Over the past decade, we have seen an onslaught of new competitors in small business banking. And it only grew. Traditional financial institutions (FIs) face pioneers – big tech players and fintech challengers – as well as a wide array of business-driven neobanks.
Case in point: In 2020, we saw Square become a bank, Stripe Treasury offer integrated banking services to a number of platforms, and Quickbooks unveil a deposit account for small businesses. And 2021 is shaping up to be another busy year, with a seemingly endless procession of disruptive neobanks entering the market – many explicitly targeting specific small business niches (e.g. freelancers, entrepreneurs, creatives, barbers! ).
Despite their inherent diversity, all of these companies share a surprisingly similar strategy for growth. To better understand what it is, we can turn to a concept widely recognized, but often misinterpreted: the theory of disruptive innovation.
How disruptive innovation helps us better understand the current competitive landscape
Fundamentally, Disruptive Innovation Theory is intended to help established businesses identify and mitigate disruption – ideally before they take hold – so the incumbent can continue to operate and grow.
The following definition comes from the Clayton Christensen Institute, based on the theories of Harvard professor Clayton Christensen:
Breakthrough innovation describes a process by which a product or service initially takes root in simple applications at the bottom of a market – usually by being cheaper and more accessible – and then continually moves upmarket, ultimately displacing established competitors.
It’s important to note that disruptive innovation takes time, as new entrants bring products to market that are never as good as current products and services, at least not initially. However, these disruptive offerings provide other desirable benefits, such as convenience, ease of use, affordability, and simplicity.
Once entrants gain a foothold at the bottom of the market, their products will often be refined and improved, until they can meet the needs of the majority of mainstream customers. Established companies (incumbents) often ignore these competitors as they continue to move upmarket in an attempt to capture higher profits. By the time they notice the disruptors, it is usually too late.
Financial institutions continue to prioritize products designed for business customers as they abandon small and micro businesses.
Historically, cash management services such as payment integration, disbursement solutions, payroll and reconciliation have featured prominently in an FI’s line of business. And for obvious reasons, these varied services can be effective when it comes to helping large enterprises and business entities increase their operational efficiency.
The main need of a small business (SME) is much simpler: to get paid. And second, being able to manage your cash flow. Indeed, money is the lifeblood of any small business, and without an easy way to receive and manage it, the reason most fail.
According to a 2016 report from the JPMorgan Chase & Co. Institute, the median small business owner had only 27 days of cash on hand. The report details the close correlation between daily cash inflows and outflows for small businesses. This close correlation highlights that any interruption in the constant flow of money can have a catastrophic impact on the health of a small business.
The problem is, most FIs lack the specific products and services that can help small business owners meet these basic needs. And the situation is hardly changing.
Certainly, most FIs want both small business and business relationships. But in the inevitable tension that accompanies prioritization, it is generally the commercial customers who receive the most attention. From a business perspective, it makes sense. Commercial customers generate higher margins and less foot traffic, while SMEs consume limited resources.
Over time, we know that preferences simply become the way business is done. FIs continued to aim high, towards larger profit margins. In the process, most of them have abandoned the low end of the market: in particular, micro and small businesses.
This customer preference may not be explicitly adopted by many FIs. However, a quick glance at a representative sample of banking sites will confirm this reality. A small business owner looking for the right solution will come across a bewildering assortment of business accounts and cash management services, along with the only small business account required. Unfortunately, the majority of these aforementioned products do not meet the needs of small businesses.
There are over 10,000 insured financial institutions in the United States, and the vast majority of them have underserved small businesses by offering them essentially the same commoditized products as a decade ago. And it was this very fact that opened the door to disruption.
Small businesses have become too big a market to continue to be ignored.
SMEs generate $ 850 billion in annual revenues for banks, a pool that is expected to grow sharply over the next seven years. The US economy has an additional impact on the appearance of small businesses: Self-employed people now number 41 million American adults of all ages, skills and income levels – consultants, freelancers, entrepreneurs, solopreneurs, temporary or on-call workers. – who work independently. to start businesses, develop their careers, pursue passions and / or supplement their income. Over the past year, the self-employed have generated an estimated $ 1.28 trillion in income for the US economy, or about 6.2% of US GDP (2018), or the entire economic output of the ‘Spain.
In addition to full-time self-employed workers, more and more Americans are scrambling to supplement their incomes. In 2019, these occasional freelancers rose to 15 million. That number has grown by more than 40% since 2016. Over the next five years, we forecast that 53% of the US adult workforce will work or have worked as a self-employed person.
Want to learn more about the state of small business? We recommend the Autobooks Small Business Report 2020, available at Autobooks.co.
Step into the classic disruptive innovator: Square
In 2009, the founders of Square discovered the basic need of small business owners to be paid – and did something about it.
The story goes that artisan glassblower and future Square co-founder Jim McKelvey needed an easy way to accept a card payment from a prospect and later realized that this lost sale could become an opportunity. Soon after, McKelvey teamed up with a friend and Twitter co-founder, Jack Dorsey, to launch Square, and quickly presented his remedy for a lingering problem for small businesses: the Square Reader.
Their idea was simple, as many disruptive offers tend to be. The dongle would be connected to a mobile device, thus becoming a point of sale system. In addition, the accompanying application, called POS, would facilitate interaction between buyer and seller, making the product and service an essentially seamless and enjoyable experience.
As mentioned earlier, disruptive technology at the start is rarely superior to existing competing products. The Reader was far from perfect. It hardly looked like the more rugged card terminals of the day, and there were security issues that were quickly addressed with future iterations. Nonetheless, the dongle was inexpensive to manufacture and provided a gateway to a market teeming with underserved micro and small business owners looking for a convenient and affordable solution to accepting card payments.
Just six months after the introduction of its Reader, Square was processing millions of dollars in gross payment volume every week. In 2011, over 100,000 new users signed up for Square every month.
To review, the first step in the disruptive process: The incumbent focuses on the high end of the market, neglecting the needs of low end customers. This allows an innovator to enter the market, even with a commodity that may be considered inferior in some respects.
What about FIs during this period? Have they reassessed their SME strategy or introduced a similar product?
In the first step above, we learned that incumbents – in our case traditional FIs – typically focus on the clients who pay the most and invest their resources in the sustainable innovations that deliver the most returns. students. It is simply a principle of good management. But it is also the reason why so many incumbents fail. This is the paradox at the center of Christensen’s revolutionary book, The innovator’s dilemma.
Surprisingly, financial institutions and large corporations have failed to see small businesses for what they are: an underserved market that needs a solution to a lingering problem. Any number of competitors at the time, especially merchant banks, could have introduced a card acceptance product just as affordable as Square’s, opening up a vast opportunity for additional revenue streams. None have.
Like all disruptors, Square did not stop with its Reader. After all, a big part of the disruption is the newcomer’s ability to refine and develop their products in order to attract a more general audience. Square focused on continuing to troubleshoot as they expanded their product offering for small businesses. The ability to accept card payments was a huge challenge, but only the first!
To learn more about the final stages of the disruptive innovation process, and how Square has closely followed this model as it has grown, be sure to read the upcoming Autobooks Guide to Disruption in Small Business. Banking.