The Opportunity Today

The notion that SMEs have been underserved by financial institutions is not a new one – for years, small business owners have complained about opaque pricing, lengthy onboarding processes, overly burdensome compliance, siloed & poorly integrated integrations, and painfully manual customer support. In many ways, SMEs have been a forgotten middle child; harder to serve than retail customers while lacking the deep pockets of large enterprises. It is no surprise then that only 18% of small businesses in the U.S. completely agree that banks are providing them the services they need to run the financial side of their business[1]. The number is likely lower in emerging markets where incumbent FIs are even more underinvested (and often even more profitable). Despite this, traditional FIs have had neither the impetus (owing to limited competitive pressures) nor the ability (owing to enormous tech debt) to change.

In recent years, we have seen this unstable equilibrium rightfully challenged by a number of businesses, several of which we at TCV have been lucky enough to partner with including Qonto, Brex, Revolut, Razorpay, Mollie, Xero, and Toast among others. While many of these vendors have unique landing points into the SME (e.g. bank accounts / company incorporation, corporate cards, online payments, PoS), their propositions are widening (and increasingly overlapping), and many businesses are vying to become the Financial OS (Operating System) for the SME.

Why should we care, you may ask? Simply put, the aggregation of these services makes a lot of sense, and the market opportunity ahead is enormous. The financial services stack of the SME has become increasingly fragmented over time (see below) and dealing with this fragmentation is not trivial. On the other hand, the benefits of consolidation to both the SME and the vendor are compelling. SMEs benefit from having fewer vendors to manage, improved integrations between applications that reduce human error and save time for already-overstretched finance teams, and the ability to effectively leverage data across their financial flows (e.g. payments processors who are directly in the flow-of-funds are able to both underwrite loans more accurately and collect repayment more seamlessly). On the other hand, vendors benefit from having improved customer retention (notoriously challenging in the SME space where structural churn is high), increased ARPU, and more strategic customer relationships.

In addition to this, the SME market is enormous. SMEs typically comprise ~50% of GDP, and comprise ~99% of total business count[2]. B2B payments are ~5x larger than B2C payments with SMEs comprising roughly half of this[3]. That said, we are at an inflection point today driven by a combination of technological & regulatory tailwinds (e.g. PSD2), growing customer acceptance (in part driven by growing B2C penetration), and the mass-migration to online-only services driven by Covid-19.

Furthermore, while SMEs have historically been able to access financial services through traditional FIs albeit in a high-friction manner, access to software has been severely lacking. Most SMEs today use Excel (or potentially even pen & paper) to manage the bulk of their finances. Given finance teams at SMEs are forced to wear multiple hats and notoriously understaffed, the potential ROI from optimizing workflows and increasing automation alone is massive, not to mention the value in having greater control & understanding of your financial position. Today, we are still early in the adoption curve, but the direction of travel is clear and the question is when, and not if.

Understanding the landscape

The suite of services falling under the remit of the CFO is broad, encompassing managing cashflow across customers, suppliers, & employees, compiling management and financial accounts, and increasingly producing forward-looking forecasts that help drive strategy. The universe of vendors attacking the Office of the CFO is similarly broad and can be largely segmented along the two axes below:

The software vs. financial services distinction is an important one, with several key differences:

  • Regulation: software products are largely unregulated while financial products require some sort of license (e.g. payment institution license, banking license etc.)
  • Monetization models: software products are typically fixed monthly subscriptions while financial products are largely volume-driven (e.g. % payment volumes or fixed cost per payment, interest rate on a loan)
  • Incumbent competitors: traditional FIs have largely offered financial products without providing accompanying software tools; next-gen SME software vendors are primarily replacing excel and other largely manual solutions today
  • Drivers of ROI: software products mostly drive value through automation & workflow efficiencies while financial services is more around enabling a transaction to happen in the first place

While the earliest businesses to emerge typically serviced one function (e.g. accounting software, online acquiring, lending, payroll etc.), businesses are increasingly expanding their offerings across both of the axes above from their initial landing point. While this may seem straightforward, we’ve learned a few things along the way:

  1. The initial wedge will heavily influence the target customer base…
    1. While SMEs are often treated as a homogeneous group, the reality is very different. The needs of a freelancer, 10-FTE, 50-FTE, and 250-FTE business vary significantly and there is a standard ‘roadmap’ of evolving requirements as businesses scale. For example, a bank account and basic payments are mission critical from incorporation, credit is relatively rare among freelancers but becomes increasingly relevant & complex (e.g. corporate credit cards, loans) with scale, accounting software is most relevant for small businesses rather than micro business/freelancers, most other software products (e.g. cashflow forecasting, spend management) are most mission critical for larger SMEs
  2. …and natural product adjacencies
    1. Not all product combinations are created equal; this is driven by both the maturity curve outlined above (e.g. an accounting software vendor may find it challenging to cross-sell a banking offering as the target customer likely already has an existing banking provider) as well as the strength of synergies between the products (e.g. the combination of corporate card issuing & spend management is particularly powerful)
  3. Product velocity is a powerful differentiator…
    1. While rate of product innovation is important for any business, this is particularly true for those executing along the ‘Financial OS’ strategy, especially as competitive boundaries between historically siloed products begin to blur. Particularly amongst SMEs, the benefits of bringing more parts of the finance stack under one roof often outweigh the benefits of going best-in-breed with the exception of a few more complex/regulated products (e.g. payroll). Increasingly, we expect to see a turf war with the spoils disproportionately accruing to those able to offer a broader, integrated suite of ‘good enough’ solutions
  4. …but be practical about the buy vs build vs partner decision
    1. That said, not all parts of the stack need to be built in-house especially in instances where there are clear regulatory barriers (e.g. providing on-balance-sheet lending and acquiring a lending/banking license) or where there are potential win-win partnerships at hand (e.g. GTM partnerships) particularly where customer acquisition economics permit
  5. Verticalized solutions have the potential to extend beyond financial services
    1. For vertical vendors, there is an opportunity to bundle together industry-specific workflows with financial services potentially taking control of multiple systems of record. This in turn drives enormous TAM expansion, competitive moats, customer delight, and with it, economic potential. This is a concept that we, at TCV, have long advocated through our ‘full-potential SaaS’ framework
  6. Let your customers lead the way
    1. Size is not static and (much like my waist size over the holidays) an S today might be an M tomorrow. Similarly, many Ms will eventually graduate beyond ‘SME’ designation and into large enterprises. Nowhere does this happen more quickly than among tech businesses which, often being early adopters themselves, typically comprise a disproportionate share of the customer base of next-gen financial services disruptors, particularly in their early innings. The advantages of this for vendors are twofold – 1) business models with a volumetric pricing model benefit from organic customer expansion, 2) vendors enjoy a constant stream of product feedback from increasingly demanding customers thereby allowing them to efficiently move up-market and, in an archetypal expression of Christensen’s Innovator’s Dilemma, leapfrog incumbents serving larger & deeper-pocketed customers

One important caveat – while the benefits of aggregation are clear for SMEs, this also needs to be balanced against the advantages of working with a specialist vendor particularly in instances where the problem being addressed is technically complex or highly localized (e.g. as a result of regulation). This dynamic has been particularly apparent in the software layer where we have seen the emergence of multiple standalone categories (e.g. accounting, tax, forecasting & scenario modelling etc). For vendors in these categories, the key pressure points will be in ensuring seamless integration into the rest of the finance stack, seeking out win-win partnership opportunities, and deepening functionality to avoid the risk of being aggregated into another system of record.

What are we excited about?

Despite the progress made over recent years, the Office of the CFO for SMEs remains a largely greenfield market with traditional FIs still controlling the lion’s share of the serviced market. The sheer scale of the market opportunity (99% of all businesses are SMEs!) and the heterogeneity within the SME base (both by size tier and even by geography) mean there is plenty of room for many seminal businesses to emerge. Furthermore, this is a truly global phenomenon and SMEs in emerging markets such as India, LATAM, and SEA are even more underserved than their counterparts in the US & Europe. We, at TCV, are incredibly excited to continue backing and working with visionary founders across the world who are building for tomorrow.

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[1] Designing Digital Financial Services that work for US SMBs, 11:FS, 2020

[2] 2020 Annual Report on European SMEs, European Commission

[3] “How the Next Payments Frontier will unleash small businesses”, Goldman Sachs Publishing, 2019