How Buy Now, Pay Later Will Supercharge Sales at Shopify

Each year, more businesses move to establish an online presence, especially amid the global pandemic where economic lockdowns have created unparalleled uncertainty. There's a thriving group of e-commerce website-building platforms, led distinctively by Shopify (SHOP -2.89%), which is making the digital transition cheap and simple. 

The $188 billion tech powerhouse serves over one million merchants worldwide, driving their online ambitions from beginning to end -- from digital storefronts to a full-service payments platform.

In 2020, Shopify initiated a pilot program with buy now, pay later (BNPL) provider Affirm (AFRM -2.56%), designed to bring the micro-lending revolution to its platform. Proven to boost sales, Shopify received many incentives to make this partnership happen -- and with the feature set to roll out globally, the company's merchants will have yet another tool for success. 

Image source: Getty Images.

The payments revolution

The buy now, pay later concept was first introduced around 2015 and has evolved significantly in the years since then. Early movers Affirm and Australian giant Afterpay sought to integrate their BNPL technology directly into existing e-commerce stores. The idea was to give businesses a sales lift by offering to finance the purchases of shoppers -- without customers ever needing to leave the website. The concept has now evolved to include digital cards that can be used anywhere in a move designed to compete with traditional credit card providers.

Shopify is unique in that it has its own comprehensive app store, filled with independent technologies that complement the broader platform. It affords the company a certain level of control over who, and what, can access its enormous merchant pool. Therefore, when it came to introducing buy now, pay later, it had the flexibility to develop its own offering -- as opposed to letting external providers flood in -- leveraging its existing payments platform as a foundation. 

Powered by Affirm, Shop Pay Installments was born, and after an extensive beta phase with over 10,000 merchants now active, it's finally set to reach all Shopify users this quarter. The company is actively encouraging its merchants to implement the installments feature in their checkouts, so customers can access it as a payment option.

The pitch is that it could boost sales volume by up to 50% -- plus, the customer isn't charged any interest or fees so it's an attractive proposition for shoppers. Instead, the merchant pays a 5.9% fee based on order volume, which is higher than the usual 2.9% Shopify payment fee.

The financial picture

Buy now, pay later companies worldwide are notorious for their large losses -- none of them have been able to make a consistently profitable business out of the lending model.

And competition is ramping up as the technology has almost no barriers to entry, which is putting pressure on margins. Of particular concern is the entry of large players like PayPal and CitiGroup, which are large enough to sustain losses to steal back the lost credit card market share. 

That's what makes Shopify's deal with Affirm so attractive. It's providing all the benefits of BNPL to its merchants and assuming none of the risk. As a kicker, it was given 20.3 million Affirm shares as part of the deal, which are worth about $1.3 billion at today's prices. Plus, Affirm pays an undisclosed fee to Shopify for each successful transaction.

Shopify reports revenue in two different categories:

• Subscription solutions, which accounts for merchants joining the platform and paying a recurring fee to keep their website active.
• Merchant solutions, which encompasses the fees merchants pay to use certain features like Shopify Payments (which includes ''installments''). 

Revenue growth in the merchant solutions category has exploded in the past year, and 2021 looks set to be even bigger.

Data source: Company filings.

Merchant solutions revenue more than doubled from 2019 to 2020, and in the first quarter of 2021, it posted 137% growth year over year. It's also making up a larger portion of total revenue over time. When the installments feature truly ramps up and drives as much as a 50% boost in sales volume as management suggests, Shopify could see an explosion of growth in this segment. 

The company has a golden opportunity to benefit from one of the most innovative consumer finance technologies since the credit card, and it will shoulder virtually none of the risk. In fact, if Affirm eventually finds a way to be profitable, Shopify's large stake in the company will likely appreciate in value too.

Overall, it seems like a win-win situation for Shopify.