Following up on the discussion about why Stripe and Square are so interesting as companies to watch, there’s the inevitable question about what’s actually going on behind the scenes with their business model and what happened between the days of PayPal and today to create such a large ecosystem of competition.
Payment Facilitator or PSP Model
Square and PayPal act as a master merchant for all of the smaller merchants that they board. This model of a single merchant aggregating a lot of small merchants used to be called the Internet Payment Service Provider model (IPSP) back when PayPal started. It’s now either called the Payment Facilitator model (MasterCard) or the Payment Service Provider – PSP model (Visa/Discover).
2011 – The Year that Created New Opportunity
IPSP was created more than two decades ago by the credit card schemes (Visa/MasterCard) mainly to enable small internet companies to accept payments online in a cost effective way. In 2011, Visa and MasterCard, as publicly traded companies looking to expand their shares of the pie, opened up this master merchant model to physical sales, in addition to eCommerce sales. That’s when companies like Square had a real way to enable small merchants to take payment in person via their phone or tablet. Look at some of the companies listed on the MasterCard Payment Facilitator website, and there are quite a few that started pretty recently.
Why This Model Works Well
Aggregating a lot of merchants under a single account can allow companies like Square to reduce the on-boarding costs and remove some of the complex aspects of card acquiring (at least to the small merchant). If they can do all of this while providing merchants a simple cost structure and easy to use reporting tool, then all of a sudden merchants are excited to start accepting credit cards. Merchants pay when they make money and rates are not outrageous. In addition, customers love the experience, and merchants get a user friendly tool from acceptance to reporting.
So great, Visa and MasterCard makes a change in 2011 to allow in-person payments, and Square wakes up some sleeping giants in the payments space to realize that there was a need among small merchants. What?!? Has anything inherently changed since the times of IPSP? Why is there so much interest in this space?
The Pitfalls of the Model – Cost
In the end, many of the people (myself included) who have a Square or PayPal dongle are not using it (often or at all). And people using these mobile POS devices for a few transactions a year or even a week are generally not worth the overhead cost. At the end of 2012, VeriFone dropped out of the mobile POS race after less than a year saying that it wasn’t worth the “razor thin margins” on small merchants who were barely using the service. Many of the start-ups in this space have, up to this point, been acquiring new customers in the name of growth and not necessarily with high profit margins in mind. As they see growth slow, these start-ups are now itching to start working with some of the larger merchants that traditional payment service providers have worked with. It’s important to note that the Payment Facilitator model only works for merchants processing under $100k USD a year, so moving to larger merchants means moving away from this current model to one where you have to get a separate merchant ID to process with a bank. As you can tell, PSP is not exactly the world’s best profit making scheme.
The Pitfalls of the Model – Risk
During the IPSP days, there were a number of players whose sub-merchants were taking payment for illegal, illicit or non-existent products and services. This resulted in the breaking of scheme rules and/or excessive chargebacks from customers. Today, the same risk applies for companies like Square and Stripe, but there are much better ways to monitor activity and flag anything that may appear suspicious. In addition, with the scale and growth of some of these start-ups, the aggregated risk in the portfolio is lowered across all of the merchants. This tends to keep all of the parties (banks, card schemes and PSP) sleep a little better at night. In the end, the card schemes are not going to come after Square just because a tiny tiny percentage of merchants is selling something illegal, and Square for their part will do a really good job of monitoring activity to shut down bad merchants quickly and staying within comfortable chargeback levels.
The current interest in these master merchant models is high because, first of all, there’s a lot of money and hype being pumped into some of the more successful start-ups. Second, technology is reducing costs and improving monitoring to allow companies to offer this model in a profitable way with a balanced risk portfolio. And third, as collaborative business models like those of Airbnb, Lyft and TaskRabbit, which require these types of payment offerings, grow and become more prevalent, there will be greater interest in servicing them and feeding off of their own hype and growth trajectories. Many things have obviously come together at the right time, but it is exciting to see how things evolve and how the various players in the payments space will work to provide relevant offerings that make profit in the long run.