Buy-Now-Pay-Later is an emergent layer in the Credit space, serving as a new way for consumers to pay for goods in the same way that they used to ‘layaway’ concept that was pioneered by department stores back in the day. Will this Business Model Innovation (BMi) revolutionize the entire market?
One of the fastest-moving markets in consumer finance is also one of the most controversial. Credit is credit, so whenever new credit products emerge for consumers they are always greeted with a healthy degree of skepticism. Nonetheless, as a result of the pandemic, BNPL seems to have crossed the chasm and reached mainstream.
What started off as a trend geared towards Millennials and GenZ has now scaled-up into GenX and beyond. Early pioneers in the space such as Klarna, Affirm, and Afterpay are now being challenged by Payments companies like Paypal and incumbents like AmEx.
Among different generations, Gen Z and Millennials are the most frequent users of the service, especially now that companies like Afterpay also offer an in-store, pay-by-card option.
With BNPL set to grow by 10-15X and processing between $650B and $1T in transactions between now and 2025, we dig deeper into the business model innovation behind BNPL and look at how it compares to traditional credit cards.
How does the BNPL (Buy Now Pay Later) Business Model work?
Unlike a traditional credit card, where the relationship is between the consumer and the corresponding bank/credit card company, BNPL transactions originate between the consumer and the merchant almost as if it were a loan.
When pioneers like Klarna, Afterpay and Affirm were founded 5 – 15 years ago, they created a new business model around the merchant, using the consumers own debit card as the payment mechanism for the transaction. The boom in eCommerce (especially during the pandemic) has now mainstreamed this business model.
These fees are much higher than a traditional credit card transaction (typically 2-3%) for the merchant. But as mentioned above, there is a different purchasing behaviour compared to a traditional credit card and also different demographics.
The main part of the BNPL pitch for merchants is the ‘Next-Gen’ shopper who is more budget conscious and careful than those consumers who spend with a traditional credit card. Most BNPL models offer purchases up to a fixed amount (~$500 – $2,000) and four payment periods (typically two weeks) to pay back the money interest free (some BNPL offerings have an attached fee, but most don’t). If a consumer misses one or more of their instalment payments, interest and other penalties are accrued, potentially leading to some kind of collections protocol if the loan goes into default.
The main reasons that consumers prefer BNPL, according to Shopify, are:
>“It was easier on my budget to pay in smaller chunks.”
>“I wanted to take advantage of a good deal now.”
>“It’s better than a credit card because it’s interest-free.”
The Next-Gen shopper using BNPL is also more likely to become a repeat purchaser, with 75% of Americans who trialed the service during the pandemic continuing to use the service. The major difference with the BNPL vs. Credit Card business model is the Customer Relationship between the consumer and the merchant, thus creating a different type of purchasing behaviour and a new value proposition. This value proposition can be summarized as:
>merchants offer BNPL to consumers (instalment payments) at PoS (Point of Sale) for purchases up to a certain amount
>merchant offerings are created and administered by 3rd Party BNPL providers (Afterpay, Klarna, Affirm, PayPal, AmEx, etc), who in turn deal with all of the logistics of the transaction
>merchants pay BNPL providers a 4-6% fee and are not responsible for collections despite the fact that they are the ones who originate the relationship with the consumer
>consumers who make all instalment payments on time have 0 interest payments. Late payments or defaults are met with interest and penalties
What is the Business Model Innovation in BNPL (Buy Now Pay Later)?
The business model innovation in BNPL is part payment processing, part banking. Whereas a traditional payment processing fee on credit cards is 2-3%, the BNPL fee is 4-6%. The obvious caveat is the credit risk associated with deferrals/defaults; however, the smaller contract size of BNPL transactions limits that risk versus traditional credit cards, at least based on the phase the industry is at today.
Merchants, however, get more value than a traditional credit card in most instances, as the BNPL channel functions as both a Customer Acquisition channel (depending on which BNPL) and a Customer Retention mechanism. The combined effect is to change the Unit Economics of each customer that originates through the BNPL channel.
The key determinant of the sector long-term will likely be the performance of the loan book and corresponding deferrals/defaults relative to revenues, especially as certain BNPL pioneers raise their credit limits in order to expand their merchant pool and gain market share.
All BNPL companies limit the size of the purchase. Afterpay, however, recently raised their limit from $1,000 AUD to $2,000 AUD. Paypal, on the other hand, only offers merchants BNPL for between $30 – $600 with its Pay In 4 service. Klarna runs a ‘soft credit check‘ (one that is not reported to credit bureaus), and therefore offers different limits to different profiles of consumers. Affirm is similar to Klarna where approvals are made on a customer-by-customer basis. AmEx’s Pay It Plan It app is attached to their core credit card offering, and gives its customers the ability to use BNPL for up to 10 purchases over $100 for a fixed monthly fee.
As we can see, the different competitors in the space are going to run with diverging strategies, which will in turn effect the business model innovation of the industry as a whole. Raising the limits opens the merchant pool and expands the TAM (Total Addressable Market) but it also increases the risks. If a more aggressive strategy is rewarded with more customers/market share in the short-term, the question is how will the corresponding defaults play out in the long-term?
Competition & Their Business Models
Banks are now moving into BNPL because it represents not just a new opportunity for growth and innovation in their product portfolios but is part of a shift in consumer behaviour.
Some Fintechs, such as Amount, have created white-label BNPL products to help banks compete with market leaders like Afterpay, Affirm, and Klarna.
The company raised a large round in December 2020 and already counts many blue-chip banks as customers.
Other banks are running their own in-house BNPL experiments (ie. Citi Flex Pay), such as trying to combine it with other products in their credit portfolio like AmEx did. Challenger Banks have also entered into the space with their own takes on BNPL products.
Banks will naturally be more cautious than BNPL pioneers, and their business models (NIM – Net Interest Margin) are also leveraged to the amount they loan out (and corresponding margins) rather than payment processing fees. But the market growth rates and innovation around payments will compel them to try and muscle their way in.
The difference in the business model between banks and BNPL pioneers may narrow as the pioneers begin to increase limits and more carefully manage consumers deferrals and defaults. Most major BNPL players themselves are beginning to look more and more like Challenger Banks themselves. But for now, the BNPL model is still a hybrid between the Payments business model and a Banking business model.
BMi – Key Components of the Canvas
What unique value does a company’s product or service create for customers?
For consumers, BNPL enables them to purchase goods/services from their favourite retailers in (typically 4) instalment payments, which are interest-free if they are made on time. The majority of these BNPL payments can be attached to their debit card of choice.
For merchants, BNPL helps to increase conversion, AOV (Average Order Value), and retention, serving as a new channel to acquire and retain customers.
What group(s) of customers is a company targeting with its product or service?
In the early phases, BNPL held a large appeal to Millennials and Gen Z consumers. As the market has evolved, Gen X and older generations have become users of BNPL products as well.
Merchants of all shapes and sizes are using BNPL. It has become a progressively larger and more important payments channel for many merchants in the last 12 months.
How does a company plan to build and maintain relationships with the customers it is serving?
The Customer Relationship is between the merchant and the consumer.
In most cases, consumers download a 3rd Party App (ie. Afterpay, Klarna, Affirm, etc) and connect the app to their bank.
Retailers will advertise – both online and offline – that they accept a certain BNPL payment provider at the till, and consumers can use their preferred app to pay the merchant directly.
BNPL providers handle all the payment/transactional details throughout the duration of the BNPL agreement (typically 4 payments x 2-week increments = 8 weeks) and handle any late payments or missed payments.
What channels does a company use to acquire, retain and continuously develop its customers?
Much of the engagement with consumers happens on the dedicated BNPL apps. Even when consumers go in-store to pay, they use these apps, which are connected to their bank card(s).
BNPL providers are now rolling out their own cards and retailers are increasingly promoting their acceptance of these offerings in their physical locations (as opposed to promoting them mainly through their eCommerce channels); therefore, there are both IRL (in real life) and online channels for BNPL to reach and retain customers.
How is a company pulling all of the above elements together to create a revenue stream(s) and generate cashflow?
Consumers typically pay no fees on any BNPL transaction as long as they make their instalment payments on time. There are flat fees for missing payments, along with interest in most situations.
Merchants typically pay 4 – 6% of the retail transaction value up to pre-established thresholds as discussed above.
The above 5 Building Blocks represent the right side of the canvas and contribute to the Revenue side of the business model.
What assets and knowledge does a company possess that allow it to deliver its value to customers in ways that other companies can’t?
With the BNPL space now including the pioneers (Afterpay, Affirm, Klarna), payments companies (Paypal), credit card companies (AmEx) and now banks, it is becoming an increasingly competitive and crowded space.
The Key Resources each possesses is their brand (and corresponding trust placed in that brand) and merchant relationships.
What activities does a company engage in that allow it to execute its strategy and either establish a presence in the market or gain market share?
Right now, major players across the competitive landscape are in the process of opening up the playbook and making moves to gain more market share. The market is in hyper-growth mode.
As an example, Klarna is increasingly making moves to expand its footprint by obtaining banking licenses in Europe and shifting its model to become more like a Challenger Bank.
What strategic and cooperative partnerships does a company form to increase the scalability and efficiency of the business?
Strategic Partnerships will form a key part of this industry going forward, especially with BNPL companies themselves making moves into retail banking.
What are the key costs associated with running the business and how can key partnerships/resources be leveraged to reduce the cost structure?
The major initial costs for BNPL companies were Technology Development and Customer Acquisition.
Now that these companies are in the process of scaling globally and competing in other segments of Financial Services, they have to deal with other costs related to payments and banking such as Compliance and Regulation.
The remaining 4 Building Blocks come together to form the left side of the canvas and contribute to the Cost Structure of the business model.
A business model is defined as:
Alex Osterwalder et al invented the Business Model Canvas to help individuals and organizations conceptualize how to analyze, create, and develop business models.
Business Model Analytics
The three main Business Model Metrics/Analytics that pertain to merchants were listed above:
>higher conversion rates (at checkout)
>higher AOV (Average Order Values)
>better retention (ie. more repeat purchases)
These three Analytics can have a significant effect on the merchant’s core business model, and it will be interesting to follow these metrics as competition in the space increases.
Some BNPL providers (like Afterpay) are now raising the limits in order to reach new types of retailers who may offer higher-value goods. In theory, these merchant Analytics should carry through to higher-value merchants as well (ie. furniture, home improvement, luxury, etc.)
But these types of high-value loans shift the entire BNPL focus from its core of focusing on lower-value goods for budget-conscious consumers, towards something that competes more with credit cards by getting into riskier segments.
As a result, the most interesting Business Model Analytics to track going forward as the industry evolves will be around the credit portfolio of the BNPL players themselves:
>rate of late payments and/or defaults
>revenues from interest/late fees as a % of revenues from merchant fees
>link between purchasing higher-value goods and late payment/default rates
As the BNPL companies become more like banks, they will have to adjust their risk metrics accordingly. Inevitably, more consumer data will used to assess creditworthiness as we already see with many BNPL offerings. But these offerings are not currently tied to consumers’ Credit Score in most situations; however, as the stakes become higher, this may change.
Overall, the rapid growth and pace of change in the industry will mean that the business model innovation itself will need to be tracked and contextualized. BNPL will become a lightning rod for criticism and regulation, especially if the industry scales in an unsustainable way and the major players become exactly like the companies they wanted to disrupt in the first place. That’s why keeping an eye on certain Business Model Analytics will help show the strengths and weaknesses of the business model as it evolves and enable key players to adjust accordingly.
What is Business Model Innovation? Innovation using the Business Model as the main mechanism, rather than product or technological innovation. Reinventing a business model – or creating a new one – is a matter of remixing the core components of a business model and developing new value propositions, revenue streams, and cost structures.