Whither the Herd?

In the world of venture capital, unicorns  are so-called because of their lofty— and rarely seen—valuations. But such companies are growing more numerous in the tech field. Payments is no exception.

In the world of venture capital and private equity, where quite a few payments startups operate, it’s astonishing how fast the term “unicorn” has caught on. In fact, the word, as applied to privately held startups valued at $1 billion or more, is barely more than two years old.

Yet such companies aren’t so rare any more. In those two years, the population of unicorns has ballooned from 39 to 150, as of mid-January. We have to add that qualifier because the number is dynamic, changing almost daily with each new funding round.

Payments startups are a key part of the trend toward rising valuations. There are either seven or nine of them among the unicorns, depending on how you define a payments company. And that’s down from eight or 10 a few months ago, when Square Inc. went public and strayed from the herd.

With so many of these creatures galloping about, does the term “unicorn” still mean anything? More to the point, do these lofty valuations, applying as they do to private firms funded mostly by a small coterie of investors, really make sense?

‘Smoke And Mirrors’

Even some of the unicorns shake their heads. Dan Wagner, founder of Powa Technologies, a London-based e-commerce and mobile point-of-sale vendor, says the term never made sense.

“I don’t like the term ‘unicorn,’” he says. “Unicorns don’t exist. We very much exist. I don’t want to be part of that club. I don’t want to be a unicorn. I just want to deliver a product.”

Wagner has delivered well enough for his investors to value Powa at $2.7 billion at the company’s latest funding round, an $80 million Series C, led by Wellington Management, in November 2014.

But over the past few months a sense of doubt has crept into the payments industry about unicorn valuations, a sense that perhaps at least some of these private share prices aren’t quite real. Some payments unicorns themselves are skeptical.

“A lot of these companies are going to have to show they’re worth their inflated valuations,” says Brian Billingsley, chief executive at Columbus, Ohio-based Klarna North America, the U.S. unit of Sweden’s Klarna, an e-commerce payments processor. “When you see some of those numbers, you wonder how they can be sustained.”

Wagner, too, has his doubts. “Some of these valuations are phantom,” he says. A company “is only worth $1 billion if someone pays $1 billion for it,” he adds in an effort to dispel the “smoke and mirrors” he sees surrounding payments unicorns.

To be sure, no unicorn in the payments business sees its own valuation this way, particularly companies that, despite their brief history, have been turning a profit. Take Adyen, pegged at $2.3 billion, whose last disclosed round, led by General Atlantic, brought in $250 million in December 2014 (funding from a subsequent round, in September, was not disclosed).

This is a 9-year-old e-commerce payments provider based in Amsterdam that now has a sizable business processing in the U.S. for clients like Facebook and Uber. Last year, it doubled its payments volume, to $50 billion, and more than doubled its revenue, to $350 million.

“We have a sustained track record of profitability,” says Kamran Zaki, a former PayPal manager who is president of Adyen’s North American operation, based in San Francisco. “We feel our valuation is in line with our performance.”

Funding Slowdown

Nobody can predict how many payments unicorns will be romping in the wild a year from now. There may well be more, and more headroom for private valuations in general. But experts contacted by Digital Transactions say a number of factors are conspiring to take some of the air out of private valuations.

U.S. interest rates are headed up. The Federal Reserve may be acting cautiously, but it is clearly moving to push rates out of what is effectively negative territory. That could put a squeeze on available venture capital as returns improve in money markets, just as low rates helped fuel venture funding. “Negative interest rates create equity inflation,” notes Eric Grover, whose Minden, Nev.-based consultancy, Intrepid Ventures, advises payments firms.

Also, the money taps are tightening for venture funding. It may not have shown up yet for payments startups, which enjoyed a record funding year in 2015, but the flow of money overall already slowed down dramatically in the fourth quarter.

After climbing steadily throughout the year, global venture funding dropped to $27.2 billion on 1,742 deals, according to CB Insights. That’s lower than the same quarter in 2014 and well below the frenetic pace in the third quarter, which saw 2,008 deals worth $38.7 billion.

A cooling off in so-called mega-rounds meant the number of newly minted unicorns dropped to a dozen, half the number in the third quarter and the lowest number for more than a year.

Right now, CB Insights doesn’t see any slowing of momentum in payments funding, but “it’s still early and difficult to say,” cautions Marcelo Ballve, research director at the firm.

‘People Were Disappointed’

Payments companies tempted to tap the public markets have seen a cautionary tale in the experience of Square. The San Francisco mobile-POS company listed on the New York Stock Exchange in November hoping to fetch a per-share price in the $11-to-$13 range. Instead, it ended up at $9 and saw its private valuation of $6 billion melt to $4.7 billion. By mid-January, Square had dipped to a market cap of $3.32 billion.

According to PitchBook, a Seattle-based platform for private-equity data analysis, 72 venture-backed companies went public last year, raising $8 billion. In 2014, there were 123 such deals good for $11 billion.

The Square example has cast a pall on a whole herd of unicorns. “I don’t think in the current market people are expecting bang-up results from IPOs,” says Steve Mott, principal at payments consultancy BetterBuyDesign, Stamford, Conn.

To be sure, the example of Square’s IPO could be unique, an experience not translatable to other payments startups. Even among these companies, Square has enjoyed an almost mystical reputation for “disruptive” capability, with its iconic card readers for smart phones and its ventures into other businesses like peer-to-peer payments and business lending, and even an ill-fated venture into mobile wallets.

Some startup founders, indeed, argue Square may have gotten by with that reputation far too long, “The private investors probably gave [Square] the cool, hip, roadmap-of-the-future-for-acquiring pass, and the public guys are just measuring them against revenues they make today,” notes Doug Yeager, founder of SimplyTapp, the Austin, Texas-based developer of software for host card emulation, a method by which mobile wallets can bypass the SIM card in the phone.

In other words, the disclosures necessary for a public offering rubbed off some of the magic. “When Square went to the [public] market, they opened the kimono,” says Grover. “You couldn’t say they were anything more than a merchant acquirer. People were disappointed.”

To Grover, at least, the Square experience may well hold lessons for other unicorns in payments, whether they try an IPO or seek more venture funding. “There’s a lot of capital wanting to go to work in payments, but how many of these companies are game changers? Most are not game changers,” he says.

‘The Intractable POS’

With Square and many current unicorns, much of the excitement they arouse has to do with how they propose to reinvent the point of sale. This place where the merchant meets the customer and takes his payment has not changed in any fundamental way for decades.

Many unicorns promise to recast that experience with everything from so-called omnichannel solutions to mobile wallets to Bitcoin. Some look to transform the POS by pushing payment so far into the background it is no longer part of the process, much as Uber does with its car-hailing app.

But that transformation is proving a lot harder than anyone figured, and this too is likely to try investors’ patience. Even the introduction of EMV chip cards, a 20-year-old technology, has been a long and troublesome process. “The gatekeeper for the payments business has been the intractable POS,” notes Mott. “Most [investors] didn’t understand how intractable the payments business is.”

He predicts many startups, the “cream of the crop,” as he calls them, will wind up being acquired rather than go public. “It’ll be more corporate exits,” he says.

To be fair, highly valued startups have been careful to nurture certain advantages that are attractive to rational investors. These advantages include hard-to-replicate technology and high switching costs, the costs clients must assume if they go elsewhere, says Hans Morris, managing partner at NYCA Partners, a New York City-based investment house that has money in 10 payments startups.

But Morris cautions that investors also like to see high transaction margins, and that’s hard to maintain as startups grow and start to sign up larger clients that have the heft to drive down pricing.

That, too, can hurt valuations over time. “What investors are betting on is that margins will start improving because you’ve made a lot of fixed-cost investments and you have very high unit transaction profitability—transaction-by-transaction profitability. The reason values go down is because that doesn’t happen,” says Morris.

Aside from all these challenges, observers simply question current valuations because of the way funding rounds are sometimes structured to favor certain investors. Some deals, for instance, guarantee these investors a particular return or that they’ll be first in line to get their money back, or in the case of an IPO they’ll get extra shares if the company’s valuation drops, as it did with Square.

Such special privileges can distort the startup’s real valuation. “Sometimes these things are a bit opaque,” says Powa’s Wagner.

‘Payments Has Gotten Sexy’

Still, all these challenges, from rising interest rates to the “intractable” point of sale to privileged funding deals, don’t faze most of the payments unicorns. It’s hard to say whether more startups will achieve such valuations any time soon, but you won’t find much pessimism among payments executives about their firms’ own current valuations. And others see plenty to be optimistic about.

“We’ve barely scratched the surface in implementing [payments] solutions. There’s an incredible amount of runway,” says Anil Aggarwal, who watches payments innovation as head of the massive Money20/20 trade show for financial-technology folks. “It makes sense to me that valuations are where they are.”

Or, as Klarna’s Billingsley sums things up: “Payments has gotten sexy.”