‘embedded finance’ trend as SaaS players with unique visibility of customer data flows are able to use that position to deliver more tailored financial products, enabled by banking-as-a-service fintechs. The proximity to customer and underlying data flows is something Apple is focused on leveraging as evident from their recent acquisition of Credit Kudos providing an avenue to enhance lending capability amongst other financial products.
2. Creative ways to get distribution. Digital ad spend by fintechs increased from $9B in 2016 to $24B in 2021 in the US alone. The customer acquisition battleground has     increased in intensity, which means figuring out creative distribution is a must e.g. freemium model (e.g. Melio and Revolut) or channel partnerships (e.g. Bill.com with accounting firms)

Opportunities for payment founders are ripe, even in tough economic conditions‍

So many unicorns have been created out of the payments space but we have no doubt that there will be plenty more, given the size of the market and the multiple segments or niches that remain underserved.

We welcome your thoughts on the above and if you’re building in these areas - come talk to us about what you’re doing!