A panel discussion on embedded lending and its massive upside potential. Banks continue to underserve SMB demand, SaaS platforms are in a strong position to monetize, and fintechs are well-positioned to fill gaps in market supply.

During the session, we defined the market, illustrated key growth opportunities and use cases, discussed operating model options, and explored key lessons learned for capturing the embedded lending opportunity. 

Please don't hesitate to contact Erik Howell at Erik@Flagshipap.com with your comments or questions.

Transcript:

Joseph Kraut | 00:15

Hi, everyone. Thank you so much for joining us. Today's session on embedded lending will be led by Erik Howell, a partner at Flagship Advisory Partners, alongside Ben Brown and Charlotte Al Usta, partner and principal at Flagship. Without further ado, I will hand it over to Erik to get us started.

Erik Howell | 01:20

Everyone, thank you very much for taking the time to join us today. We'll be focused on embedded lending. We'll be doing a presentation that should take about 10 or 15 minutes, and then we'll have a panel discussion with my colleagues, Ben, who's a partner based in the US office at Flagship, and Charlotte, who's based in Europe.

Most of you probably know Flagship; we're a specialized boutique that focuses on payments, fintech, and software. We pride ourselves on the breadth and depth of expertise and insights in those three subject matter areas. We do about 100 engagements per year and have 50 folks located between the US and Europe.

For embedded lending, we think this is a really exciting opportunity for many reasons. There are a lot of ways to play, a lot of different use cases, a lot of different provider types, and a lot of different operating models that participants in fintech can use to participate. There are really good fundamentals: there's good end customer demand, customers love credit, and generally for this particular model, it's underserved by banks. That creates good competitive white space. Very strong industry tailwinds because there's a macro shift in end customer behavior, whether it's consumers or businesses, to interacting through software platforms. We'll interchangeably use the words platform, SaaS, or ISV, but we mean typically large software platforms, either consumer-facing or business-facing, that customers are working with every day.

These are great distribution opportunities for embedded lending. There are good industry tailwinds and good availability of interesting providers. If you're an investor looking to make M&A, there are great opportunities for that. If you're a platform looking for a partner, great opportunities for that. If you are an enabler or a lender or even a vendor to those enablers or lenders, there's a good ecosystem available of people to work with. And finally, we'll go over some clear value creation vectors.

Just to set some context, the definition of embedded lending puts the ability to finance in the hands of the end user, whether they be consumer or business, on the platform they're interacting with. Here we show two different examples. One is a home improvement use case: the ability to finance work being done at your home. This is from the US. On the right-hand side, from abroad, buy in store and get financing. This is a bit more of a traditional use case. It's a pretty broad definition. We could discuss what's embedded, but embedded has existed for probably 100 years; even going back to old-school retailers, you could always finance things on credit. Embedded now in the software context brings that to the next level through digitization.

There are a lot of different ways to participate in embedded lending. On the left-hand side, we lay out some use cases. If the end customer is a business, you can finance operations and growth. That could be revenue-based financing, often called merchant cash advance. It could be regular revolving credit cards, working capital lines of credit, overdraft, term loans, or installment loans. There are ways to finance assets, leasing, financing trade and supply chain, and accelerate collections like factoring and invoice financing. One that may be familiar to us as consumers is financing sales of goods or services to end consumers. That could be buy now, pay later, private label store credit cards, regular installments or sales finance, or co-brand cards.

There are many different provider types. These could be financial institutions or banks, specialized consumer or B2B finance lenders, BNPL, leasing companies, or trade finance specialists. A pretty wide variety of provider types. We'll use the words providers and lenders interchangeably.

If we look at who serves this market, a big question we typically get is: what's the role of banks? If we look at the US as an example, it's a nice big homogenous market that is very software-forward. Banks have traditionally been very strong in direct-to-corporate channels, working with retailers (that business has existed for a long time), working with dealers, and working with some larger types of professionals and advisors. Where banks have historically been less good is working with smaller providers, SMBs, and particularly those through software platforms. Why? Banks typically have lower risk tolerance, so just getting the approval rate necessary to make it interesting for the platform can be challenging. Banks find it difficult to serve micro and small businesses effectively. Particularly for B2B lending, many processes tend to be a bit manual. Overall, there's a suboptimal user experience, integration capabilities, and relationship management capabilities for working with software and platform partners.

Particularly in the US, banks are great at doing things like co-brand programs or very established sales finance programs. But when it comes to working with software platforms, which typically move at a much faster pace and have different user experience requirements, banks are typically mismatched. All in, this creates a lot of white space in the market for different types of non-bank providers, for example, fintechs.

We've done some interesting primary survey research on pain points for these types of software platforms that can be the key distributors for embedded finance. Cost, of course, matters. But very important is the user experience. Common challenges we've seen are clunky onboarding, lack of insights given by the lender during the process, and a general perception of poor service quality. Key buying behaviors, the key points that providers need to deliver, are: deep integration with the software, cost (again, important), good features that are comparable to if you bought the product outside the software environment, quick and easy sign-up, transparent pricing, and approval rates.

These are things we've found banks see as a bit challenging when working with multiple software providers. Ultimately, the scale you need to be working with is tens, and multiple years from now, if not hundreds of different software providers. It creates a different model than many banks are used to working with, but one that fintechs have proven to be quite good at.

There are good natural tailwinds in the space. If we look at the US, which does tend to lead Europe, 79% of large SaaS platforms we've found offer some form of embedded finance, and nearly 100% offer payments acceptance. The next product set on their target list is different types of lending. About a third of large US software platforms offer some type of lending. They don't cover all lending, but they offer some type. Another third plan to offer it in the next three years. That's generally considered to be one of the biggest natural opportunities and ranks before other products like banking, insurance, and wealth management. This is the US, which does tend to lead because usage of software platforms is higher. It's a big homogenous market, so the software platforms themselves are scaled. For Europe, it is a trend, although we anticipate it being a few years behind the US, just because the software platforms themselves are smaller and more geographically fragmented.

How to participate: participation doesn't mean that you have to be the lender. Clearly, you can be the software platform. That gives you a better product, a better reason for people to use your platform because you're getting access to more products, and stickiness; the more products a platform has its customers using, the lower attrition. There's a direct revenue stream. Distributors like platforms earn a revenue stream from that. There's pretty good availability of partners, and over time you could selectively in-source things as you scale.

For merchants and brands, you can be a distributor, and this business model has existed for decades. The key benefit here is incremental sales: if you provide credit or financing, customers generally will buy more, and you get a revenue stream from that. Again, you can use partners and in-source over time if you want, although many choose not to.

If you're a fintech, say a PSP (payment service provider), it's a great complementary product. You can create an additional revenue stream. Very much commonalities with SaaS platforms or merchants and brands. You don't have to be a distributor or a lender. You could be a technology or data provider, some sort of processor, data provider, underwriting engine, or credit bureau. You're selling discrete solutions, but that's still good revenue in a high-growth segment. You can be reselling someone else's solution, packaging it as part of a broader offering, or building your own solution organically.

Finally, lenders. The key distinction here is that the lender is the one actually providing the balance sheet and taking credit risk. They're getting the lion's share of the economics. Keys to success here: scale and lower cost of acquisition.

We look at supply, a lot of logos (apologies for those being tiny), but we've tried to distinguish between who is in the EU/UK and who's in the US. I'll caveat that this is not everyone, so inevitably we miss someone; please don't be offended if we've accidentally missed your logo. We're trying to break down the ecosystem.

There are core tech providers, meaning the processor or ledger system where the loan is physically housed. There's a pretty broad landscape of risk and fraud technology and other credit data providers, including transactional fraud risk monitoring and credit bureaus. There are things variously called orchestrators, banking-as-a-service, or program managers that wrap a wide variety of services together and make that easy for a distributor to use. I could go to a program manager and get a whole bundle of things on a pretty end-to-end basis.

When we talk about lenders, there's a variety of types. Obviously, there are banks and financial institutions. There are specialists that tend to be fintechs or B2B finance organizations focused just on term loans or working capital for businesses. There are providers of sales finance, installments, and cards primarily for retailers and brands. B2B and B2C BNPL providers, trade credit providers, revenue-based finance or merchant cash advance providers focused on SMBs, and invoice financing/factoring. There are other provider types too, certainly leasing, trade finance, etc. The point is there's a pretty broad ecosystem. For each particular business model or product set, you'll note there's a variety of providers. Not just one or two. There do tend to be larger ones and smaller ones, but it's a really interesting ecosystem. If you are an investor, there are great M&A opportunities. If you are a software platform looking to partner, there are great potential partners. If you are a fintech or bank looking at who else you should cooperate with, there are great potential product partnerships here too.

Finally, to close out the slides (which we will distribute, by the way, so you don't have to capture multiple screenshots), I wanted to talk about value creation vectors. We think there are great opportunities to create value in this space. How to do that? One is very clear targeting and distribution. In embedded lending, we're lending money. You need a very specific customer segment and way to do that. You need to pick a segment and distribution channel where you, as the lender, are getting sufficient access to data and history. There needs to be a pretty well-defined value proposition so that you're avoiding adverse selection. And ideally, some sort of natural distribution channel so that your cost per acquisition is reasonable.

Lending is a high-value-at-risk game, so strong execution is critical. Strategy is great, and as consultants, we love strategy. But you have to be able to nail the basics: risk, operations, underwriting. Those things are more critical. I'd say it's better to have great execution of that than the average strategy, and in things like lending, you will do very well.

Competitive funding structure: think of this as cost of goods sold. Balance sheet efficiency is key. Here's where banks have a great advantage that I'd say they often underutilize: they have very low cost of funds, so they can lend at a pretty competitive price. If you're a fintech, you have an equity-heavy balance sheet, or you have to go to secondary lenders, so the cost of funding is much higher. The price you have to charge the client is much higher, and that can create risk of adverse selection.

Fourth, quick, easy digital processes. Banks are good at a lot of things, but having worked at a bank, being quick and easy unfortunately wasn't always one of them, although we tried. Being able to have full end-to-end digitization is very important, not only for the customer experience but for your own economics.

Finally, and probably obviously, strong risk management. We are lending money, so we need to be very good at that. It has to be well documented. There have to be strong processes. That extends across the lifecycle, not just underwriting or managing existing account credit risk, but very strong oversight over collections processes as well.

That's the prepared content. We will enable you to access that later. Now we will step into a few questions for the panel, and then we'll try to leave about five minutes to see if we have any interesting questions from the audience. With the help of my colleagues Ben and Charlotte, Ben will cover the US market perspective and Charlotte will cover the European market perspective.

First question I'll give to Ben: what evidence have you seen of demand or traction in the market for the types of things we're talking about? Can you give us some examples?

Ben Brown | 17:14

Yeah, absolutely. One of the slides you showed, Erik, was responses from software companies on their current participation in different types of embedded finance and their interest in adding new products in the future. Embedded finance includes all the types of financial services: payments in, payouts, lending, banking, insurance, even employee benefits. The leader in those categories has been payments acceptance, where almost every software company that it's relevant for already has payments acceptance built in or is pretty close to launching it. About 78% of the respondents in our survey of vertical SaaS companies said they already had payments acceptance. Only about a third said they have embedded lending. That's a much lower number, but it's still meaningful. Another third said they're planning to add it. There's a really rapid progression of adding lending into these platforms. When you talk to the software companies, a third of them already have it and are trying to figure out how to grow it, or another third say, "I want to add that in the future." The majority of software companies will be looking to add lending alongside payments going forward.

If you zoom out and look at the actual volume in the market, we see really big volumes in alternative lending. On the consumer side, $500 billion in BNPL loans per year globally, $60 billion a year in the US alone, and growing twice the rate that credit cards are. A pretty big market and continuing to grow rapidly. With individual players like Klarna with more than $120 billion in GMV, Affirm with $30 or $40 billion in GMV last year, individual players are also growing to decent scale. If you look at the B2B side, in the US, non-bank lenders lend about $500 billion a year to small businesses. We think about 10% of that flows through platforms and embedded finance partnerships today. It's certainly a minority. Not every software platform enables that today, but a lot more are interested in doing so. We're seeing those flows grow pretty rapidly with key names like Shopify Capital or Square Loans originating tens of billions of dollars a year added together.

Charlotte Al Usta | 19:47

Just to complement here, Ben, a key question for all of those providers, whether it's a software platform or some of the global PSPs targeting the SMB space, is whether the opportunity is effectively the same in the US versus the UK and Europe. It's a legitimate question because, as you just explained, the US is much more advanced when it comes to embedded or integrated payments. What is important to understand is that there's a big difference between the US, UK, and Europe as you think about the payment mix to start with.

For example, if you take merchant cash advance as a product, it was initially framed as an advance on card sales. But effectively, the payment mix in Europe is much more cash driven. You have way more account-to-account, much more direct debit. What you're now seeing is that the specialists servicing software platforms, PSPs, or banks are adapting to that, because otherwise you leave out a big pool of lending opportunity.

Regulation is also different and much more fragmented in Europe than in other markets. Although there are some differences and nuances in the US market, MCA or other forms of lending are sometimes seen as credit and sometimes not, depending on the country.

Two more important points. Credit data availability is not equally the same across countries. The US is best in class. The UK is quite good. But, excuse my French here, it kind of falls off the cliff as you go toward broader Europe. And if you look at the maturity of embedded lending, whether distributed via PSPs, software platforms, marketplaces, neobanks, or banks, the UK is typically much more advanced because UK merchants and consumers are much more used to fintechs versus mainland Europe.

Ben Brown | 22:11

The fragmentation of the regulatory environment in the two regions is really key. The US isn't quite as easy as it seems from the outside, unless you're a bank, though the bankers on the line will furiously be disputing that in the comments. The nice thing about being a bank is that you have exportation and preemption, so you can lend nationally in the US. If you're not a bank, there are state lending licenses that you have to get in a lot of different places. You can have 40-plus different lending licenses and state-level regulators that you have to deal with. I wouldn't say they're harmonized, but they're generally consistent, much more consistent than in the European landscape, where you have very different countries with very different rules. One nice thing about the US is that it's just a larger market where, even if it's still complex, it's a little easier to either figure out how to get that portfolio of state lending licenses or work with a bank partner who can lend nationally, which is what we see a lot of fintech companies do.

Charlotte, your point on payment mix is really key. Today it's really important to think about payments as digital payments. In the past, we've thought about cards and alternative payments, but that's an outdated way of thinking. In some markets, especially in Europe, cards might be the minority type of digital payment. At Flagship, we really focus on the world as digital payments and embedded finance. It's not cards and XYZ; it's digital payments, wallets, digital A2A, and push payments. Cards are certainly part of it.

I was at a conference yesterday, the Vertex Vertical Software Conference in New York City, talking to vertical software companies about the kinds of things they're launching and the experiences they're having. I was talking to one fundraising platform that does charity fundraising, and they said in-person events are really key for them. People will go to these events and write paper checks (which the Europeans on the line are probably thinking, "What's a paper check? That sounds like the 1980s"). But people will write $50,000 paper checks to donate to charities. As a payments platform, figuring out how you can enable those payment flows alongside your card workflows can be really key. And then, can you lend against those kinds of things? One of the companies there yesterday does cash advance or factoring on invoices. That's another really important angle on embedded lending.

Erik Howell | 24:59

Okay, we've got a lot of great questions from the audience. I had more prepared questions, but I suggest we shift to the audience because they have better questions. Joseph, can you lead us through it?

Joseph Kraut | 25:10

Yep. Thank you so much, guys, for all your questions. I will share them in the order they came in. This is a question to Erik and the rest of our panelists. The first question: is there any evidence that offering embedded finance as a PSP influences churn?

Erik Howell | 25:28

I would say yes, and Charlotte can probably help me out here. The numbers we've seen for specific products show that if a PSP offers them, their attrition rate for that merchant acceptance relationship is definitely lower. They've confirmed that quantitatively.

Charlotte Al Usta | 25:46

Yes, that's the case whether it's a PSP or a software platform. It comes down to the fact that the more products you stack on top of the core payments proposition, the less churn you will have. Keep in mind that, as Erik presented earlier, SMBs specifically are highly underserved when it comes to lending. The demand for financing, whether for C2B verticals, B2B verticals, or horizontals, is really high. You're really enhancing the overall product package you're offering to your merchants, so it will have an impact on churn for sure.

Ben Brown | 26:25

In embedded payments, we see that a typical merchant portfolio has 15% attrition per year, 15% churn every year. In an embedded payments portfolio using software-integrated payments, that can be 3% to 5% per year. Lower customer acquisition costs, lower churn, and really strong performance. When you add lending on top of that, it creates lock-in. On the software side, you've got data and workflow lock-in. On the lending side, you have additional financial lock-in if people owe you money.

At the conference yesterday, people were talking about how payments, payouts, and banking require selling. They're sales-driven products where you have to know how to educate your customers that those exist and convince them to use them. But lending is really a product-led sales motion. People want money. If you're willing to give them money, they will seek that out. It's important to be targeted about who you make those offers of credit to. But what software platforms are finding is that it's much easier to sell embedded lending than other products, because who doesn't want easy money?

Charlotte Al Usta | 27:50

One thing to add, an interesting KPI here. If you look at the maturity of the different use cases, most often it's buy now, pay later and merchant cash advance that are most mature; that's more on the C2B side of things. On B2B, it's factoring, invoice financing, etc. Interestingly, what we found through some of our research is that once a merchant takes out a merchant cash advance, over 80% are coming back. This number in itself is really strong because it shows how underserved that specific segment is. There's a little bit of nuance between channels and verticals, and also as it comes to size (micro versus small versus medium will obviously differ a bit). But there's really strong demand, which will ultimately affect the churn rate.

Joseph Kraut | 28:51

Got it. Thank you so much, Charlotte. Leading into our next question: for software companies, what have been the major challenges in launching embedded lending?

Erik Howell | 29:04

I would say finding the right partner with the right approval rate. There are providers out there, but each software company has a very different set of needs. They'll have different integration needs and serve different target customer segments. With lending, you need a partner that can maximize approval rates and serve as many of those customers as possible in a quick and easy way. There are a lot of providers out there, but depending on who you are, there may be more or fewer providers available. Ben or Charlotte, what have you observed?

Ben Brown | 29:36

Finding the right product is really key, because it's easy to say embedded finance is hard payment acceptance, merchant cash advance to businesses, and having a bank account built into the platform. But there are more answers than that, as Erik showed on his slide earlier. The right answer for each platform is very different.

We just completed an embedded finance strategy project for a vertical software company where the obvious answer seemed to be embedded lending. But they said, "We actually piloted that already. It didn't have that much take-up. We need to dig into who the real users of our platform are." In this case, there were multiple users: people working at the companies using the software, the customers of the companies using the software, and the employees of the companies using the software. All kinds of different potential users of embedded finance solutions, and different product models you can use even for something like business lending. As Erik showed, there are so many different kinds of models. One key is making sure you understand your customer, their needs, and that you design a product around them.

The other is understanding where you have a right to win and a right to sell. For vertical software companies, two of the terms that get used a lot these days are "system of record" and "system of action," and those play into your embedded finance strategies. If you are a system of record, that can give you a data advantage because you have all this information about businesses, and you can use that data for making smarter underwriting decisions and smarter targeting decisions. If you're the system of action, where somebody might be generating an invoice, developing a quote, or buying products for inventory, that gives you a workflow advantage. Think about the example Erik shared, where somebody quoted him way too much to finish the garage of his house: putting that offer of credit right at the top of the estimate. Those workflow advantages where you can put the offer right in front of somebody at the right place at the right time are really key.

Another example we've heard in the past is for businesses. If you're an elevator repairman called into the Google office to help fix their elevator, and the clerk at check-in says, "Sorry, unless you have a million dollars of workers' comp insurance, you can't do work with Google today," being able to go into your software package and say, "I need to increase my workers' comp," and click that button to do it right there, means you can do that work that day and earn that money. Otherwise, you'd have been turned away with no other work to do that day. By having software where you can access financial services right on the spot when you need them, that's really key.

Charlotte Al Usta | 32:42

Just to add on that quickly. It's not because merchant cash advance, buy now pay later, invoice financing, or factoring are some of the most mature products within lending. It always comes down to how your customers behave, and the answer will be different across verticals and horizontals.

Second, finding the right partner is important. But I still think a key item, whether for payments, specific lending use cases, banking, or payouts, is that you need to sell it. Once you've found the right partner, it's still all about go-to-market and educating the merchants, notifying the merchant that you have the product. Specifically in lending, as Erik mentioned, you need a partner that allows you to open the funnel in a broad way. You want to have broad eligibility. You want pre-approved offers. You want to notify the merchant in the dashboard: "You're eligible for this amount, take a few clicks, and a couple of hours later or next day you actually have the funding in your account."

Go-to-market is important. For the software platform, as you think about operating model, if you already have payments and other embedded finance products, you need to structure the team. You have a partnership person responsible for partnerships, whether for payments specifically or working capital. And you need a person who really helps sell the product. That's something that is very often actually underestimated by a lot of players.

Erik Howell | 34:37

I think we're at the time. We've got a lot of questions, but we know who you are, so we promise we will follow up and answer those questions via email. Certainly, very happy to set up a separate conversation if that's helpful.

Thank you all for attending. Thank you for sticking with us. Have a great day.