Cover Story: Is it Still Hip to Be Square?

Is it Still Hip to Be Square?

The answer, after five eventful years, is yes. But it needs to find a consumer strategy, and right now there’s no app for that.

Nobody in the staid world of the payments business had ever seen anything like it before.

Dozens of buttoned-down bankers rushed the stage where the two young founders of a small tech startup had just finished speaking. Cameras and smart phones flashed as small contingents from the crowd eagerly clapped arms around the two bemused techies, then gingerly stepped away so other groups waiting their turn could step in.

Just moments before, a woman in the audience had evoked peals of laughter when she told one of the entrepreneurs that her fresh-faced Twitter-using relatives had erected “a shrine” for him.

The scene was one of the biggest payments conferences in the country. The time was April 2010. And Jack Dorsey and Jim McKelvey must have wondered what sort of lightning they’d just caught in their Square bottle.

Their little startup, Square Inc., is five years old now, and on many meaures it is a rollicking success. It has pushed out about 5 million of its mobile card readers, its original product, far more than any other vendor. According to various estimates, head count has ballooned to nearly 900 and annual processing volume to almost $30 billion, not counting traffic from Starbucks Corp. stores.

From its San Francisco headquarters, it has entered Canada and Japan and unleashed a raft of other products: Square Register, for merchants that want more sophisticated reporting; Square Stand, for somewhat bigger merchants that want a countertop point-of-sale system; Square Wallet and then Square Order, for the consumer market; Square Market, for merchants that sell online; Square Cash, for a piece of the person-to-person payment business; and, just recently, Square Credit, to stake a claim in the burgeoning merchant cash-advance market.

Still privately held, Square keeps its numbers close to the vest. Even so, from a standing start in the spring of 2010, when those first readers went on the market, Square is thought by many observers to be perhaps the most successful startup the payments business has ever seen.

Certainly, it has been the most prolific money-raiser among venture-backed payments startups since its founding.

“They’re definitely a formidable company,” concedes Mitch Cobrin, chief executive of AnywhereCommerce, a Montreal-based rival whose clients include Bank of America Corp.’s merchant-acquiring unit. “I have a lot of respect for their achievements to date.”

But while that rock-star glitter still attaches to the company and its founders, Square faces a very different market and very much more complex challenges. Indeed, the steps it takes now could either propel the company onto a Google-like trajectory or sink it into the ranks of other once-celebrated mediocrities.

It’s a company known for Apple-like devotion to design, to streamlining payments so ruthlessly that they become simple for even unpracticed merchants. “Square has done a fabulous job of making it easy to accept a credit card,” says another competitor, Jason Richelson, a former wine merchant who started ShopKeep POS when he lost sales because of problems with a processor.

That focus on design and function shows up in the popularity of its applications. Square ranks fourth in the U.S. among all financial-service app providers, with 2.15 million unique visitors monthly.

Moving Upstream

And yet forces both within and beyond Square’s control could overwhelm it. “I don’t see anyone associated with it still doing what they’re doing in five years,” says Eric Grover, who follows merchant acquring and transaction processing as principal of Intrepid Ventures, Minden, Nev. “I don’t see an exit that makes the guys associated with it very happy, even five years out.”

For starters, the business Square didn’t invent but did more than any other company to commercialize is more competitive than ever. Mobile point of sale—card acceptance on a mobile device—has migrated from smart phones to tablet computers, and from flea markets and plumbers to single-store retailers and even small chains.

That’s called moving “upstream,” and the shift can be seen in the changing composition of Square’s processing volume. Only two years ago, about a quarter of Square’s transactions came from iPads, according to numbers Square releases. The balance originated on a mobile phone. Now, iPads account for 60% of transactions.

At the same time, 40% of dollar volume now flows from businesses doing more than $100,000 a year in processed transactions. That’s pulling Square out of micro-merchant territory.

Upstream merchants are a mixed story for transaction processors. They keep systems humming, which drives more transactions across a fixed-cost base. Not surprisingly, Square this year began offering what it calls custom pricing to merchants that process at least $250,000 a year. “We have thousands of businesses on custom pricing in only a few months,” says a Square spokesperson. “Attracting large merchants to Square is good for business.”

But they also constitute a much more demanding, and ultimately more price-sensitive, market. And probably dozens of companies, ranging from other tech startups to independent sales organizations to big corporations like NCR Corp., are now serving it.

Meanwhile, Square’s efforts to launch consumer products have met with mixed results. Its big gun in this market was Square Wallet, a technically sophisticated product launched in 2011 and canned this spring after lackluster adoption. Its replacment is Square Order, which lets you store payment cards to pay in advance for orders at cafes and coffee shops.

Square Cash, which allows consumers who have a debit card and an email address to email money to anyone else who also has those things, may or may not prove successful. It’s too new to say.

But while Square Cash lets Square hoover up consumer email addresses for other uses, it’s also racking up transaction costs Square isn’t recovering, since the service is free to keep it competitive with services from banks and non-bank processors.

‘Great Smoking Crater’

Then there’s that Starbucks deal. Two years ago, chief executive Dorsey celebrated with Starbucks chief executive Howard Schultz after the two agreed on a landmark contract calling for Square to process all card transactions at the coffee chain’s 7,000 stores and for Starbucks to invest $25 million in Square.

For Square, it looked like the coup of a lifetime. Not only did the deal give it entrée into an enormous pool of day-to-day transactions, it conferred instant credibility on the company among big merchants. That’s crucial if Square is to keep moving upstream.

That wasn’t all. The deal also included what was then called Pay with Square, one of a series of names Square gave Square Wallet before finally settling on Square Wallet. With Starbucks accepting Wallet, the consumer side of the business looked set for an explosive takeoff.

But since then the champagne has gone flat. Starbucks has its own mobile app, based on a digital version of its proprietary prepaid card. Not surprisingly, that’s the product it promotes—so much so that U.S. baristas are now taking it for more than 15% of all transactions in company-owned stores.

At the same time, Square couldn’t very well charge Starbucks its standard 2.75% rate for processing. Neither party will say what the fee is, but it’s reportedly a touch over 2%. It’s hard to make money in that region. Square lost more than $20 millon on Starbucks traffic just last year, according to sources close to the matter cited in an April story appearing in The Wall Street Journal.

This one-two punch led Bryan Derman, a senior analyst at Menlo Park, Calif.-based consultancy Glenbrook Partners, to post a blog entry in May calling the tie-up with Starbucks “one of the great smoking craters in the annals of payments.”

But not for Starbucks. “I think Starbucks played it brilliantly, Square, not so much,” says Matthew Witheiler, a Boston-based general partner at Flybridge Capital Partners who follows payments companies. “It provided credibility for Square, which they needed. It provided transactions for Square. But what it didn’t do is get consumers aware of Square because Starbucks tightly controls the app and the experience.” Starbucks refused to comment for this story.

Two Strategies

What does it all add up to? Financially speaking, a $5.2 billion valuation, built partly on Dorsey’s glamor as a cofounder of Twitter, partly on Silicon Valley mojo, partly on performance to date, and partly on a private share offering placed earlier this year by Square insiders.

That’s a ton of money for a payments processor, and hardnosed observers aren’t buying it. “It’s a nosebleed valuation,” says Grover of Intrepid Ventures. “It’s what you’d put on somebody who has an anti-Alzheimer’s drug.”

Grover points out that Vantiv Inc. earlier this year assumed debt to pay what seemed like a whopping $1.65 billion for Durango, Colo.-based Mercury Payments Systems LLC, a heavily tech-oriented processor doing about $34 billion annually in volume, a bit more than Square.

That doesn’t mean Square can’t pull more rabbits out if its highly innovative hat. Or, as Flybridge Capital’s Witheiler says, “don’t underestmate the power of Dorsey.”

But that huge valuation could be more an albatross than a blessing. A hoped-for initial public offering didn’t come off earlier this year, and the company won’t comment on its current IPO plans. Meanwhile, it denies it’s talking to possible suitors, despite reports this spring that Google Inc. was sniffing around. (Square would not make operating executives available for this story).

Observers say two strategies Square is already pursuing could combine to help realize at least a good chunk of that value. The key, as always, will be execution. One is the movement toward larger merchants. The other is the effort to recruit consumers—by the millions.

Put merchants and consumers together in numbers that exceed a tipping point, and you might crack a maddening problem that has plagued payments systems for as long as anyone can remember: finding enough consumers to make it worthwhile for merchants to accept, and enough merchants to get consumers to use.

Visa and MasterCard solved it—sort of—by creating powerful national brands and letting the banks sort out the business of signing up merchants and cardholders. American Express Co. and Discover Financial Services, which directly issue cards and sign merchants, have taken decades to create these networks.

Why bigger merchants? Because it’s a hard slog making money on tradesmen, farmers’ markets, and hot-dog stands, no matter how many you sign up. Yes, they’re willing to pay high fees just for the ability to accept cards on a smart phone. But their transaction traffic is erratic, now spiking, now plummeting to nothing. And they’re needy customers, driving up service costs and tying up resources.

The spell Square casts is such that people forget the business of providing card processing on a cell phone dates back at least to 1990. There’s a reason these predecessors aren’t around any more.

Nobody outside Square’s tight-knit inner circle knows its financials. The closest peek anyone got came through the April Wall Street Journal article that cited sources who pegged its losses at $100 million in 2013 on a fully weighted basis, up from its 2012 shortfall. Gross margins—what’s left after paying direct transaction costs and absorbing fraud—fell to 21% from 27%, the article said. “Gross profit from our payments business alone more than covers our fixed costs,” says the Square spokesperson.

‘I’d Have to Re-Evaluate’

One way to get bigger merchants is to grow your own. This is where new products like Square Capital come in. It’s the old cash-advance model—sold many times over by thousands of ISOs—with a twist: you have to be invited by Square to apply. If you accept, you can finance more equipment or meet other needs and pay Square back with a percentage of your card proceeds.

Follicle Hair Salon in San Francisco, which runs Square Register on two iPads, has used two advances totaling almost $30,000 in the past nine months to add 27 chairs after moving into larger space. With Square holding back 10% of sales, Follicle has paid back the first loan and is down to $3,300 on the second.

“I’ll do it a third time if we have a second level [of the building] to expand to,” says owner Giacomo Ghianni. “I doubt I would have had luck with the banks.”

Using a loan—or even a series of loans—this way can turn little merchants into bigger ones. And it tends to lock them in to Square, awkward as it would be to switch processors when you need Square-processed card volume to repay Square.

Certainly, the pool of prospects seems more than willing to adopt mobile acceptance, whether on a phone or a tablet. Some 52% of small U.S. merchants are now flowing anywhere from three-quarters to 100% of their card volume through app-based terminals.

A certain percentage of Square merchants will remain content to be occasional or seasonal sellers. But a good many, with or without Square’s help, will grow, and as they do they may not remain content to pay Square’s rates. There’s plenty of competition nowadays, after all.

This could prove especially true of Square Order, the new app that lets customers order a product and pay in advance using a card they’ve already loaded in the wallet. When they arrive at the coffee shop, for example, their drinks and sandwiches are waiting for them. They can zip in and zip out.

That’s pretty nifty, but as of July 1 Square Order transactions cost merchants an eye-bulging 8%. Merchants say competing services are just as expensive or more so, but that doesn’t mean they’ll always be happy paying up.

Coffee emporium River City Roasters in Wheaton, Ill., for example, is an enthusiastic early adopter of Square Order. Erich Goepel, co-owner, says he hopes the service will help him compete with a Starbucks store across the street. The app is so new that Goepel is getting only a few orders, so the fee doesn’t faze him.

But, he adds, orders may “potentially” pile up, “at which point I’d have to re-evaluate” either the service or the fee. For now, though, he’s also using Square Market to sell online and has a Square Stand on order for his store.

Or take Souvla, a Greek restaurant not far from Square’s headquarters that’s serving as a literal test kitchen for services “not yet available to the pubilic,” says owner Charles Bililies. “We were feeding dozens of Square employees every day who were coming down to test everthing.”

Naturally, the beta products are top secret. But Bililies can talk about Order, which he likes a lot. “It takes five seconds to verify and send an order to the kitchen. We can do two to three times the amount of business using that app compared to conventional business,” he says.

But Souvla, of course, plans to grow and add locations. As it does, Bililies says, “I’m hoping [price concessions] will be part of the conversation” with Square.

Leveraging Merchants

Nothing unusual in this. Even conventional ISOs come under pressure from merchants about pricing as they add volume. But while Square may be an ISO of sorts (it’s technically a merchant aggregator; see sidebar at end of story), it is no conventional ISO. Heavy-hitter investors have poured far more money into Square than into any other payments startup that has emerged over the past five years.

Keeping them happy, experts say, requires finding ways to make money off that massive merchant base other than through transaction fees. That’s where the consumer side of the business comes in handy—if Square can find a way to monetize it. “The business will not be built off interchange, period,” says Witheiler. “There has to be another part of the story.”

That second part of the story, leveraging the merchant base, is what Witheiler calls “part two,” and it’s been a stumbling block for a bunch of startups. “Nobody has figured that out,” he says.

Rick Oglesby, who follows acquiring and mobile payments as a senior analyst at consultancy Double Diamond Group, Centennial, Colo., says the Starbucks deal at first looked like the ideal platform on which to launch Square Wallet, and hence Square’s consumer business. But Square had its hands full just keeping up with the tidal wave of Starbucks traffic, and the consumer push for Wallet fell by the wayside, he says.

The Starbucks connection “was about building a brand for Square and enrolling customers in Square consumer services,” Oglesby says. “It was about providing a launching pad for a whole bunch of services. But it turned out to be a processing deal.”

That doesn’t mean it wasn’t the right strategy, though. And Square may well try again. Says Oglesby: “I’m sure Square learned a lot.”

In one way, Square is already taking another tack. Last October, it launched Square Cash, which lets people pay other people via email. Both the sender of money and the recipient must have a debit card. Square processes transactions as if it were a merchant handling ordinary debit card payments in its store, so senders’ bank accounts are debited and receipients’ accounts credited via a reversal.

It’s pretty slick, but Square is absorbing debit interchange with no offsetting revenue, since the service, for now at least, is free. Why? Well, for one thing, free attracts more consumers. And the more consumers sign up, the more email addresses and debit card numbers Square takes in, which can prove useful for promoting other services.

“They could use that Square Cash enrollment for Square Order,” suggests Oglesby. As a side benefit, by getting people to use debit cards instead of credit cards in other apps, Square can also lower its transaction costs.

‘We Want Them To Love It’

Square started out in 2009 after McKelvey, a glassblower, lost an order because he had no way to accept a credit card, so the story goes. The company has moved well beyond that original vision, which linked card acceptance to the emerging smart phone. But through all the new apps, the move into the consumer market, and all the funding rounds, it has clung stubbornly to one key insight: Payments badly need a radical overhaul.

“It’s a form of communication, and it’s never really been designed in a human way,” Dorsey told that banking audience back in 2010. “It’s something that many people just have to deal with; they don’t love it. We want them to love it.”

 

Square Through the Years

2009

February: Company founded

December: Unveils Square app for mobile merchant acceptance

2010

May: The app becomes available commercially for the just-introduced Apple iPad tablet, with iPhone following later

June: Encounters temporary shortage of readers from Chinese supplier, shores up underwriting to counter emerging credit-risk issues with merchant test group

2011

April: Visa Inc. invests an undisclosed sum

May: Launches Card Case, the original name for Square Wallet

October: Announces it has 800,000 merchants using its dongle

November: Introduces first loyalty feature with ability for users to detect merchants extending “first-time” offers

2012

June: Introduces digital punch cards allowing merchants to set rewards according to number of visits or amount spent

August: Announces acquiring and acceptance deal with Starbucks. Merchant count reaches 2 million

Also announces flat $275 monthly processing fee

October: Expands into Canada

December: Introduces digital gift card support for merchants, later discontinued

2013

March: Receives cease-and-desist letter from state of Illinois for not having a money-transmitter license

May: Expands into Japan

June: Introduces Square Market, kills digital gift card service

July: Bans firearms merchants

October: Launches Square Cash, a person-to-person payment service

November: Rolls out Quickbooks integration through deal with Intuit Inc.

Eliminates deposit holds and limits for merchants.

Drops flat $275 monthly pricing plan

December: Introduces 4th generation of iconic card reader. In contrast to its predecessor, the new dongle is 45% thinner and lacks a built-in battery, drawing on power from the mobile device.

2014

February: Seven Whole Foods stores start accepting Square at locations in the store other than the front checkout lanes

March: Square Market starts accepting Bitcoin as overall Square user count exceeds 5 million

May: Launches Square Capital, its own version of the merchant cash advance with a twist—you can’t apply for an advance. Square determines who’s eligible and sends an invitation

Launches Square Feedback, allowing customers to give comments to merchants on Square-generated digital receipts.

Discontinues Square Wallet and replaces it with Square Order

Annual processing volume reaches $30 billion (not counting Starbucks); head count approaches 900

July: Announces it will introduce early in 2015 an EMV-capable card reader

 

Visa’s Dicey New Rules for Aggregators Like Square

Merchant aggregators like Square Inc. could absorb a powerful hit when a revised set of network fees from Visa Inc. take effect April 1, 2015. Depending on the size and number of aggregators’ sponsored merchants, the revisions could significantly boost actual fee payments as well as drive up programming and administrative costs.

The revisions, which are related to the network’s 2-year-old fixed acquirer network fee (FANF) regime, reduce costs for most small merchants but effectively eliminate what has been a $40,000 monthly cap on FANF fees for aggregators.

With that cap no longer in place, major aggregators like Square and PayPal Inc. will no longer enjoy an upper bound on their FANF liability.

Acquirers pay the FANF fees to Visa and then choose whether to pass them on, in whole or in part, to their merchants. Aggregators typically absorb the fees, building them into the rates they charge their sponsored merchants.

Sometimes called payment-service providers, aggregators sign up merchants on their own merchant account rather than setting one up for each seller. The method allows small merchants to begin accepting cards sooner than if they had to undergo standard underwriting.

Under the new FANF regulations, merchant aggregators will be required to track and report sponsored merchants individually by their tax ID numbers, rather than treat their volume in the aggregate. (Also, with these changes, Visa has designated aggregators as payment facilitators rather than payment-service providers.)

At the same time, aggregators will no longer be part of a separate table of fees that also applies to card-not-present merchants and fast-food restaurants and that caps the monthly FANF toll at $40,000. The cap occurs when monthly volume reaches $400 million, a lofty level not likely to be reached except by very large aggregators. The revised fee table covers card-not-present merchants, fast-food outlets, and unattended terminals.

That means aggregators will have to sum up the fees called for by the FANF schedule that applies to each of their merchants and then pay the total. In addition to the card-not-present/fast food/unattended terminal schedule, two other FANF tables cover physical merchants, one for so-called high-volume stores and one for all others.

The impact on super aggregators like PayPal and Square is hard to predict precisely, since neither company releases details on its merchant makeup. But observers figure the loss of the cap is likely to mean they will face a monthly FANF toll significantly greater than $40,000, given the volume levels they process.

But the new FANF rates also include a break for small merchants, and that could work in aggregators’ favor, since they typically process for micro-merchants and slightly larger sellers. Merchants with less than $200 in monthly volume will be subject to no fee, regardless of which table they fall into (though their tax IDs will still have to be reported to Visa individually).

Those with $200 up to a penny under $1,250 in monthly volume will pay 15 basis points (0.15%), again regardless of schedule. That results in a fee of 30 cents up to $1.87, compared to the $2 minimum fee under the existing FANF tables.

Still, an aggregator serving thousands of very small merchants and having to compute and total the fees for each one could easily exceed $40,000 in monthly fees. For example, 25,000 merchants each incurring the $1.87 levy would total to $46,750.

Visa introduced FANF in April 2012 to provide incentives for processors to send more volume across its network as the Dodd-Frank Act’s Durbin Amendment handed new routing flexibility to merchants.

 

Square Prepares for EMV

Square Inc. this summer ended months of speculation with an announcement that it will start taking orders later this year for an EMV smart card reader, which will process chip-and-signature as well as magnetic-stripe transactions. The move comes just 14 months ahead of a key U.S. EMV deadline.

Square did not release pricing information for the reader, but it is widely expected to be significantly pricier than the existing mag-stripe dongle Square has offered, through several generations, for the past four years.

The existing reader sells for $10 in retail stores but can be ordered for free directly from Square. The technology necessary to interact with EMV chips will drive up the cost of the EMV reader and make it unlikely Square will offer it free, experts contend, though in a blog post Square says the new reader will be “incredibly affordable.”

“We will release pricing details for the Square Reader for chip cards soon,” a Square spokesperson said in an email message late in July.

Square is also working on incorporating EMV capability into its Square Stand product, according to the blog post. Square Stand holds a point-of-sale tablet for countertop merchants and has a built-in card swipe.

EMV stands for the Europay-MasterCard-Visa standard for chip cards. The United States is the last of the developed nations to adopt the standard, which will be required of all U.S. issuers and merchants by October 2015 to avoid liability for counterfeit card fraud, according to rules from Visa Inc. and MasterCard Inc.

That timetable has led many observers to question how Square intended to deal with EMV, given that it has distributed approximately 5 million of its famous mag-stripe dongles to U.S. merchants. The company has also entered both the Canadian and Japanese markets, which have adopted the EMV standard.

Now that it has announced an EMV device, Square is playing catch-up. A number of competitors, including AnywhereCommerce, MagTek Inc., and PayPal Inc. already offer EMV-capable dongles for mobile acceptance. Indeed, these days such technology is “table stakes” for such companies, notes Eric Grover, principal at Minden, Nev.-based payments consultancy Intrepid Ventures.

While Square may be late to the EMV game, Grover says that’s understandable. “Square primarily serves small and casual merchants, most of whom are unaware of EMV and reluctant to pay for extras unless there’s something tangible in it for them,” he says via email.

Like the existing Square reader, the new EMV reader will attach to smart phones or tablets through the mobile device’s audio jack. Users will run transactions, however, not by swiping cards but by dipping them lengthwise into the reader’s slot so the reader can interact with the chip on the card. The card will also need to be left in place in the reader for the duration of the transaction.