Float and breakage are not new concepts to those who work in payments, but with so many software companies getting into payments a brief refresher might be in order.
You generate float when you pay a company or a supplier before that company renders a service to you. Unless that supplier gives you interest, or something else back, before rendering the service, you are, in effect, giving that company an interest-free loan. Why do you give someone else money and let them earn your rightful interest on it? Normally because it is part of another transaction and giving them float is part of the deal.
Insurance premiums we pay to the property-casualty insurance companies are the most famous case of float. We pay auto and home insurers premiums and if we later have an accident they pay us back (usually with a lot of tussling involved). Warren Buffet made part of his fortune by underwriting insurance policies very well and by then investing billions in float like no other investor. (See here for Buffet’s great explanation of float.)
Businesses with Float
Float abounds in other businesses, beyond insurance, as well:
- Payroll processing. ADP expects to hold average client balances of $25 billion this fiscal year. (This is money ADP holds before disbursing it to their customers’ employees). Even at rock-bottom interest rates, ADP will earn more than $400 million this fiscal year from the float. (In FY20, this source of income was about 15% of EBIT. In the old days, of higher interest rates, it was more like 20% of EBIT.)
- The entire US Banking System. As you no doubt know, your remote deposit check is often not available for your use until several days after you deposit it. (Even if it is drawn on the same bank.) That’s the banking system’s float.
- Warranties. Such as the kind BestBuy tries to sell you. After all, these are just a form of insurance.
- Credit cards. Credit cards give you float and even compensate you for the float in the form of cash-back or miles. The card issuers can afford to pay you because they are charging the merchant a fee and charge you interest on any unpaid balance at the end of the payment cycle.
- SaaS software. Yep, if you pay your annual subscription in advance you are providing float to the SaaS provider, though often that company will give you an attractive discount for doing so.
- SaaS marketplaces. Some SaaS marketplaces are structured so buyers pay upfront and suppliers are paid later. AirBnB used to do this and so did some of the online travel agencies. This is hard to maintain, but Pinduoduo in China seems to pull it off. Paypal, which started as a marketplace payment solution, earns float if you keep your money in a Paypal account.
- Life insurance. As with property and casualty insurance, you pay upfront for life insurance and your beneficiaries get paid when you die. In the meantime, the insurance company invests your cash.
- Prepaid and Gift Cards. You pay to load that card up and until you (or the giftee) use that cash the company has free use of it. My favorite example is the Starbucks card/app. Starbucks ended last fiscal year with $1.3 billion in stored value and deferred royalty rewards revenue on its balance sheet. That’s a big loan. (Read more about Starbucks’ “banking operation” in a great post here.) If you think that is big, Amazon had a balance of $3.3 billion of unredeemed gift cards on its balance sheet and the end of 2019.)
Think of breakage as float with whipped cream and a cherry on top! You create breakage at the end of the float period if you forget, or fail, to redeem whatever you were paying for, to begin with. The best example is the Starbucks card. Have you ever received a Starbucks card as a gift and lost it? Or left $1.25 on it and tossed it out? That’s breakage. For those dollars, Starbucks received not only the use of your money but Starbucks kept the entire amount that went unredeemed. Think about the profit margin on breakage–its 100%! In the fiscal year 2019, Starbucks recorded $140 million in revenue from breakage (according to complex, and recently modified accounting rules).
Breakage is a natural outcome of human nature (behavioral economics) exacerbated by vendors’ policies and programs.
Businesses with Breakage
Breakage is important in several industries:
- Prepaid, rebate, and gift cards: because we lose them or lose interest in them. And don’t think this is small potatoes. The gift card business is a $100 billion annual business with 2-4% going unredeemed every year. Simply put, the gift and rebate cards businesses are turbo-charged by breakage. (Many states are cracking down on the rules associated with gift cards, but they remain lucrative.
- Warranties: because we forget we have them, lose the receipt, or the warranties have loopholes, etc.
- Airline Miles Programs: last year United’s Mileage Plus program generated 12% of United’s revenue or $5.4 billion and $1.8 billion in EBITDA. United sells miles to credit card companies and hotel chains for up to $0.02 per mile and redeems them for less than half of that–if they ever get redeemed!
- Gym Memberships: gyms are hoping you sign up, but don’t come too often and they are usually right. We all think we will work out more than we actually do.
- Life insurance: breakage occurs because:
- whoever owned the insurance is dead,
- you have moved five times,
- the beneficiaries have changed,
- the insurance company’s name has changed twice, and
- the insurance companies never try to find you, you have to find them!
As you can see all breakage includes a float period, but not all float ends in breakage. Breakage is not a big deal in the payroll, banking industry, or property/casualty insurance businesses. Those kinds of payouts are over a much shorter time horizon and we and the banks track that money that closely. We can remember who our auto and car insurance providers are!
If you can design your SaaS and payments business to include some float and breakage, it’s like adding an extra shot of espresso to that latte!