Friar Tuck Financial Services: A Classic Unbundle/Re-bundle Strategy

Financial services businesses traditionally created a broad portfolio of financial services and then packaged them in a bundle for customers. Chris Dixon has previously explained the justification for bundling in a blog post so well that I will not repeat those points here. You can find a link to Dixon’s post in the end notes. Unfortunately, bundles can become so expensive or cumbersome to consume that “overshoot” can kick in. In other words, as a bundle grows in cost and complexity, it can become exposed to an unbundling attack.

I intentionally avoided the term “freemium” above which is inaccurate in this blog post since the unbundle stage of this strategy need not involve a service that is “free.” The unbundle strategy is about one service done really well (or at least a small subset of the traditional bundle done really well). A business adopting an unbundle/re-bundle strategy has not adopted what Clayton Christensen describes as genuinely “disruptive” strategy in his book Innovator’s Dilemma since there he was writing about an offering that is inferior to existing solutions in a overlooked low-end customer segment. An unbundled strategy can involve a service that is better than an existing solution and/or targeted at a high-end customer segment.

One common problem with an unbundling strategy is that the service by itself may not cover the cost of the business or at least provide an attractive return to investors. An opportunity can arise if venture capital funded business and large corporate investors can be patient enough to wait for benefits like network effects associated with adoption in the unbundle stage to take hold and for the customer base to achieve critical mass. These entrepreneurs and investors are counting on the strategy eventually shifting from unbundle to re-bundle and for higher profits from that shift.

The origin of what I am calling the “unbundle/re-bundle” strategy can be traced to this statement made by Jim Barksdale during the Netscape IPO Roadshow. He said: “In business, there are two ways to make money. You can bundle, or you can unbundle.” My interpretation of what Barksdale was saying is that unbundling can be a cost-effective way for a business to build a customer base that can eventually be used as a fulcrum for re-bundling other higher margin services. Barksdale did not invent the concept but he did give it a very nice name in addition to a big dose of publicity. As an aside, I have complied a list of Barksdaleisms and you can find a link to that in the end notes like: “Nothing happens until somebody sells something. If a company doesn’t have profits over the long haul, then it’s gonna be a short haul”.

The purpose of the unbundle part of the strategy is to acquire customers in a very cost effective way. The unique advantage of a software-based business model is that the marginal cost of providing an additional unit of the service approaches $0. One reason why the unbundle/rebundle strategy is popular is because many entrepreneurs and investors do not like raising huge amounts of money for marketing, which dilutes their equity. Writing some software and creating a free service in the cloud is like alchemy in that lines of code can be turned into a substitute for cash that would otherwise be spent on marketing.

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Another advantage of the unbundle/re-bundle strategy is that the service can be built from the ground up to be very simple to use. The most modern approaches to software can be used and there is no need to integrate with legacy services. That advantage starts to evaporate when the re-bundle starts, but it is useful while it lasts.

One of the best ways to explain the unbundle/re-bundle strategy is with examples. I have selected two examples that have been in the news a lot over the last few years. I could have written about other examples, but they would have been more boring.

ROBO-ADVISORS

Robo-advisors offer software-based services like asset allocation and tax loss harvesting to investors and as I said above are an example of an unbundle/re-bundle strategy. Some robo-advisors are software plus some human contact and one (Wealthfront) offers only software-based services. Robo-advisors are addressing a significant need since some people do not want to deal very often with a human and just want access to a great software based service. Other people of course want to be able to talk to a real person. They value having regularly scheduled calls with a real people and having the ability to call someone if that is necessary or desired.

When people ask me which type of financial advisor I recommend I say “it depends.” Some people want to talk to an advisor and some people want a 100% software based solution. The fees charged by these two services are different as you probably know. What a customers pay for financial advisory fees is a huge determinant of their investing activities. I “roll my own” solution and don’t use either approach. The bottom line for me is: I don’t think any of these types of advisory firms are going way any time soon. When I hear or see advisory firms snipe at each other I am mostly amused. My view is: vive la différence. More choices is better for everyone. Having said that I also think that there are very few human-based financial services firms that do not understand the increasing importance of software. Younger clients tend to be more comfortable with a software-based solution and older clients tends to like to be able to talk to a human more often.

It is worth noting that there are some human-based advisory firms who will not work with anyone who has a relatively small account. In other words, many people people with a low level of assets under management are under-serviced by human financial advisers. These accounts must be handled with a software-based approach for the customer relationship to be profitable for the provider.

A financial advisor with a low cost of customer acquisition and low churn will be more profitable. Other variables for the advisor like any business include gross margin and revenue per customers so I will say a few words about that here. On the topic of gross margin, low cost of operation is key. Software costs a significant amount to develop, but it scales really well at high assets under management. On the topic of revenue per customer, once the robo-advisor begins to offer additional services that generate a higher fee, the re-bundling process has started. The re-bundling of services by robo-advisors is natural since the basic asset allocation services are not fully capable of providing an adequate financial return to investors by themselves. The shareholders of robo-advisors did not take on a vow of poverty and some re-bundling should be expected.

Two important questions to ask any provider of financial services business are:

Are the fees associated with these fully services revealed to customers?
Is the advice given by the financial services provider valuable?

How would you answer these questions in the case of a robo-advisor?

ROBO-BROKER DEALERS

A new breed of company has appeared in recent years which I will call “robo-broker dealers.” These robo-brokers dealers are not financial advisors. They are instead enablers of just about anything the customer wants to do in financial services. Day trading, options trading and margins loans are all enabled by most robo-brokers. Robo-brokers dealers are not really in the advice business. Robo-broker dealers are instead more similar to the firm “Duke and Duke” in the movie Trading Places. A key scene in that movie includes this dialogue:

Randolph Duke: Some of our clients are speculating that the price of an asset will rise in the future. And we have other clients who are speculating that the price of the asset will fall. They place their orders with us, and we buy, or sell, their asset for them.

Mortimer Duke: Tell him the good part.

Randolph: The good part, William, is that, no matter whether our clients make money or lose money, Duke & Duke get the commissions!

Mortimer: Well? What do you think, Valentine?

Billy Ray: Sounds to me like you guys a couple of bookies!

Randolph: [chuckling, patting Billy Ray on the back] I told you he’d understand.

I will illustrate how a robo-broker-dealer uses an unbundle/re-bundle strategy in this blog post by writing about a fictional firm called Friar Tuck Financial Services which offers its customers the ability to trade stocks “for free” (i.e., with no direct fees attached). Friar Tuck does disclose that it: “collects interest on the cash and securities in Friar Tuck accounts, much like a bank collects interest on cash deposits” which might make some customers think that this is all they “pay” as an indirect fee.

The goal of a robo-broker dealer like Friar Tuck’s unbundling strategy is to reduce customer acquisition cost (CAC) while creating positive cash flow and lifetime customer value (LTV). Lifetime value is a way to calculates what Warren Buffett wrote about in his in his 1991 letter to Berkshire Hathaway shareholders: “In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.”

What a business pays to acquire a customer is an important part of the calculation of LTV. One benchmark for customer acquisition cost (CAC) via traditional methods occurred when E*Trade recently purchased stock brokerage customers from Capital One for approximately $170 each.

“Capital One Financial Corp. is selling more than 1 million brokerage accounts to E*Trade Financial Corp. for $170 million as the bank exits the self-directed online investing business. The accounts include about $18 billion in customer assets.”

How much Friar Tuck desires to pay in CAC per customer via the unbundle strategy is unclear, but one goal might be the amount that Friar Tuck competitor Robinhood spends to acquire a new account through its referral program.

“When you refer a friend, you also get a share of stock too – valued between $3 and $150. You won’t necessarily get the same stock but you could. The stock is not automatically deposited into your account. You will get a notification (or look in your history/past invites screen) and you have 60 days to claim the reward. You can sell the stock after 2 trading days but you have to keep the cash value of the stock in your account for 30 days. That value will be reported on a 1099-MISC.”

Because of breakage (some people will not claim the fee in time) the actual amount paid to acquire a customer can be less than this referral fee. Friar Tuck can create a lot of value if it can acquire financial services customers for less than $50 instead of $170. CAC is always an average number and the real CAC will certainly be higher since other higher cost customer acquisition methods will inevitably be used. Some customers are cheap for Friar Tuck to acquire and some are not.

Friar Tuck is using well proven techniques to boost customer and revenue growth including the “zero” price point for the stock trading. Daniel Ariely the author of Predictably Irrational writes “Zero is not just another price, it turns out. Zero is an emotional hot button — a source of irrational excitement.” People have an irrational love of free. I am reminded of this every time some stale food item is left in a kitchen in a workplace and it disappears in minutes.

As promoters like to say on TV infomercials “there is more” to Friar Tuck’s indirect fees and expenses.

Friar Tuck generates most of its revenue by routing orders through the high frequency trading forms Apex Clearing, Citadel, KCG, and Two Sigma. Andy Rachleff has a post on pay for order flow in the end notes that is worth reading. You can see an example of such payments also in the end notes.
A Friar Tuck competitor receives the following additional payments:

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Friar Tuck also matches up buyers and sellers adopting a process known as “internalization.” If one client wants to buy 100 shares of X and another client wants to sell 100 shares, the two orders could be matched up internally, and the robo broker dealer can collect the very small difference between what the buyer pays and the seller receives.

What services have robo-broker dealers like Friar Tuck re-bundled? After starting out with free stock trading Friar Tuck began to sell higher profit services as extras that are less indirect in nature but still rely on the presence of the installed based of customers to serve as sales leads for a cross-sell/up-sell. For example, Friar Tuck sells a “Platinum” level of extra services that include:

The ability to buy stocks using margin loans;
Access to premarket and after-hours trading during certain periods; and
Faster access to deposits for trading (i.e., non-Platinum members must wait two days for deposits over $1,000 to be usable to trade again).

Friar Tuck margin loans vary in price depending on how much margin the customer wants to borrow. The lowest tier of Platinum costs $6 per month and allows users up to $1,000 of margin loans to buy more stock than they could without the loan. It is important to point out that Friar Tuck charges Platinum customers for access to margin loans regardless of whether the customer uses it.

The questions I asked about robo-advisors were:

Are the fees associated with these services fully revealed to customers?
Is the advice given by the financial services provider valuable?

How would you answer these questions in the case of a robo-broker dealer?

It is worth noting that whether Friar Tuck will make a profit is a different question than whether it is wise for people to use the service. As an analogy, being a bookie can be a great business, but for the customers of a bookie gambling when the odds are substantially in favor of someone else is not a wise thing for someone to do.

Felix Salmon recently did an excellent job of explaining the difference between these broker dealers (in this case a broker-dealer business called Robinhood) and a robo-advisor:

“Robinhood is not in the same business as the robos. Can you use your Robinhood account to just buy an S&P 500 ETF and sit back and do nothing? Yes. Does Robinhood’s messaging encourage you to do so? Hell no.”

Friar Tuck does unfortunately enable some of the worst types of behavior by investors, without providing any cautionary advice. Margin loans. Sure! Rapid trading of shares to the full extent permitted by law? Sure! Trading options? Sure! Crypto-currency trading? Sure! A robo-advisor is like a wise old friend giving you advice for a fee and a robo-broker dealer is like the proprietor of a casino collecting a financial rake for helping you indulge in your worst behavior. Can robo-broker dealers like Friar Tuck improve their service by providing sound financial advice? Sure! Can they make a profit even if they do not provide sound financial advice? Sure! Being a bookie can be a great business.

GENERAL THOUGHTS ABOUT THE UNBUNDLE/RE-BUNDLE STRATEGY

The two previous examples illustrate different versions of an unbundle/re-bundle strategy. The use of the unbundle-re-bundle approach is far broader than financial services. For example, Atlassian used an unbundle/re-bundle strategy as did WordPress.

The unbundle/re-bundle approach only works if a complementary profitable service can be found and maintained for the re-bundle. What can be gained by this or any other growth strategy must be continually renewed. What was at one point gained via an unbundle/re-bundle approach can quickly be lost because of what Bill Gurley points out here:

“If a disruptive competitor can offer a product or service similar to yours for “free,” and if they can make enough money to keep the lights on, then you likely have a problem. “Digital offerings have very strange economics in that multi-sided markets are often involved and offerings in such a market can have close to zero marginal cost once it has been created. Solving the “chicken and egg” problem inherent in any platform business usually involves either a free egg or free chicken on one “side” of the market. It’s easy to wake up in a digital world and have whatever you were selling now being offered “for free.”

The venture capitalist Ben Horowitz (who worked with Jim Barksdale at Netscape) identifies several important product/market fit myths: “Myth #1: Product/market fit is always a discrete, big bang event; Myth #2: It’s patently obvious when you have product/market fit; Myth #3: Once you achieve product/market fit, you can’t lose it; and Myth #4: Once you have product/market fit, you don’t have to sweat the competition.” Markets and the actions of competitors in that market (which are not always visible to outsiders) are always changing. Constant adaptation is therefore required to retain product/market fit.

Ideal unbundled services are viral and have a very low or even free price. The unbundle-re-bundle can be effective as a business model because cost of educating the potential customer about the benefits of the service can be dramatically lower once that customer has used it in an unbundled setting first. The need for advertising to create awareness is lower, the need to pay third party resellers is reduced and any expenses associated with support can be replaced by self-education. The unbundle/re-bundle approach leverages other human tendencies like reciprocity and inertia, which further lower the cost of sale. John Vrionis describes why the unbundle/re-bundle has better unit economics: “Evangelizing a new religion is hard work, and more importantly it is expensive. Conversely, selling bibles to a group of believers is a lot easier…”

For any business acquiring a customer can be accomplished in two ways: (1) organically by word-of-mouth at very little cost; or (2) inorganically through expensive paid sales and marketing. The first method is much more valuable than the second not just because customers cost less money to acquire. Bill Gurley points out: “Organic users typically have a higher NPV, a higher conversion rate, a lower churn, and more satisfied than customers acquired through marketing spend.” Customers acquired with an unbundle/re-bundle approach are much more likely to be acquired organically and their unit economics will be far better for the provider of the service.

The unbundle/re-bundle approach works best when there is a huge market of potential customers since the conversion rate in this model will not be high. The further way from enterprise the service is, the lower the conversion rate will be. As an example, Dropbox has 400 million active unique users and 500 million registered unique users, but only 11 million paying subscribers.

Best practices include:

Avoid selecting “unbundled” items that have significant variable COGs. Selecting software-based unbundled services that have almost zero marginal cost works better.
The best unbundled services have network effects and are viral.
Make sure that the item you select as the unbundled side of the marketplace has complementary services that might be sold at a profit. Unbundled checking at a bank or wealth management as a robo-advisor are good examples of a service that makes upselling natural (many types of financial services).
The best forms of unbundling make it natural for the users to register revealing their personal data and set up a credit card on file and making conversion to the re-bundle easier.
The best unbundled services have low churn since they are sticky.
The best complementary services that will be re-bundled are services that people are accustomed to paying real money for (convincing people to spend money in a new category is not easy).

End Notes:

Chris Dixon on bundling: http://cdixon.org/2012/07/08/how-bundling-benefits-sellers-and-buyers/

Jim Barksdale: https://25iq.com/2014/05/31/a-dozen-things-ive-learned-from-jim-barksdale-and-barksdaleisms/

Felix Salmon: https://twitter.com/felixsalmon/status/977769364626829312

Pay for order flow: https://blog.wealthfront.com/silent-assassin-fees/

Order flow payments example: https://d2ue93q3u507c2.cloudfront.net/assets/robinhood/legal/RHF%20PFO%20Disclosure.pdf

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