What Business Is Square In Exactly?

Square has reportedly confidentially filed for an IPO under the JOBS act (Bloomberg, WSJ, etc).

In response to the announcement and long before there has been a lot of skepticism about Square's core credit card processing business model. Even with thirty billion dollars a year in processing, running a large engineering, product and design organization on top of such a low-margin business has lead to large losses. I've written in that past that Credit Card Processing is a Hard Business and about Credit Card Processing as a Commodity Business. 

As a contrast, with Stripe's recent announcement of Visa's investment, a number of outlets reported that they're doing approximately the same volume as Braintree's $20B. Their press site says they're at 270 people as of May. It's not hard to imagine Stripe with that leverage being profitable. Square has, in my sniffing around, roughly ten times as many people as Stripe with only 50% more processing.[1]  

Obviously Square does not perceive their business to be that of merchant acquirer and credit card processor. That is, the old model that Stripe and Square were two sides of the same coin, one card-present and the other card-not-present, does not make sense any more. The differences between them are only increasing. 

Square As The Small Business Operating System

I have theorized previously that Giving Credit Card Processing Away might be an effective way to build a big business. Square has done just that. Square created an cloud-based OS platform for their merchants by effectively giving away credit card processing and then cross selling their customers first party apps that tie into the point-of-sale and card-reader solutions. 

Specialization is a virtue in corporate planning. Square lists sixteen products on their site and people assume they aren't specialized. 

Product specialization is frequently cited as the best way to build a business. The argument goes that businesses usually get big on their singular excellence in one product: even broadly defined. ZenPayroll and Zenefits are providing payroll and employee/benefit management, respectively, better than Square could ever do. 

Square looks like a company that will throw anything at the wall to see what sticks. My reading though is that they specialized in one customer set. That's the internal rationale for all their products — "we're the one stop-shop for (very) small businesses".  I'll admit that some of their products feel a little afield, Caviar in particular. But in the finance space, customer segment specialization is common even when offering a number of different products: American Express and the high-end consumer, Capital One and subprime, Lending Club and subprime, Earnest or Sofi and high-end millennial, LendUp and subprime. 

To me, Square is building an interesting cross between how many finance companies operate and how many technology companies operate. They're cross-selling to a particular market segment with a loss-leader. 

This actually isn't that dissimilar than the business models of most retail banks. You get a demand deposit account, which really doesn't make them very much money, on the idea that they'll cross-sell you other financial products in their supermarket. 

Square is actually even better off because their supermarket of products are mostly high-margin technology products, something that banks often try to emulate but fail at. Email marketing, invoicing, payroll, employee management, appointments are SaaS businesses, with the margins to match.

There are a lot of small businesses in the world where one holistic solution is the right one. Maybe some of those businesses graduate to better tools, but most businesses aren't startups: they don't see radical growth. They go slow and steady and peak as "life-style" businesses. Just this morning I was at Philz Coffee, where I was rung up on a Square register. Philz is growing rapidly and maybe they'll need bigger and more complicated tools, but I bet you could run that business still today completely within the Square ecosystem. 

Taking Square Capital As An Example

I want to focus down on Square Capital as prototypical of their business model moving forward.

Factoring (selling invoices or receivables at a discount) and invoice discounting (borrowing against invoices or receivables) are big businesses. Historic ones too. Although I'm not an expert on the history, I've heard it said that these two tools were some of the first financial and banking products to exist ever. Some models of the development of money markets start with these tools. But I digress, invoice discounting is something frequently used by corporate treasurers to manage liquidity, their cash position, and even, yes, make certain capital investments. 

Traditional banks and factors are not very good at originating business from small- or micro- businesses. It just doesn't make sense within the context of their costs of acquisition and, even more acutely, their cost of underwriting to work with these businesses. A number of startups have cropped up recently within this market. Kickpay, Fundbox, Bluevine, etc. Let us stipulate theses companies are smart enough to build a great product and to acquire users cheaply, the biggest difficulty for these new entrants is verifying data, identifying the merchant, and ascertaining their credit worthiness. One can often make very good money on these collateralized loans but only if you can underwrite correctly. 

Enter Square. Fifteen of their sixteen products produce data on merchants: their activities, their growth, their sales, their employees, the number of appointments they have, the number of deliveries their making, and on, and on. Capital can effectively make high-margin returns on that data by deploying what amounts to invoice discounting against future credit card receivables. The program is young. They've only deployed $100M in Capital. But even if none of their other businesses made any money, they could get a Lending Club style P/E ratio (still 73 despite getting pounded in the markets) by doing a larger, much smarter, much more data-driven version of OnDeck's business.[1] 

If that's the case, Square would be a great business. It just won't be the one we thought it was.

Bullish on Square

And that's just one product line! I leave it as an exercise for the reader to repeat the analysis through all of Square's products one-by-one. Some of them are duds. But enough of them are winners. They're fast-growing, high-margin businesses built on top of a simple premise: let's make card processing cheap and then cross-sell.

I'm eager to read Square's S-1. I think they might have a tumultuous IPO and a difficult roadshow given people's perception of their business but, in the long-term, I'm bullish on their prospects.  

...

[1] These two businesses are actually really different not just in their target market but in how they source their capital and manage it on their balance sheet, but that's not particularly important here. 

Giving Credit Card Processing Away

I've written in earlier blog posts about how I don't think that credit card processing is a particularly good business (Credit Card Processing is a Hard Business and Credit Card Processing as a Commodity Business).

The gist of my argument is that a company in the card processing business has to reach truly massive scale before starting to profit. That is very hard to do. Square, Braintree, Stripe, and WePay prove that one can build valuable businesses but they have all achieved massive scale. Braintree after all was purchased mostly for their consumer product and its network while Stripe is working hard to build out Stripe Checkout so it can store consumer card data and do the same.

I was chatting with Jareau Wade, one of the co-founders of Balanced Payments, to get some idea of comparables on the scale. He pointed out that Vantiv processed roughly $530B last year and currently has a market cap of $5.7B. Heartland Payments processed roughly $120B last year and currently has a $1.6B market cap. At the time of Braintree's acquisition it had a processing run rate of $12B a year and was worth $0.8B. PayPal did not perceive Braintree's value as coming from their processing business, no matter how fast it was growing.

My comments on card processing led me to a thought experiment: maybe a processor could give card processing away and make money some other, higher margin way.

No independent sales organizations (ISO) - such as Stripe or WePay - could make the marginal cost of a charge zero because a huge percentage of the fee they collect goes to the card networks and their member banks (often called, not quite accurately, the interchange fee). In fact, big businesses can often get a card processing fee structure of interchange + some margin (known as "interchange plus" pricing). Maybe these processing business could charge everyone that way and find some other way to make most of their money. They can't quite make it zero margin because the processor does take on some risk but they could run this part of their business at break even.

A business that comes immediately to mind that could do this is Sift Science. They could just give processing away on top of their already profitable product. Sift Science is proving that a ton of businesses will pay them for better credit card fraud protection. They've cracked that nut but their system get better and better as they see more transaction. More data improves their algorithms and their blacklists. One way they could see a lot more transactions is if they just gave the transactional service away for free.

I'm not actually advocating that Sift Science get in to the processing business. They're running a great business and likely don't need a different path to user acquisition. It would certainly burden them to become an ISO with someone like Wells Fargo or Paymenttech. I am using them as an example though of how one could build a business that gives processing away while helping build a profitable core business.

As a contrast take Square, for example. They keep releasing (not particularly successful) products to try to get at bigger margins: Cash, Wallet, Register etc. Rather than running a processing business and then trying to find one's high-margin product it would be better to figure out a high-margin product where dirt cheap processing would be a way to get a lot of people to use it.

Credit Card Processing as a Commodity Business

I wanted to expand on my post from yesterday after some great feedback. When I said that credit card processing is a commodity business, I was not saying that it was a bad business. It is just a hard market to be in exactly because processors need to get to a huge processing volume to generate meaningful revenue. In the credit card processing business, volume is the only metric that matters.

Companies that operate well in credit card processing are to be praised and any industry that is producing multiple companies with multi-hundred-million-dollar valuations is a very healthy one.

Having said that, many companies create something that is heavily differentiated from their competitors and are able to charge for that differentiation. Apple creates laptops that are 10x better than PCs running Windows, so many folks are willing to pay 2-3x as much for their laptops. Apple is able to take their differentiation and convert that into increased revenue and better margins.

In the world of credit card processing one cannot charge more if one says they are in the card processing business. Even if someone created an idealized solution for dealing with the payments system, once a user reaches sufficient scale they will be more concerned with the variable components of the processor’s cost than the lower fixed costs of development and set up.

That makes perfect sense. Most business wants to commoditize all of their inputs and differentiate their outputs. Technology businesses, and big businesses that rely on contractors or system integrators, will eat a month’s worth of horrifically painful engineering as it is much cheaper over the long-term than paying even an extra few basis points (hundredths of a percentage point) on each transaction. That is, if a business is doing enough processing that even small increases in marginal cost matter then increased upfront fixed costs won’t.

To succeed in credit card processing, a processor can succeed in one of two ways.[1]

The first is to clearly be in the credit card processing market, have razor thin margins, drives toward massive volume, and create a much better product so folks use the product at all. Businesses will not pay the processor more for a better product though. The processor will invest more and more money in their product but with margins that get more and more squeezed on the one hand by knowledgeable large enterprises, the processor’s most valuable customers, that want things like an interchange plus basis points pricing. And, on the other hand, processors will get squeezed by the absolute fixed costs of what the banks and card networks charge the processor. Adding insult to injury, as the processor gets better known fraudsters pay more attention to it, increasing the cost of simply operating

That is a hard place to be. That is the place that Braintree, Stripe, WePay, and Balanced operate in as well as a ton of companies that we are not as fortunate enough to have heard of. Ultimately, Square is there too — although their situation is slightly more complicated. It is not necessarily a bad business to be in: any entrepreneur would be happy to be added to the list of successful processing companies.

The other way to succeed in credit card processing is to figure out how to be a payments company without appearing to be one so you can just charge much more. That is what most marketplace companies succeed at doing. They have built a better and better product experience, whose heart is credit card processing, and they can charge for that something better. What they have done commoditize their input — credit card processing — and differentiated their output into “booking blackcars” or whatever it might be. Ultimately, their core business is having their customer pay with credit card and then paying it out to a wide set of merchants, e.g. drivers, via electronic checks (ACH). That’s Airbnb, Eventbrite and others. Whether or not those companies go on to use Braintree or Stripe as their payments gateway does not matter because they are making such a large percentage of every transaction.

Addendum: Braintree’s Revenue

Braintree is actually a gateway, rather than a full-stack processor, for many of their best known and largest customers. That is a high-margin game with little risk. In this world, they make $49/month and $.10/transaction from those customers. That might make their margins higher than I suggested yesterday. It is actually hard to calculate the precise difference or relative value of those different business models without knowing how much they would make on a percentage basis, the average ticket size for those customers, and how much risk the company’s processors take on.

If this is all mumbo jumbo to you, dear reader, then keep your eyes peeled for future posts explaining various parts of the payments system.

[1] This is a model for argument. I think it’s useful but I also know that I’m simplifying important and complex businesses into gross categories.

Thank you to Daniel Kimerling, Jim Brusster, Brent Goldman, and Spencer Sugarman for suggestions and edits.

Credit Card Processing is a Hard Business

Braintree sold to PayPal (Ebay) this morning, which reminded me that I am a payments skeptic and especially skeptical of credit card processing.

Credit card processing is a commodity business. Companies advertise fees like 2.9% but the vast majority of that goes to the card networks and to the issuing and acquiring banks. On top of that, the majority of processing does not actually happen anywhere near the posted rates. Most processing is by large merchants (following the ubiquitous 80-20 rule) and those merchants get volume pricing and other discounts.

The margins in the card processing business are incredibly small. A company would be very lucky to make .5%. That’s not discounting the money lost to risk or the cost of acquiring customers.

Let’s take the biggest online example. PayPal processed $144.973B last year. If that was entirely processed over credit cards than they would have made - assuming 0.5% - $0.724B on processing itself. $724 million isn’t all that much.

PayPal actually made more like $5.6B last year because they make most of their money by having people use electronic checks (ACH) while charging them credit card like fees, and by charging customers high, and opaque, foreign exchange and transfer fees.

Compared to the high margins of other software companies it isn’t all that great to be in the credit card processing business. One needs a lot of infrastructure to make not all that much money, and ultimately the biggest player in online processing business gets most of their revenue from other parts of their business.

Braintree is processing $12B a year with few revenue streams outside processing. A generous reading of their net income would put them at $60M a year. I doubt they are actually near that number and, as mentioned in the press, I assume that their purchase price is so high because of a generous understanding of the value of the Venmo network.

A bunch of folks have asked me what the acquisition means for Stripe. Having worked at Stripe I think they are the best online processor on the market. They have the best solution and certainly the best team.

But is the acquisition good for Stripe? Yes and no. Yes because over the next few months Stripe is going to have an influx of great customers and their transactional volume.

The one caveat is that, inside payment circles, Braintree was known for bidding ridiculously low in bake-offs between them and other processors for hot companies like Github, Airbnb, etc. So low that they might be losing money on the deals just to secure them. Some of these customers might not move over to Stripe exactly because they’re being given an unreasonable deal, one that PayPal can sustain. Those companies have also already built their payments systems on top of the Braintree’s infrastructure.

On the other hand, this deal pegs Stripe's short-term market value. Stripe is growing faster than most YC companies but let’s assume, given their time in market, that they are processing single digit billions a year. If Braintree sold for $800M and is processing $12B than the deal depresses Stripe’s implied valuation. I don’t think that matters since they have plenty of cash but the sale highlights how hard it is to be in the processing business. And, Stripe is the best there ever has been in the business.

I actually think that there are two interesting places to play in the credit card processing system these days. One is to be what I call a vertically specific payments company. That’s Airbnb, Uber, and Eventbrite and a different blog post entirely. The other is if you can own more than one layer of the processing stack like Credorax does in Europe.