September 5, 2021

The secret to Square’s $29b acquisition of Afterpay

Last week we learned that Square is acquiring Afterpay, let's break down the why square would pay a premium for this publicly listed company.

Written by

Lachlan Duffy

Last week we learned that Square is acquiring Afterpay in the largest M&A deal in Australian history! The reaction was broadly positive but mixed: some pundits claiming that Afterpay sold too early and had a much bigger opportunity whilst others noting that Afterpay had never turned a profit and would likely never pay back the cost of the acquisition.

The acquisition makes a lot of sense for Square and I wanted to dive in and have a look at the synergies at play and where Square as a company is heading.

A break with tradition: Australian ‘Consumer’ tech beats the world

Decacorn successes, Canva and Atlassian are members of a small club that prove Australian software companies can be best-in-class global successes. The category of Australian and hyper-successful, consumer technology companies is an even smaller class. ‘Hyperlocal’ business models like marketplaces and consumer fintech require significant ‘boots on the ground’ investment and operations headcount. These cost structures have traditionally been too prohibitive with Australia’s market size and funding depth. Almost always we see US Technology Companies who are well-funded coming to Australia and dominating: Uber, UberEats/DoorDash, Airbnb, Lime Scooters, and others.

Afterpay is probably the first (of hopefully many) of this new club of Australian consumer tech companies winning in the US. Zip and more recently (and curiously), Linktree (backed by Nick Molnar) and Mr Yum (partnered with Afterpay) are notable examples of consumer tech companies following suit. I look forward to seeing more bold and ambitious consumer companies start in Australia and win overseas.

Square and Afterpay — Merchant and Business Banking Synergies:

Afterpay Margins to Increase Dramatically:

Afterpay currently has a net margin of ~2.2%; this comprises a take-rate of ~4% Gross Merchandise Value (total value of goods sold) ‘clip of the ticket’ from merchants, of which it pays out ~1.2% to payments processing providers and the rest in other fees.

For H2 2020, Afterpay paid out $110m in payments processing fees for a net-revenue of $213.9m. All-in-all, this amounts to an annual run-rate of $220m in processing costs and the payment processing represents 50% of Afterpay’s net margin. For a more detailed teardown of Afterpay’s margins, read Jason Andrew’s article.

One of Square’s main product lines is payments-processing technology — the very payments processing fees that make up 50% of Afterpay’s net margin. It varies by market, but by partnering with Square, Afterpay could save as much as $50–100m per year in at-cost payments processing, resulting in a net margin of 2.7–3%. A material step-change for Afterpay and certainly points to real tangible value created year after year through the acquisition.

Of course, this assumes that Square takes over 100% of the payments processing of Afterpay’s customers — all 75,000 ‘active merchants’ — but it does point to what synergies are possible.

On the flipside, Square’s customers with a POS system or card-present payment option will likely soon be able to accept Afterpay, if they didn’t already — which will add incremental revenue to Square’s seller ecosystem, with the opportunity looking most promising in the US.

Square Launches Business Bank Accounts: Distribution Acquired

At TEN13, we are big believers that distribution is in many cases, more important than product. Unless a product is truly an undisputed 10x value proposition, a large ecosystem of cross-sell opportunities for pre-existing customers seems to be more valuable than having a better product. The proliferation of Microsoft Teams against Slack is the most notable example which springs to mind. See below to see how Microsoft Team’s Daily Active Users overtook Slack despite Slack’s early mover advantage, thanks largely to superior distribution.

Only last month, Square announced that it was launching Business Banking. The Afterpay acquisition nets Square 75,000 new merchants into its ecosystem, a large customer base which it has oversight over revenue, customer profile, and the ability to cross-sell them business products. With oversight on the Afterpay revenues, invoice financing and revenue-based financing seem like obvious new products — with a much broader suite of typical business banking products to follow as Square begins to build trust with these merchants and capture more value.

Trust is a key

It’s common in the Fintech industry to see that as trust is built between the customer and the bank, customers transact more and will migrate over their full financial operations to the one Fintech or Banking Provider.

This is something we have seen in TEN13 portfolio company, Chipper Cash; as customers have transacted with Chipper Cash and built trust they end up transacting more. As a further consequence, their 3m customers then take up other financial products in the ecosystem like crypto, Airtime, and more.

A Land-Grab Opportunity Emerges:

Crucially — Square has a massive carrot which it can now offer as an acquisition incentive that no other bank or financial institution can easily offer: increased bottom-line revenues by reducing Afterpay fees or waiving Square’s ‘clip-of-the-ticket’ (the 1.5%-2% processing fee) on Afterpay transactions. The gross profit margins of many businesses are less than 20% (and sometimes a lot less) and Square could conceivably offer it’s business banking customers lower payments terminal fees or lower Afterpay fees (thereby increasing gross margins) in return for using Square’s banking services.

An aggressive acquisition campaign centred on this point has a Unique Selling Point (and 10x value proposition) which can’t easily be replicated — with limited exceptions (Paypal and others) no other Fintech or Bank has the cost structures, distribution, and ownership over a businesses’ customer base to increase its revenue at the stroke of a pen in return for exclusivity over a business’ banking and financial products like Square.

I look forward to seeing how this one plays out. In competitive markets with lots of dollars being invested in a land-grab for a huge prize, the consumers (in this base — SMBs) always win and I suspect businesses will enjoy this one.

Business banking customers despise the Big 4 banks and yet they still have incredible customer retention. It’s a no-brainer for Square to aggressively take the lead on business banking while they have the advantage and the Big 4 banks remain asleep at the wheel.

Consumer Synergies: Cash App

Afterpay has great distribution and Cash App (Square’s retail peer-to-peer money transfer platform) will be a material step-change in its value offering to its ~11m customers worldwide. Distribution is king and being able to cross-sell Afterpay’s customers the rest of the financial products in Cash App’s ecosystem will be a material game changer for Square.

Cash App will soon have a BNPL option in multiple major markets: including the US, UK and Australia and will obviously bring BNPL to Square’s 40m Monthly Transacting Customers Globally. On the flipside, Afterpay customers will be able to start purchasing shares, cryptocurrency as well as deposit-taking amongst a wider feature set of what is fast becoming an emerging banking ecosystem.

The Cash App target demographic is similar to Afterpay’s — a mobile-first generation of Gen Z and Milennial users who are eager to part with the incumbent ‘Big 4’ banks and other stalwart global banks who have underinvested in their product and consumer offering for decades.

It’s an oversimplification to say that Cash App is buying Afterpay for its customers, but we can see that there are strong synergies in being able to target a new band of engaged customers with additional products.

Afterpay also pairs extremely well with Square’s boosts program; with Afterpay capturing a strong 4% of the GMV of the sale of goods, Square could combine its ‘boosts’ program to offer cashback rewards in conjunction with Afterpay’s BNPL product. Imagine a world where consumers get paid 2% cashback upfront for using a BNPL product? This would be a very compelling value proposition to consumers, but clearly one which would require strong oversight for edge cases.

Without doing any analysis, we know with Fintech that as one company adds more financial products, retention, monthly usage and ARPU tend to increase (all things being equal) and we expect to see Cash App have greater usage in Australia. Square has seen this with WAUs increasing in relative terms of their Monthly Active User Cohort and with BNPL now added, we should see this increase even more.

And if Square’s 40m customers start using BNPL in any similar way to the early cohorts from Afterpay, well, that’s a substantial amount of income in a few years time:

source: afterpay

Net Negative Churn: A rising tide floats all boats

The thing about signing up young people to banks is that there is a ‘rising tide’ in these cohorts. Young people tend to get promoted and earn more over time and they become increasingly more valuable as customers.

It might seem ‘expensive’ buying 11m milennial customers who use BNPL for US$29bn, but over the medium term (~5–10 years), these customers will be signing up mortgages and investing heavily in their super or 401k. Square will already have them on board as customers and will be ready and willing to capture their value as customers.

Looking to the Future: Will this be Square’s last acquisition target in Australia?

Australia is a lucrative market for financial services and products and its no wonder that one of our largest companies by market capitalisation is a bank (hint: CBA). (Well actually, maybe it is surprising if you look at their NPS!)

Not to sound too self-serving, but when we look at the Cash App Ecosystem and Square’s Seller and Merchant ecosystem, we see several key missing products where Square can both expand and deepen its product offering (maybe even through acquisition) in pursuit of its goal as a ‘full-stack’ financial platform.

  • Home Loans: Launching Home Loans in the future is an absolute no-brainer. Australia has a home ownership rate of 67%. This financial product will clearly be a ‘buy-or-build’ proposition for Square. Given the competition and ‘noise’ in Australia, in the buy case, Athena Home Loans could be an acquisition target — closing in on a $1bn+ valuation, scores of customers have signed on and Athena has strong cut-through in a crowded mortgage market on its model through a D2C acquisition channel. It has better interest margins through efficiencies in its model which are shared with the consumer and a very strong NPS. When millennial Afterpay and Cash App users will be buying home loans in the next 5–10 years, it makes sense for Athena to be a potential acquisition target for Square.
  • Superannuation: There is a lot of money in Superannuation in Australia — literally [trillions of dollars in funds.] Superannuation (or 401k in the US) would sit alongside deposits, stock purchasing and home loans as an obvious feature in the Cash App ecosystem. Superannuation as an asset class is sticky; users almost never churn, typically never look at their Superannuation balances with most millennials/Gen Z will have active balances in the thousands. As with home loans, this is a buy or build proposition — but given the reticence of customers to move their Superannuation around and the regulatory hurdles to setting up a Superannuation fund, it makes sense to acquire a pre-engaged set of customers and incorporate it into Cash App. Having just recently crossed the US$1bn in FUM threshold, Spaceship could be a clear target for Square to launch this financial product in Australia.
  • Micro and SMB Products: As Square deepens its product offering to SMBs and tried to win business banking customers off incumbent global banks, Square will need to win on both product and price. It is not unforeseeable for Square to either buy or build a suite of financial tools for micro and SMB customers. TEN13 portfolio company Bookipi has a presence in 130+ countries (with the largest markets being in Australia, the US, and the UK) and provides invoicing, payments processing, expensing, and micro-accounting solution for micro and SMB customers, and recently just released a feature for customers to track their cash flow through Bookipi.
  • POS Ecosystem: Square has a POS for merchants and a card-present payment option. In the US, Square is trialling a rollout of its table-ordering QR Menu product to bring the consumer menu experience from the offline to the online world. Mr Yum has recently launched in both the US and the UK and has a long way left to run, leaving us super bullish on the opportunity they have to bring the menu and table ordering experience online to the $600bn+ Food and Beverage Market worldwide. If they continue their rapid rate of growth, it’s not inconceivable that Square could look to bring them into their POS ecosystem and add more value to their merchants.

Square: A Full-Stack Fintech with a $1tn+ Opportunity?

Square still needs a lot has to go right with new products and for their current rate of growth to continue, but the edges of the map are filling in and we can start to see the full opportunity ahead for them: the bundled fintech to ‘rule them all.’

It’s become more likely that Square has a $1 trillion + opportunity with the recent acquisition of Afterpay when you consider the broader fintech industry, which is made up of the following areas and continues to grow.

My AfterThoughts:

As an Australian in Tech and VC, I feel we as an ecosystem have a shared desire for many more $100bn+ tech companies to emerge; global flagbearers and ambassadors for our tech ecosystem to prove that yes, with 1% of the world’s GDP we can do it. I feel that with the Afterpay acquisition we might have lost a great candidate for such a role.

China has Tencent and Ant Financial, the US has Google, Amazon, Apple, Microsoft, and others. whilst Europe already has SAP, with Revolut and UIPath closing in rapidly.

Australian giants Atlassian and Canva are also creating a global presence for Australian technology company — but we are still searching for our first US$100bn milestone and many more after that (I note that Atlassian’s share price increased by 25% last week on the back of the results — I might be out of date by next week).

Whilst I can’t help but feel that Australia has lost a credible opportunity for a potential $100bn+ Tech company in the next 5–10 years, I do believe that Afterpay will live on to play a meaningful role in Square’s $1 trillion + play at becoming a Full-stack Fintech.

On the plus side, we now have a new generation of cashed-up investors looking to fund Australian Technology Companies and a wealth of talent who will look for their next big challenge to work on….. If that’s you get in touch.

About Lachlan Duffy

Lachlan is an Investor at TEN13, Australia’s leading Venture Syndicate Platform with investments including Chipper Cash, Clipchamp, Go1 and Mr. Yum. Prior to TEN13, he worked at unicorn scale-ups Uber and Deliveroo in roles covering strategy, growth and operations.

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