Here's why most software companies shouldn’t build a capital product.

Convenience has now become table stakes. 

In the past few years, especially since the onset of COVID, we’ve come to expect that what we need can be dropped on our doorstep with the click of a button. Those expectations go beyond our personal lives and carry over into how we run businesses, which is why embedded financing is growing so fast. 

For independent software vendors (ISVs), offering capital to their customers can be a powerful step up in the relationship. Putting capital in their hands when they need it helps ensure SMBs stay healthy and operating, and giving them access to that capital through your software platform increases stickiness and loyalty by letting them get everything they need in one place.

Small business owners want quick access to capital where they already spend time, in the software they use to run their business day to day. Add to that increasingly difficult access to traditional financing, and there’s an enormous opportunity for software companies. But in addition to the opportunity, it also presents a big challenge.

The challenge of building embedded capital 

To put it simply, building a capital product is incredibly hard. There are a lot of moving parts and hurdles you have to clear to make it sustainable. When you really break it down, there are five crucial requirements:

1. Access to quality customers at the right point in time, with low customer acquisition costs (CAC) and a frictionless conversion process (that’s really four requirements all by itself)

2. Consistent and homogeneous data sets for underwriting risk—a challenge given the inherent complexity and inconsistency of small business data

3. A proven underwriting history with reliable risk models that deliver consistent results

4. Efficient operations capable of automating end-to-end processes to keep variable operating costs below about 2% of revenue

5. And, of course, access to capital 

The trouble is, access to capital hinges on the successful execution of the previous four requirements. The increasing verticalization of software gives an advantage in two of these areas, but can software companies overcome the others?

And when it comes to building in-house, should they even try?

The verticalization of payments and industry-specific software 

The verticalization of payments has been an ongoing trend, with comprehensive software tools that help business owners manage their operations seamlessly. This trend will only continue, leading to more end-to-end operating systems that simplify business management and payment processing. A prime example is Toast, a widely recognized platform that helps restaurateurs oversee just about everything.

Industry-specific software holds unique, accurate, real-time transaction data, which can be a solid foundation for a capital offering. It also provides a steady funnel of new customers, already engaged with the software and using it regularly. However, while vertical software can address the first two requirements of low CAC and consistent data, it falls short in underwriting expertise, operational efficiency, which limits access to external capital. 

These are formidable challenges that even many pure-play lenders struggle with, especially during tough economic cycles. Having had the opportunity to play a significant role in the growth of both QuickBooks Capital and Square Banking, I can say two things for sure: these are high hurdles to jump, even for companies with massive resources available to them, and they’re the kind of problems that Fintech was born to solve.

To build or not to build?

Integrating financial services within industry-specific software can provide a ton of value to business owners. But the greatest strength of these software companies lies in their specialization. They intensely focus on and understand their industry, and building a capital product in-house distracts from that focus in a way that would be catastrophic. The solution is to partner with someone whose strong suit is connecting businesses to capital through technology. 

Fintech has a significant role to play in making financing more accessible to small business owners, and embedded financial services make perfect sense. With domain expertise across finance and technology, the right Fintech partner can automate the underwriting process, getting accurate results from live data with as little as 3-6 months of history, whereas banks traditionally need two years of audited financials and tax returns. 

Along with operating efficiency and tech-driven underwriting, they can also build compliance and regulatory tools into their embedded offerings, creating a turnkey solution. This allows software companies to leverage their deep industry knowledge and data through an embedded solution as simple as an off-the-shelf product.   

At Pipe, we’ve built an embedded product, Pipe Capital, that does exactly that. Vertical SaaS companies and payment processors can deliver a fast, frictionless capital experience to their customers, with a native look and feel, without building anything from scratch. Multiple integration options let them decide exactly how hands-on they want to be with the process, based on resources and priorities, and they can launch capital to their customers in as little as a few weeks. 

Conclusion 

The rise of embedded finance presents an exciting opportunity for software companies to expand their offerings and empower small businesses. However, it's crucial to recognize the challenges inherent in building a sustainable capital product. Careful consideration, expertise, and strategic partnerships are essential for success in embedded finance. Vertical software solutions and Fintech can work together to create massive value and give small businesses a new level of financial access.