This is the sixth in my highly self-acclaimed series of posts on the nine value propositions offered by B2B platforms/multi-sided markets. Fair warning: this post is slightly longer than most, but hopefully it is worth it to cover what is often a needlessly confusing topic.
Value Proposition #6: Transaction Financing
The core value proposition of transaction financing is credit arbitrage at the invoice level. Transaction financiers help suppliers get paid faster (e.g., borrow) at a lower interest rate. This arbitrage can be achieved because:
- the buyer’s credit rating is better than the supplier’s and
- the buyer has indicated in some way that they are likely to make good on the payment due to the supplier (e.g., approved an invoice or even just established a reliable, granular history of paying the invoices in a predictable time.)
Large buyers typically have thousands of small suppliers who are paid on net 45, net 60, or longer terms. Suppliers can sell their receivables (factoring) to companies who will pay partially on these receivables up-front and then pay most of the rest later (less interest charges). The net effect being a high implicit interest rate, as the lender is often buying a portfolio of receivables of varying quality and history of payment.
All forms of transaction financing, whether they are:
- dynamic discounting,
- supply chain finance,
- reverse factoring (and many other names)
are really just “improvements” on this factoring theme. Suppliers are paid at lower effective interest rates (e.g., more/earlier) because the risk of invoice rejection has been reduced. Despite the different names in this space, the only real variables are:
- How much assurance is the buyer giving the receivable holder that they will pay on time?
- Who is providing the capital for early payment and what is their cost of capital?
- What legal structure (e.g, subordination, recourse, etc.) is involved (which relates to the first question)?
Examples of Transaction Financing:
- Early payment discounts, including dynamic discounting. In this case, a buyer agrees to pay a supplier’s approved invoice earlier than term, at a discount. For instance, a 2% discount might be taken if the payment is made in 10 days, otherwise the payment will be made in full at 30 days. (This discount is called “2/10 net 30″, for short, and it is still the most common early payment discount.) In the case of early payment discounts, the capital for the early payment is provided by the buyer.
Many buyers already offer early payment discounts to their suppliers, either manually, through their ERP systems, or through dynamic discounting software from Ariba, Taulia, and others. (Dynamic discounting exists because 2/10 net 30 is a stupid payment term–since it ignores possible discounts on days 11-29!)
- P-cards. Procurement cards pay suppliers very quickly in return for a discount just like an early payment discount. The main (non-legal) difference here is that a bank is providing the early payment, allowing the buyer to hold onto their money longer and make only one payment to the bank instead of many small payments to suppliers. (Suppliers also gain by normally not having to submit invoices.) Because the discount the bank takes from the supplier is high, the bank can afford to pay some of this back to the buyer in the form of rebates and rewards programs for buyers. There is also a clear legal structure difference here for both the buyer and the “merchant”. P-card providers are American Express, Visa issuers, and MasterCard issuers. For a variety of reasons, p-cards are typically only used on small ticket items.
- Supply Chain finance. In this case, a bank or multiple banks, plus perhaps a technology provider, will set up a legal and technical infrastructure that allows buyers to pay suppliers early on approved invoices at interest rates based on the buyer’s credit profile because the buyer has guaranteed to pay approved invoices on a certain date. Prime Revenue is the leading generalized, non-bank supply chain finance technology supplier, but there are specialized providers in freight and energy (Cass) and even online media payments (Fast Pay), as well as other verticals. Many of the major banks have either bought, built, or partnered with technology providers to provide this service and act as the capital provider. Non-banks are getting in the game of providing capital as well, since they are less highly regulated.
Strategic Issues Facing Transaction Financiers
- Trust and uptake. At the end of the day, with most of these products, a supplier is going to be asked if they want to get paid early by someone “new” at a discount. That is not an easy sell. Merchants who accept credit cards understand this approach, so do suppliers who accept early payment discounts from their clients. Hence the acceptance of these models. Beyond these two approaches, the sales pitches for these products can easily look like phishing scams to wary suppliers. This is why banks have had a little more success than small start-ups in this market. Bottom line: whenever you are talking about people’s payments and bank account numbers, they get really nervous. (It’s hard to remember, but credit cards did not really take off until more than 25 years after their introduction!)
- Two-sided legal structure. The less risk there is for the lender, the more attractive the interest rate they can offer. And the least risk involves guarantees by the buyer to make good on all approved invoices by a certain date. This requires a negotiation with a large enterprise’s treasurer. Not a fun task.
- Big Data and the Supply Chain. P-card providers pay suppliers upon shipment–this works because the goods are cheap and the rejection rate is low. Supply chain finance pays upon invoice approval. There’s no reason that payments could not also be made upon other supply chain triggers starting with the PO, progressing to Advanced Ship Notices, or anywhere else in the supply chain, as long as the lender has a great view into the risk they are taking by lending at that point in the procure-to pay-process. Big Data will allow this. Look for Transaction Financiers to move upstream in the process over time.
- How much supply chain automation to add (value proposition #1)? The first big opportunity in supply chain finance (SCF) comes when the invoice is approved by the buyer earlier than the payment term. At that point, in effect a new asset class has been created that has substantially lower risk to lend against. SCF providers have an incentive to help clients get invoices in and approved faster. Ariba started with supply chain automation and added dynamic discounting and supply chain finance. Xign was similar. Taulia started in dynamic discounting and added supply chain automation. Cass offers essentially complete AP outsourcing largely in an effort to get the invoice approved faster.
- Legal, Accounting and Securitization issues. Most readers will be bored by this stuff, so I won’t go into it, suffice it to say that these assets should ideally be some day standardized, rated, traded and securitized like mortgages or commercial paper, but given what happened in 2008, no one wants to come forward right now and suggest that!
Transaction Finance has been around forever, but its automation has been a long time coming. Make no mistake though, this area has arrived and will inexorably grow at double-digit rates. There is a lot of money at stake in how supplier payments are handled currently, and very little economic rationality, so the area will continue to disrupt. The promise of this disruption is part of the reason Tradeshift, Tungsten PLC, C2FO and others can raise 10′s or 100′s of millions of dollars with no revenue to show. Watch out, though, change can be slow in B2B payments. Check, please?!;-)
Up next, the closely aligned seventh B2B platform value proposition: Industry Big Data.