What Business Is Square In Exactly?

Square has reportedly confidentially filed for an IPO under the JOBS act (BloombergWSJ, 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.