March 2020
A few people have written about “embedded finance”: nonfinancial software companies that have a material financial product. Shopify is the poster-child: SAAS + payments = subscription revenue + transaction margin, in an all in one solution with few peers, riding the wave of offline to online payments and commerce. Everyday, more and more examples of this trend emerge, most built on Stripe Connect.
Vertical neobanks are an emerging flavor of embedded finance, that happen to be on the issuing side rather than the acquiring side. They offer a product with core financial benefits, that differentiate them from the majors (Chase, Wells, BofA, Citi). Typically these benefits will include one or more of the following:
You can think of a vertical neobank as a checking account + debit card product, focused on a specific customer segment (rather than focused on a broad swath of “consumers”) that solves a money movement problem for that customer segment segment, and monetizes by capturing the balance available to that customer segment at the end of the money-movement. Most vertical banks look like: “Checking account + money-movement tool that automates something that was previously really manual and error prone”. I use money-movement here because it’s not exactly a payment - sometimes the same customer is on both sides of the transaction. The important parameter is that they are in a financial flow, and they materially impact the flow of funds, rather than simply providing information, visibility, or analytics about the customer's money.
The two categories I’ve been able to identify thus far are 1. Software or tech enabled companies with a large user base, offering financial services to their specific userbase, and 2. Brand new startups building both the moneymovement product and the checking account from scratch, in parallel.
In writing this I realized several of the companies that led me to this insight not yet public, so I can’t list them here just yet. I'll update later with their permission or after they launch publicly.
This arrangement will also have appeal for the customer segment for a few reasons. First, Chase, BofA, Wells and others have always been quite horizontal. They’ll take your deposits, make money off you and charge fees, but their offerings are roughly equivalent to one another, and roughly equivalent regardless of your needs as a customer. In addition, lots of customer segments have unique payment, financial or tax related problems that have grown complex enough to warrant a whole industry that solves only the non bank problem; think of things like bookkeeping, payments, taxes, etc. To focus on one, would seem like a distraction and call into question why Chase (or it’s peers) are not focused on the others.
Second, Chase, Wells and others would not perceive it as their responsibility to build a solution to a problem that’s not traditionally a banking problem (even though it is a material financial problem to you as a customer in that segment). Finally, the majors actually make it incredibly hard to open a business bank account. I once spent 4 weeks opening a Chase business banking account; it involved sending 4 faxes, calling back twice and walking physically into branches twice to hand verify a piece of paper I had previously faxed. All this after signing up online. There may be some unspecified good reasons for a “Globally Systematic Important Bank” to do this, which I won’t discuss, but regardless, it is not a good experience for any customer.
In the future, as issuing platforms become more mature and less expensive to experiment with, I anticipate you’ll see even more vertical neobanks. As the barrier to entry for issuing drops, you’ll see one of these from every company that has aggregated a captive segment of customers, and stands in their money flow. Some fun examples:
I could go on, but you get the picture. A big hurdle to this stuff happening today is that the banking-as-a-service platforms that exist are so intensive to integrate with, that for most companies I’ve listed above, it’s still too expensive to run this experiment; they can't even get a prototype up during a hack week because they need a whole BD team to go negotiate with most BAAS platforms prior to issuing an instrument.
As far as I can tell, you need at least two things to successfully run a vertical neobank program; proprietary customer acquisition in a specific segment, and differentiated financial benefits for the segment. This is not unlike co-branded cards of yesteryear. Programs like the Costco card and the United MileagePlus card worked really well for years because United had massive scale customer relationships through its loyalty program. This meant essentially that Chase (as the financial partner) could acquire a relatively high quality customer segment for incredibly low CAC (cost of acquisition would essentially be the deal economics with the brand). The same is true for category 1 companies, and the main difference is, because they are in the money flow they can compete for deposits, and in competing for deposits, they don’t have to be especially good at credit or underwriting to succeed. And if they do well on the deposit/debit side, at some point the tail wags the dog.
Thanks to Temi, Femi, and Bo Jiang, Roberto Medri, Jim Esposito, and Justin Overdorff for reading this in draft form.
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