The payments industry often paints small merchants (SMEs) as a monolithic vertical ripe for disruption. SMEs are not a real vertical. They're a myth, a lazy label slapped on a wildly diverse group of businesses.
Pure payments companies directly targeting SMEs are wasting their time for two reasons:
1. SMEs are an amalgamation of very different verticals that have dramatically different daily needs
The term "SMEs" encompasses a broad spectrum of businesses—from restaurants to fitness studios, to local trucking companies and real estate rental agencies. A restaurant is not a gym, and a trucking company is not a spa. Each of these sectors has distinct payment needs.
A restaurant needs to manage inventory, tips, and mobile orders. A gym needs recurring billing and drop-in payments. A trucking company needs fuel cards. A real estate agency deals with high-ticket transactions.
No single payment solution can serve them all effectively. It's like trying to sell the same pair of shoes to a marathon runner, a hiker, and a ballet dancer. Good luck with that.
2. The economics of SMEs are misleading
Payment operators love flaunting the marginal transaction economics on small businesses, usually 300 basis-points or above. If you only include payment settlement cost as your marginal cost (let's say 30 bps for simplicity), your gross margin will obviously look very appealing. What’s not to love about 90% gross margin?
This thinking often masks the total cost of acquiring and servicing a small business over time. Think about your annual marketing budget (and its conversion rate), the sales team overhead, onboarding/compliance, and customer support costs. Now imagine a business turning over $5mm per year. If you have a 100% share of checkout on that merchant, maybe it's worth it (more on this below). More than likely, you have a fraction of the total checkout. At 10% share of checkout for example, you’re generating $15k ARR on this merchant. The marginal economics may look appealing, but in the aggregate this is unlikely to be a profitable merchant.
Who has the right to win with small merchants?
Many companies that are successful in dealing with SMEs do not primarily generate revenue from payments processing alone. A few examples:
Shopify: the main product is ecommerce store-front tools. Payments is the value-add service.
Toast: full-suite software for restaurants and bars from inventory management to payroll. Toast has a right to win those restaurants’ payment flows.
Square: leading point-of-sale hardware manufacturer. Square’s payment processing is embedded into the hardware.
In all of these businesses, payments is the tangential monetisation opportunity to another primary service. The primary business is SaaS and/or hardware. Payments is the convenient add-on, enhancing the primary service offering rather than being the service itself.
The smarter play for pure payment companies
Given these challenges, a more effective strategy for pure payments companies to serve SMEs is through vertically aligned service providers, e.g. industry specific services, hardware, SaaS, and/or payment facilitators (PayFacs). These entities are the “Toasts” of their verticals. Think Mind&Body for gyms, Sunday for restaurants, Procore for constructions, Zenoti for Spas, etc.
These entities specialize, going deeper rather than broader. They solve for the breadth of a specific industry’s daily operational needs, receivables and payables being one of many such daily functions.
As a pure payment company, these industry vendors become distribution channels. Instead of chasing 10,000 restaurants, you court the top 10 restaurant SaaS vendors that serve restaurants. This also means you can have a leaner, more focused sales force.
The trade-off here will be margin compression. The channel partner will want to add a mark-up on the payment fee for themselves, which means you’ll likely need to take a margin hit. The benefit is more volume so this should be a net positive over time.
Pure Payment Companies Should Focus on Larger Clients
Pure payment companies should have direct merchant sales teams focused only on enterprise and strategic merchants. The scale of these clients make the economics of payment processing more sustainable.
These merchants may also prefer to go through a PSP of their choosing, but having a direct relationship is economically viable. Large merchants also have more complex product, coverage, and service level needs so a direct relationship is often necessary.