October 20, 2020 Investment Themes

So You Want to Branch Out Into Lending? 3 Considerations for Vertical SaaS Founders

So You Want to Branch Out Into Lending? 3 Considerations for Vertical SaaS Founders
Photo by Roberto Cortese

Vertically-focused software companies are an interesting beast – and the topic of their ability to expand their opportunities through offering financial products and services has been the subject of many conversations of late.

Over the last decade, we’ve seen vertical SaaS darlings like Shopify, MindBody, and Square grow with incredible capital efficiency and broaden their total addressable market by expanding beyond pure software and offering financial products, often starting with integrated payment processing. These companies have proven the leverage that comes from owning the merchant relationship to take more of the payment value chain, with MindBody more than doubling its payment take rate over the last five years. 

As some vertical SaaS companies have absorbed more and more of the payment value chain, they’ve looked to their next act in financial services. Increasingly, we’re seeing vertical SaaS companies with integrated payments launch lending arms–Square Capital as one of the first entrants, and more recently followed by Shopify. In the process, they’re further expanding TAM and signaling a long-term vision of becoming vertically-focused banks.

But how easy is it really for SaaS companies to expand into lending? It’s complicated. Sure, lending may enable your customer base to further grow their business, and in the process buy more of your product. But it also opens the door to multiple new categories of risk that are difficult to understand unless you’re deeply experienced, including operational complexity around capital markets, collections, underwriting and regulatory risk.

If I were a vertical SaaS founder considering this move, these are the three questions I’d ask myself first.

What’s my strategic rationale for launching into lending?

Many SaaS founders I talk to about launching lending view it purely through the lens of driving margin or further expanding TAM. They reason that they have an embedded customer base (so low CAC) and an underwriting advantage from having payments data (so lower default). Lending thus seems like a natural way to make more money from existing customers. 

If this is the only rationale, I’ll argue that the cost of launching lending–in time, resources, and complexity–will significantly outweigh the benefits. 

Building out a full stack lending arm–with in-house underwriting, risk capital, and loan processing–is an enormous undertaking that takes years to get right. It can make sense, but the rationale should be far more strategic than just juicing margins or increasing lifetime customer value. Lending should help your customers move forward in some fundamental way and drive synergies with the core business. Let’s look at some examples:

  • Square Capital–Square’s lending arm accelerates the progress and expansion of the Square seller, driving more revenue for its core POS business
  • Faire–Faire offers trade financing to retailers who wish to test new products from their marketplace with free net 60 returns, a hook that alleviates concerns of transacting with a merchant and helps acquire customers more efficiently

If your goal is simply to increase revenue per customer, a full-stack approach might not make sense but partnering might. ServiceTitan partnered with Green Sky, for example, to enable commercial contractors on their platform to extend loans to their customers to further grow their business (which in turn benefits ServiceTitan). This entailed significantly less operational complexity, but met their strategic goal of growing revenue per customer

Can I reasonably compete with established lending institutions?

This is what you’d be up against: banks who have been lending for literally a century or more. Sure, it’s tempting to say that decades in the business have made them slow to change, more bureaucratic, less agile. But the reality is this: they’ve stood the test of time. 

Banks have decades of customer data that give them a powerful structural underwriting advantage. Adjudicating risk is their strength, as natural as breathing. Unlike software companies, lending institutions also have a substantial processing advantage. They have great call centers, excellent fraud detection, and established claims management processes. It’s easy for them to move fast because the pieces have been firmly in place for ages.

In contrast, many software companies are convinced they have an advantage because of existing customer data sets (although, again, banks have these too). They assume that customer acquisition cost will be free because of this intact base, but in fact, that’s inaccurate. These are new products that require an entire internal team — including sales and enablement — for support, which drives CAC higher. 

Do I see lending as an element that makes me more attractive for an exit?

We talk to companies that view lending as the big opportunity – but it should not be your central strategy for becoming a major vertical SaaS player. Instead, focus on your core product as the higher priority, especially if you are not at substantial scale (read: $20M+ in ARR). And remember that 95 percent of exits are through M&A. An acquirer may not see lending as a value add but as an element of risk that detracts from your company’s appeal.

Ultimately, lending is clearly not a Day One opportunity. At best, it should be on your radar as a strategic long-term option to deepen moat and further expand TAM. Think early about the pieces you’d need to build and have in place so once you reach the scale, customer base, and data insights needed, you can invest in this opportunity with purpose and confidence.

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John Cowgill