Cover Story: Private Equity’s Prize Wheel

Loyalty systems, rapidly adaptable mobile and e-commerce technology, and data-security applications are attracting lots of venture capital. Here’s a look into the minds of investors. Hint: They’re not too keen on NFC.

Peter Lucas

If you want to know what the next hot new company in the payments industry will be, follow the money. Startups and early-stage companies, after all, need cash—and plenty of it—to grow their sales forces, develop technology, attract new talent, and pay their day-to-day bills.

A young company’s insatiable need for cash makes venture-capital firms and private-equity investors the front-line prognosticators in determining which firms with cutting-edge ideas are capable of altering the payments landscape, since they don’t bet on long shots. Companies that don’t pass muster after due diligence typically are left out on the cold.

Sure, some startups can get off the ground with investments from so-called angel investors, rich individuals willing to back a new idea with a couple hundred thousand dollars. But angel investors usually don’t have pockets deep enough to cover startups over the long haul.

That’s where venture-capital and private-equity firms come into play. Armed with tens of millions—and in the case of corporate venture firms, hundreds of millions—of dollars, these firms have the money entrepreneurs need to turn a promising idea into a company with a high valuation that can be converted into tidy sums of money when it is sold or taken public.

‘Compelling Solutions’

Securing venture capital depends on a number of criteria. Investors today not only look for products that make payments more convenient, better protect consumer data, or monetize loyalty and consumer-behavior data into sales for merchants, they also base their investments on the strength of the management team and how large a piece of the market the new company can carve out.

Through the first three quarters of 2012, venture-capital firms infused nearly $711 million into startup and adolescent e-commerce companies, according to Thomson Reuters. This year’s investments could tie or exceed the $753 million invested in all of 2011, and already are well beyond the $447 million invested in 2010.

But investments, while increasing, still remain at a fraction of their levels in the late 1990s and early 2000s, a boom that ended with the massive Tech Wreck bust.

The rapid pace of technological change transforming payments is luring investors to bet on up-and-coming companies. Indeed, the digitization of payments has ushered in an era of innovation not seen since Visa Inc. and MasterCard Inc. began connecting banks and merchants to their global networks on a large scale in the 1970s.

“There are many compelling solutions in the digital economy that have the potential to change consumer behavior in a monumental way,” says Tom Blaisdell, a general partner for DCM, a Menlo Park, Calif.-based early-stage venture-capital firm, and former Intuit Inc. executive. “This is the most innovation I’ve seen around payments in a long time.”

Among the companies grabbing investors’ attention is Lexington, Mass.-based Cartera Commerce Inc., a provider of multichannel marketing and loyalty solutions. Cartera’s platform enables merchants and banks to electronically deliver personalized offers to consumers’ mobile phones or computers and track their redemption.

The company’s OfferLink program rewards consumers that link their credit or debit cards to merchants within the Cartera network with loyalty points that can be redeemed for cash, airline miles, or other incentives. Between January and Sept. 30, the company received $12.2 million in growth equity from its previous investors.

“What makes loyalty solutions appealing is that they can monetize consumer behavior for merchants by increasing consumer spending and purchase frequency,” says Matthew Witheiler, principal for Boston-based Flybridge Capital Partners, which is an investor in Cartera. “The opportunity to tie data around a financial transaction to marketing initiatives that increase consumer spending is generating quite a bit of interest in loyalty.”

Of the 3,000 or so companies Flybridge evaluates annually, it invests in just 10 to 15. Of those deals, two or three are likely to be home runs and about the same number are likely to either lose money or break even. The remaining companies end up turning a modest profit for Flybridge.

To some venture-capital firms, loyalty and customer-relationship-management (CRM) solutions will become the backbone of digital-payments technology. Entrepreneurs developing new payment solutions, such as enabling a small merchant to accept payment via a mobile phone, can leverage their merchant relationships to provide CRM applications.

“A lot of small merchants don’t have systems to manage loyalty programs, so it is a natural fit for entrepreneurs providing payment solutions to move into this area, because the data around the transaction can be used to influence consumer behavior,” says Andreas Weiskam, managing director for Karlsruhe, Germany-based SAP Ventures. “There are also opportunities for these entrepreneurs to provide other business-management applications, such as enterprise resource planning, to small businesses.”

‘Very Skeptical’

Although SAP Ventures, which is the growth-equity investment arm of enterprise software giant SAP AG, has yet to invest directly in a payments company, it is eying a couple of prospects in the mobile-payments space—Dublin, Ireland-based Sum Up and London- and Berlin-based Payleven. Both firms provide mobile-payments-acceptance solutions for merchants and charge merchants 2.75% of the transaction amount.

As a growth-equity firm, SAP Ventures invests in companies that have moved past the startup phase and need more capital to scale their business.

“We typically look for companies globally that are generating revenues of $5 million or more and that we can add value to through our affiliation with SAP and its partners,” adds Weiskam (box, page 28).

The explosion of mobile commerce, both from a consumer and merchant perspective, has many investors evaluating deals in this market. For consumers, m-commerce unfetters them from their computer and the physical store, providing them with the freedom to shop in new ways.

Merchants already are feeling the growing influence of m-commerce. Mobile devices are projected to account for more than 20% of Web traffic this holiday season, up from about 11% of online holiday traffic just two years ago, according to International Business Machines Corp.

On the flip side, payment providers see m-commerce as a way to change the way consumers pay for purchases, such as by tapping their phone on an in-store point-of-sale terminal or using an app to access a digital wallet stored on a secure server.

The big bet in mobile payments so far has been on digital wallets based on near-field communication (NFC), a powerful technology that can marry payments and marketing data. Yet the difficulty that NFC wallets, which require phones and terminals to have NFC-enabled chips, have had gaining traction, despite the backing of such deep-pocketed companies as Google Inc. with its Google Wallet and Verizon Wireless, AT&T Mobility, and T-Mobile USA with Isis (“The Troubled World of NFC Wallets,” November), has many financial executives questioning whether an investment bubble is building.

“The risk with investing in NFC wallets is that it is a product being built for which there is no market right now,” says Flybridge Capital’s Witheiler. “I am very skeptical of investing in that space.”

The primary reason for investors cooling on NFC wallets is that, although their numbers are increasing, smart phones with NFC chips account for only about 5% of all smart phones in the United States.

Many investment executives argue that it will take at least five years for NFC-based wallets to gain any real traction with merchants and consumers, which makes betting on the technology today too risky for them.

“The time frame for mass adoption of NFC-enabled phones and convincing merchants to retrofit their POS systems to accept NFC wallets is beyond that of most investors’ horizons,” says Scott Ford, managing director for Kansas City, Mo.-based OpenAir Equity Partners. “There are significant infrastructure hurdles facing NFC wallets.”

Venture-capital and private-equity investors look for a return on investment (ROI) at a targeted level in three to six years, on average. Firms investing in startups, for example, may hold their investment for six years, or longer in some cases, because it usually takes that long for a young company to generate the kind of revenues needed to deliver the desired ROI.

On the other hand, growth-equity investors, which infuse money after the startup phase, typically hold their investments for three to four years because they are investing in more mature companies on track to hit their revenue projections sooner.

Typically, early-stage investors look for a return of five to 10 times their investment, while growth-equity investors look for a return of three to four times their investment, on average.

In addition to concerns about the lack of supporting infrastructure for NFC wallets, the reluctance of many merchants to embrace the technology is helping sour venture investors’ opinions of the NFC wallet as an opportunity.

Wal-Mart Stores Inc., the world’s largest retailer, and a number of other big retailing firms are in the process of developing a mobile-payments network called Merchant Customer Exchange (MCX). Although MCX hasn’t yet said which technology or technologies it will use, observers believe NFC is unlikely to be its first choice.

“It’s tough to make a Series A investment in mobile [wallets] today because the market is so underdeveloped,” says Dan Rosen, founding partner of Commerce Ventures. Series A investments typically run between $2 and $10 million. In comparison, seed money for a startup usually is between $200,000 and $1.5 million.

San Francisco-based Commerce Ventures was formed in August after Rosen left Highland Capital Partners and will specialize in funding companies bringing new retail technologies to market, such as mobile payments. The company is raising capital for its first fund, which, according to Forbes magazine, reportedly will be between $20 million and $30 million.

Investors’ Radar

The riskiness of NFC-based mobile wallets has investors turning more of their attention to companies developing alternative wallet technologies that can be combined with loyalty solutions.

Boston-based LevelUp, for example, received two rounds of funding earlier this year, $12 million in June and another $9 million in August.

LevelUp is providing a new twist on the digital wallet by allowing consumers to link a credit card to a 2D bar code that resides on their smart phone within the LevelUp app. When the wallet app is launched, consumers making a purchase at a LevelUp merchant scan the code at the point of sale and automatically earn rewards.

The startup further strengthened its hand by slashing its merchant-acceptance fee from 2% of the transaction to zero. Instead, the company earns merchant fees of 35 cents per dollar of incremental sales generated by the redemption of rewards. About 60% of LevelUp customers make a repeat purchase at the same merchant within two to three weeks of their first purchase, the company says.

Launched in July, LevelUp changed its pricing model after watching how merchants struggled to generate repeat sales from consumers making a purchase through a daily-deal offer. “LevelUp has done pretty well as a mobile startup,” says Rosen.

Another digital provider appearing on investors’ radar screen is San Francisco-based Cimbal Inc., a developer of mobile-payment and marketing platforms. Like LevelUp, the Cimbal wallet generates a 2D bar code linked to a credit or debit card that can be scanned at the point of sale. While merchants do not pay a software licensing fee to accept Cimbal or have to upgrade their POS terminal to accept it, they do pay a transaction fee.

In addition to enabling mobile payments, the Cimbal wallet also can be used for person-to-person payments. The company launched in 2010 with seed money from angel investors.

“With mobile wallets, improving the consumer experience is what’s pushing the technology forward,” says Peter B. Ognibene, managing director for Berkery, Noyes & Co. LLC, a New York based investment bank. “Players that have a head start with their technology over their competitors can attract the capital they need to quickly capture significant market share.”

With mobile payments evolving at a breakneck pace, merchants have a greater need for identity-verification solutions to reduce fraud. Atlanta-based IDology Inc. is one company that has caught the attention of investors as a growth-equity opportunity. Founded in 2003, the company provides real-time identity and age-verification solutions for card-not-present transactions.

“Identity verification and fraud prevention will be hot areas because card-not-present merchants need it to make their business more secure from fraud,” says Ognibene. “With growth-equity investments it is easier to predict where a company will be in five years, because the company has a track record of performance.”

Interest among corporate buyers in acquiring anti-fraud startups was evident in late October when Hopkinton, Mass.-based EMC Corp. signed an agreement to buy privately held Silver Tail Systems of Menlo Park, Calif., for an undisclosed sum. Silver Tail provides predictive analytics for fraud prevention and detection. In 2011, EMC acquired NetWitness, another security startup, for an estimated $400 million, more than 10 times its revenues.

Other technologies gaining investors’ notice include those that use social-media data to validate someone’s identity when making a purchase online.

“It’s an additional form of data that can be used to supplement the information already used to verify someone’s identity online,” says Commerce Ventures’ Rosen. “It’s an area I like.”

‘A Lot of Niches’

But not all investors look for such cutting-edge opportunities. Los Angeles-based The Gores Group LLC purchased the former Hypercom Corp.’s U.S. operations in August 2011 and rebranded the No. 3 domestic POS terminal maker as Equinox Payments LLC (“Equinox Looks for a Summer Solstice,” November).

The purchase was the second foray for Gores into the POS terminal world. Gores bought a controlling interest in VeriFone Systems Inc. from Hewlett-Packard Co. in 2001 and later sold the company.

What attracted Gores to Hypercom is the belief that merchants want an alternative to VeriFone terminals, which dominate the U.S.

“Equinox has a large installed base, is a primary player in the market, and represents an attractive platform for growth,” says Craig Brooks, vice president of mergers and acquisitions for The Gores Group. The firm typically looks to acquire mature companies and manage them for growth for at least four years.

Software, however, remains the real differentiator behind any POS terminal. Earlier this year, Boston-based independent sales organization Merchant Warehouse introduced Genius, a cloud-based platform that aggregates myriad payment applications, including NFC, QR codes, gift cards, and loyalty programs into a POS terminal. In July, Merchant Warehouse received an undisclosed capital infusion from Boston-based Parthenon Capital Partners.

“Investors are looking more at integrated technology plays today,” says Merchant Warehouse chief executive Henry Helgeson.

As the convergence of mobile payments, loyalty, person-to-person, gift, and other prepaid cards and data security continues to build momentum, firms believe there will be plenty of new, profitable opportunities.

“Payments may be a mature industry, but there are a lot of new ideas and a lot of niches that can potentially yield huge market share,” says DCM’s Blaisdell. “It’s a good time to be an investor in the payments industry.”

Corporate Venture Capital Blazes a New Trail

With more and more innovation being driven by small companies, many bigger corporations are setting up venture-capital arms to tap the creativity of cutting-edge startups to help advance their own core technology.

SAP Ventures, for example, typically looks to invest in companies past the startup phase that have developed technology that can benefit from parent SAP AG’s application programming interfaces, can be leveraged by SAP’s technology partners, or that SAP can resell.

“One of the first things we look at in a potential investment is how SAP and technology partners can benefit from the company’s technology,” says Andreas Weiskam, managing director for SAP Ventures. “Sometimes we also invest in a company for product-integration opportunities.”

SAP Ventures, which manages a $350 million fund supplied primarily by its parent company, typically makes an initial investment of $5 million to $12 million in a company, and more over the life of the investment as required. The firm usually makes eight to 10 investments a year. Through October, however, it had completed just four deals.

“Some of the company valuations we are seeing have given us reason for pause,” says Weiskam.

Among the deep-pocketed corporations that have moved into venture capital is Google Inc. Earlier this year Google Ventures invested in Austin, Texas-based WhiteShark Media, an operator of online marketplaces for coupons and deals. With Google looking to add more value to its digital wallet through loyalty and couponing programs, WhiteShark represents an intriguing fit.

EMC Corp. launched EMC Ventures in 2011 to invest in startups with promising technology. That year, the company was part of an investment syndicate that infused $20 million in Aria Systems, a cloud-based billing company. Previously, EMC, whose RSA division is a leader in security technology, only invested in companies with technology that complemented its core solutions.

Although venture-capital investing is a good way for corporations to acquire access to technology they might not have otherwise developed in-house, a healthy return on investment remains the venture affiliate’s primary purpose.

“We will invest in promising companies that are not necessarily an automatic fit with SAP or its partners,” says Weiskam. “Our goal is always to look for growth opportunities for our investors.”