Good Business, Bad Business – Fintech edition

When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact. – Warren Buffet

As I age in the business world, I have internalized this buffet quote. I superficially understood it early on in my career, but now I understand it! With fintech as the backdrop, this post is a view of my mental model on business models and gross margins in general. What makes a good high gross margin business?

Let’s start with a 30,000 ft view of what forms a business. Businesses exist to provide value to a set of customers via the products they create. A firm solves a need and customers pay them to solve that need. At its core, a company is a machine that takes raw ingredients (physical widgets, human capital, and intellectual capital) and transforms them into products that customers pay for. Raw ingredients cost money (cost centers) and customers pay money (revenue centers) for the finished product. A good business, in the long run, generates a consistent profit i.e (revenue – cost) is a positive number. Profit takes various forms such as free cash flow, EBIT or EBITDA – but the simple model holds, value creation only happens when what you get for the product is higher than what it costs to make it.

With this context, how do companies to consistently generate value? It is about getting more revenue by growing your customer base while simultaneously controlling costs. As you produce more to serve more customers, costs will go up. The rate of this cost growth has to be lower than the rate of revenue growth. This is why software businesses are highly sought after as the marginal cost of servicing more customers is almost zero. In the software business, your costs are primarily headcount, which is fixed but your revenue growth is only limited by your TAM.

 - Dilbert by Scott Adams
Credit: Scott Adams

Now lets shift gears and think about if you are the owner of the business. What is the one thing that you care about? Its top-line growth. If you don’t have revenues it doesn’t matter if you control costs. You don’t have a business. Imagine you are pitched two ideas – idea A is about growing customers and idea B is about controlling costs. All things being equal you should always choose Idea A. All businesses care about revenue more than costs. Getting new customers and retaining existing customers is on top of mind for every business owner. Given a choice of building products to solve the problems of this market, products that increase revenue for the business are far more valuable than products that enable cutting costs in the business. For example, it is easier to sell a sales and marketing product to a business than a workflow automation product that automates an area of their human process to save costs.

Where do the traditional fin-tech models lie on this spectrum? Let us look at some examples

  • Payments processing: The prevailing model is to charge a fee (flat or interchange+) to accept payments. As the customer volume goes higher the cost charged goes lower. As a consequence, whenever a business gets large enough, they will shop around for payment providers. Cost is the #1 deciding factor.
  • Lending/Financing: The model is fee-based. Charge a processing fee to process the loan and a headline interest rate. Businesses regularly shop around for lending options. Cost is the #1 deciding factor.
  • Any kind of backend processing system: For example an underwriting system that will automate everything. Smaller companies will balk at the price and larger companies will do a bakeoff. It will be mostly decided on the price. Once you are installed, it is sticky – but you face a renegotiation every renewal term. Less downward price pressure, but it still exists.
  • Compliance/KYC/RegTech: All considered cost.
  • Fraud: This is a hybrid. Reducing fraud increases revenue. However, this isn’t something that is the #1 item on the procurement list though.

With these examples, you realize that most of the traditional models are viewed as costs by the buyer. It is hitting the cost side of the business that needs to be controlled. As a consequence margins are always compressing.

The revenue side of the house is where the gross margins lie.

I’m not that smart to be the only one who has this insight. Revenue enhancement based models are emerging. My favorite is the Buy Now Pay Later (BNPL) market. Affirm, Afterpay, and Klarna are the big kahunas in this space. The product is an interesting twist on payment acceptance and financing. Affirm offers the end customer an option to purchase a product in easy installments at zero percent interest. From a customer perspective, it is a great deal – no interest financing on everything. Given a choice between paying upfront or paying overtime without extra charges, a savvy consumer will always pick the paying over a period of time, factoring the time of value money. For the marginal customer who was on the fence, the ability to pay over installments with zero fees makes them cross the fence and buy the product.

Effectively, Affirm is positioned for the business selling the good as a mechanism to increase conversion. Increasing conversion means more customers i.e now affirm is thought off as in the revenue-producing side of the house. Businesses have more willingness to pay for this service and this is how affirm makes money. It charges the merchant for the service. This model I presume gives them more pricing power than being positioned as a plain vanilla payment acceptance product.

You can see a similar trend in the payments space. Startups such as Bolt payments are positioning themselves as revenue enhancers. Their value proposition to business is that use Bolt in your checkout flow and we will continuously optimize your conversion. Better conversion equals more revenue. Businesses are willing to pay for this and I presume it gives bolt pricing power as they are helping the customer increase their revenue. This is better positioning that plain vanilla payment processing.

Can every cost model be switched to a revenue-enhancing model? With lending, I find it hard to conceptualize – debt that enhances revenue is effectively equity. Maybe that’s where the world is heading? instead of taking on cash via debt sell a piece of future cash flows for cash now? Income Sharing Agreements for everything?

As I get deeper into my fin-tech career, I’ve internalized this model and reflexively categorize products using this framework – is it revenue enhancing or cost-saving? Revenue enhancing is where the margins are, cost-saving is where there is a high chance of commoditization and lower margins. Go where the margins are, be a revenue enhancer.

Any other interesting models that you have come across that do this switch from the cost side to the revenue side? Drop me a note!

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