# The smaller more and more in FinTech

### My editorial

And so I am going down another path of business planning. As I wrote in my last update in French (J’enveloppe et à la prochaine ), I am taking on preparing a business plan for a FinTech project. Just as with that BeFund project regarding the environment of smart cities, I will use the opportunity to wander (intellectually) here and there, to dive into adjacent topics, and to do, generally, what an academic teacher like me likes doing, i.e. boasting about things that I read somewhere.

I think I am going to stick to the basic idea I have hinted at in J’enveloppe et à la prochaine, namely that of a functionality that trades promotional coupons for various stores, online and ordinary. I purchase from those stores standardized deeds of purchasing power. I purchase, for example, at Starbucks, 10 000 standardized coupons worth €5 of retailing purchasing power each. Anyone holding such a coupon can use it to pay, at Starbucks, €5 of retail price charged for whatever they are buying. I buy those coupons in a wholesale amount, and I negotiate with Starbucks a wholesale price. Let’s say they grant me 25% of discount on the retail price, thus I buy each coupon worth €5 in retail for a discounted price of (1 – 25%)*€5 = €3,75 and it makes 10 000 * €3,75 = €37 500. I resell those coupons in auctions, where the starting price I am calling the auction with is slightly above the price I paid to Starbucks. Let’s say, I start auctioning at €3,90 apiece, which gives me my baseline margin of (€3,90 – €3,75)/€3,75 = 4,0%. My customers bid with different prices of their own, and according to the price they actually auction those coupons, I can earn an additional margin. At the baseline, I can earn 10 000 * (€3,90 – €3,75) = €1500 on the whole deal. Each eurocent auctioned above the baseline price gives me an additional 0,27% in terms of relative margin and €100 in gross margin from the deal.

I go to the Investor Relations page of Square Inc., a U.S. based company, quite big on FinTech. I download their 10-K annual report for 2017, and I read it. Reading financial statements is a sin of excessive curiosity, and you have to repent for it, by trying to understand, which is painful and so it makes a good penitence. Table 1, below, introduces some fundamentals as for how they earn (or lose) money at Square Inc.

Table 1 The Income Statement of Square Inc. , thousands of dollars

 Revenue: 2017 2016 2015 2014 2013 Transaction-based revenue \$1 920 174,00 \$1 456 160,00 \$1 050 445,00 \$707 799,00 \$433 737,00 Starbucks transaction-based revenue \$- \$78 903,00 \$142 283,00 \$123 024,00 \$114 456,00 Subscription and services-based revenue \$252 664,00 \$129 351,00 \$58 013,00 \$12 046,00 \$- Hardware revenue \$41 415,00 \$44 307,00 \$16 377,00 \$7 323,00 \$4 240,00 Total net revenue \$2 214 253,00 \$1 708 721,00 \$1 267 118,00 \$850 192,00 \$552 433,00 Cost of revenue: Transaction-based costs \$1 230 290,00 \$943 200,00 \$672 667,00 \$450 858,00 \$277 833,00 Starbucks transaction-based costs \$- \$69 761,00 \$165 438,00 \$150 955,00 \$139 803,00 Subscription and services-based costs \$75 720,00 \$43 132,00 \$22 470,00 \$2 973,00 \$- Hardware costs \$62 393,00 \$68 562,00 \$30 874,00 \$18 330,00 \$6 012,00 Amortization of acquired technology \$6 544,00 \$8 028,00 \$5 639,00 \$1 002,00 \$- Total cost of revenue \$1 374 947,00 \$1 132 683,00 \$897 088,00 \$624 118,00 \$423 648,00 Gross profit \$839 306,00 \$576 038,00 \$370 030,00 \$226 074,00 \$128 785,00 Operating expenses: Product development \$321 888,00 \$268 537,00 \$199 638,00 \$144 637,00 \$82 864,00 Sales and marketing \$253 170,00 \$173 876,00 \$145 618,00 \$112 577,00 \$64 162,00 General and administrative \$250 553,00 \$251 993,00 \$143 466,00 \$94 220,00 \$68 942,00 Transaction, loan and advance losses \$67 018,00 \$51 235,00 \$54 009,00 \$24 081,00 \$15 329,00 Amortization of acquired customer assets \$883,00 \$850,00 \$1 757,00 \$1 050,00 \$- Impairment of intangible assets \$- \$- \$- \$- \$2 430,00 Total operating expenses \$893 512,00 \$746 491,00 \$544 488,00 \$376 565,00 \$233 727,00 Operating loss \$(54 206,00) \$(170 453,00) \$(174 458,00) \$(150 491,00) \$(104 942,00) Interest and other (income) expense, net \$8 458,00 \$(780,00) \$1 613,00 \$2 162,00 \$(962,00) Loss before income tax \$(62 664,00) \$(169 673,00) \$(176 071,00) \$(152 653,00) \$(103 980,00) Provision for income taxes \$149,00 \$1 917,00 \$3 746,00 \$1 440,00 \$513,00 Net loss \$(62 813,00) \$(171 590,00) \$(179 817,00) \$(154 093,00) \$(104 493,00)

The first thing to notice about Square Inc. is that they obviously had copied my idea of doing business with Starbucks. Can you see that ‘Starbucks transaction-based revenue’ and the ‘Starbucks transaction based costs’? Yeah, that’s right. My idea. Of course, looks like they had this idea like 4 years before I had it. Still, time is relative. My idea is my idea. In my home town, i.e. Krakow, Poland, we are really mean. I mean, really mean. Back in the days, like hundreds of years ago, some Krakowians had been repeatedly displaying an unusual taste for profuse spending and sharing. That was quickly taken in hand by the town council, which expelled those guys. They had to travel far, in order to find a new home. They settled on kind of a big island in the West. No, not Numenor. The name on postcards was different. Anyway, this is how the Scottish nation rose from the mists of history.

That Starbucks deal at Square Inc., it seems to have taken quite a while to become profitable. From 2013 through 2015, the transactional margin on this particular business was negative, -18% at first, – 14% next. Then, right after it had started to bring profits, in 2016, they closed the deal. Strange. Their remaining transactional business seems OK: I mean those ‘transaction-based revenues’ and ‘transaction-based costs’, right above Starbucks. It looks really juicy, like consistently 56 – 57%. Me, with my 4% in that Starbucks idea, I should deserve to be kicked out of Krakow, to Scotland, for extreme profusion in sharing my profits. Nobody saw anything, right?

Besides the transaction-based margin, at Square Inc., I can see two big items: subscriptions and services (very profitable), accompanied by the sales of hardware (not-really-profitable-as-such-and-per-se). Visibly, that hardware serves to provide services. Anyway, save for that slight stumbling on the Starbucks deal, and for the small loss on hardware, the essential business processes at Square are profitable. Basically, if they were not spending as much as they do on product development, the whole circus would be strongly profitable. This is what I thought since the very beginning, when I started to play (mentally) with that Starbuck idea: it just looks too easy. Some typical wholesale trade, some mobile app for online auctioning and Bob’s my uncle. Why isn’t everybody doing it? Well, now I know why: it staying technologically competitive that costs real money and is really tricky. This is very much my intuition in that business plan for the BeFund project; smart as they are, those technologies, they are like children: you need to invest an awful amount of time, energy and money in their education.

As those technologies grow in volume, at Square Inc., their education seems costing less and less. In 2013, expenses on product development made 64,3% of the gross margin, and it fell down to 54% in 2015, and further down to 38,4% in 2017. Provisional conclusion: there are economies of scale on research and development, in the FinTech business. Yes, you have to spend more and more as you want to grow your market, and yet that more and more is smaller than the more and more you receive in gross margin. Said gross margin tends to grow as well in proportion to revenue, from 23,3% in 2013 to 37,9% in 2017.

Good, I have just identified one more reason why the FinTech industry is just apparently easy to enter. With those economies of scale, a FinTech business seems to need at least \$3 billion in revenue in order to have a well-grounded, solid, operational margin.

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