PayPal 100 years old – surely not?

Well no. PayPal’s not 100 years old. In a remarkably understated way though, which no-one noticed – not even PayPal – the California-based payments platform is celebrating a milestone.

In March 2007, PayPal celebrated being 100 months old.

Yes, the upstart firm with only 133 million users and more merchants than Visa, MasterCard and American Express combined, is just 100 months old.

It is a pure child.

Younger than MacAuley Caulkin in Home Alone, and just a bit older than Drew Barrymore when she starred in E.T., PayPal is striking way above its weight … striking fear in some bankers’ hearts and hope in the social revolution of the Internet age.

But what is PayPal really all about, why does it work the way it does and where is it going in the future?

I was lucky enough to find out by visiting PayPal’s UK Headquarters to get an update on PayPal Mobile, PayPal Europe and PayPal worldwide, so here’s the low-down.

PayPal’s roots

PayPal launched into the bright lights of the Internet age in December 1998, 100 months ago. If you google PayPal’s history, many articles write that the firm started in December 1999 or other dates. Don’t believe them as the firm itself dates its founding from 1998, although the discussion of the dates is whether you take PayPal from its current form or original form as we shall see.

Now 8 1/3rd years old, PayPal is like a young gorilla pounding around and showing it’s the dominant alpha male of the Internet jungle. The fact is though that back in December 1998, PayPal was nowhere near as cocky as it is today, and it’s not even that cocky now. In 1998, PayPal emerged at a time when there were many other contenders for the online payments crown, including eBay’s very own payment service, Billpoint. So when we look at PayPal’s winning formula, we need to really understand its roots which go back to two founding firms – Confinity and X.com– which came together in the late 1990’s to form PayPal.

Confinity is often viewed as the real roots of PayPal, as X.com acquired and merged with Confinity, who owned PayPal, in March 2000. In fact, it was not until PayPal and X.com came together that the company really started to rock and roll so I reckon the founders were the two creators of Confinity, Peter Thiel and Max Levchin, and the force behind X.com, Elon Musk. These three youngsters, now in their thirties, were the creators of the world’s most widely accepted retail payments system.

Now there are varying accounts of what actually happened during the creation process. One of the best known is in a book called 'PayPal Wars', but I don’t think you should read other books to get the low-down, especially as Elon Musk describes this book as being “written by a sycophantic jackass called Eric Jackson”. This description appeared in a 2000 word update by Mr. Musk on what really happened back in those heady days and, bearing in mind that Elon was CEO of PayPal during its most prolific period of growth in 2000, I’m going to go with his view.

Prior to PayPal, Elon had created X.com using the proceeds of his stake in a former business. X.com was one of the first online banking sites offering everything from checking accounts to insurance services, mortgage lending, and bonds. Some of the other founders included investment banker John Story and former Intuit CEO Bill Harris.

To attract new clients, X.com offered $20 to anyone who opened a free online checking account. Members who referred new customers to X.com were awarded $10 for each referral. Within two months, X.com had gained 100,000 customers with the only similar operation, e*trade telebank, running with 130,000 customers.

In March 2000, X.com acquired PayPal which had been in operation since December 1998 and came out of Confinity, which was created by Max Levchin, an online security specialist, and Peter Thiel, a hedge fund manager.

Max Levchin was the real visionary in this partnership, and had been driving an idea of using handheld devices to wirelessly transfer money. In 1998, Max met Peter Thiel with the aim of trying to get financial backing for his idea and Peter helped him gain a $3 million investment from Nokia. They created Field Link and then Confinity, both focused upon developing encryption software for Palm Pilots, and Confinity became PayPal in December 1998.

Back then, PayPal was pretty much rejected by its target users because no-one wanted to use Palm Pilots for their financial services, which is what PayPal offered back then. The original PayPal was basically offering a wireless payments services through the infrared port on a Palm Pilot, and no-one wanted that. Just as, for those with long memories, no-one wanted WAP banking back in the late 1990’s. That’s why PayPal 1.0 tanked.

So what made the difference?

Why PayPal works

PayPal works for three major reasons.

The first reason was timing, as Max Levchin and Peter Thiel saw that there was no way to support person-to-person buying and selling on the Internet during 1998. As a result, they switched their focus from the failed ventures supporting payments using handheld devices to making payments using the Internet.

Back then, less than a decade ago, most internet commerce was still based upon traditional payment systems using cheques and money orders. Even eBay was fuelled by payments made by regular land mail back then.

That is not to say that there were not online payments trials taking place at the time. For example, there was a lot of marketing flurry over firms such as Beenz and Flooz. The trouble was that people did not trust these payment systems because they were new and were flawed because they were not trusted as real currencies.

PayPal had a few vital differences:

• it used the dollar as its medium of exchange, rather than trying to create a new currency for online payments;
• it used email for communications; and
• it used the existing bank networks for making the payment

In fact, although many of us think PayPal displaces banks, it actually enhances banking services as demonstrated by the bank services behind PayPal. For example, PayPal runs through Wells Fargo and JPMorgan’s infrastructures and generates payment transactions through Visa and MasterCard. As a result, the US backers of PayPal from the banking industry are making a mint through the massive volumes of payments that PayPal generates, as are the bank cards and deposit accounts used to provide PayPal payments.

In other words, PayPal is just a layer on top of the bank network, not the bank network itself. This means it is a complement to banking, not a replacement.

The fact that PayPal relied on tried and trusted methods of exchange – the US dollar and the banking networks – meant that it rapidly became accepted and used online.

This is the first critical factor.

The second is the viral nature of PayPal or, as it is sometimes referred to, the network effect.

The network effect is true of telephones, fax machines and computers where each one added to the network has a ‘squaring’ effect, as in it doubles the power of the network.

Think of it as the difference between a one-way transaction and a two-way transaction.

The TV is a one-way transaction – it just receives a signal. Therefore, each additional TV on the network is just another TV on the network. One TV becomes two TV’s becomes three, four, five and so on. Three TV’s switched onto the network are just three TV’s on the network therefore, because all they do is receive.

With the Internet, each user creates a squared effect because the Internet is two-way, not one-way. The Internet can receive, like a TV, but also send. Therefore, three PC’s on the network become nine rather than three, because of this squared effect. In other words, the networked effect enables nine variations of communication between the three devices: PC1 to PC2 and PC3, PC2 to PC1 and PC3, and PC3 to PC1 and PC2. It is not just another dumb device on the network, but an interacting, intelligent point of communication. The next user makes it sixteen possibilities, or 42, because they can now all interact with each other. It’s not just another one-way device.

This squared network effect is the very nature of the age of interacting and socialising online, and is a core reason why PayPal took off as quickly as it did. For example, as you gain each user they become a viral marketer for PayPal. And viral marketing, as we now know, is one of the critical factors firms are trying to exploit on the Internet today but seven years ago, few people had got this message.

But Elon Musk had the message.

Elon Musk of X.com takes the credit for this growth effect as, in March 2000 Confinity was acquired by X.com Corporation. Elon took the PayPal corporate name from Confinity and began aggressively marketing the firm through special promotions, such as offering $10 to new sign-ups for PayPal accounts. This is similar to the approach he had taken with X.com. The result was that PayPal surged from just 12,000 accounts in January 2000 to over 2.7 million by August 2000, and PayPal has fundamentally built this understanding of the networked effect into all of their thinking.

Nevertheless, PayPal was still just a fledgling and there were many other contenders around at the time, apart from Beenz and Flooz, such as eBay’s Billpoint and Amazon’s Accept. Equally, the banking industry had not sat on their hands, as Citibank had launched c2it with AOL and MSN, BankOne had emonyemail, and Western Union had BidPay.

So how did PayPal beat all of these established names?

This was attained through the final success factor, which has been the most critical in building PayPal’s business. It made online payments cheap by minimising the cost of transactions and authentication.

Rather than writing about this in my own words, here is Elon Musk’s view (taken from his article on ValleyWag.com):

“A vital competitive advantage over time was that PayPal had significantly lower transaction fees. In order to achieve the lowest transaction fees for sellers, it is critical to minimize the amount of money that enters PayPal via credit card.” So PayPal encouraged users to leave funds in their account by offering competitive interest rates. “If you don't offer a competitive interest rate, customers quickly transfer their PayPal funds to their bank account. If you do offer a competitive interest rate, you can make at most about 1%/year net. Compare earning 1% over the course of a year vs. making 1% instantly when the transaction occurs. The difference is orders of magnitude.

“The other part of the secret behind PayPal's much lower fee structure was having a low cost way to authenticate a customer's bank account, so that we could pull money into our system for a few cents per transaction, like writing a virtual check … the idea (was to make) two random deposits of less than a dollar into a customer's regular bank account, creating a four digit password that a user could enter into PayPal to authenticate that bank account. We biased the random amounts toward the low end, so it cost us less than 50 cents per authenticated account. As soon as a user authenticated, the system would default to paying by electronic check, which cost PayPal pennies per transaction vs. around 3% for a credit card payment.

“In light of the above, now look at the PayPal fee structure of 1.9% to 2.9% per transaction. The company obviously makes no money on credit cards transactions! Almost all the profit comes from payments funded from customer balances funds or from bank account transactions, which have close to zero cost.”

The result of being based upon banking services and offering the lowest cost per transaction through e-mailed payments established PayPal’s business model. The promotion, marketing and ‘network effect’ then turbo-charged PayPal to become the de factor standard for online payments.

For example, PayPal was one of the first to offer a business account for high volume Internet merchants. Introduced in June 2000, the costs were 30 cents plus 2.9% per transaction, which was much cheaper than doing business through credit cards. As a result, merchants flocked to PayPal too, with over two and half million business accounts opened with PayPal within eighteen months of the launch.

These merchants were also often small business entrepreneurs offering their goods through eBay and so the combination of PayPal being attractive to small businesses and eBay selling became a natural fit.

By October 2001, PayPal was being used to pay for a quarter of all eBay transactions.

No wonder eBay sat up and took notice and swooped on the business after PayPal went public in February 2002.


PayPal Today

The result of all of this history is that PayPal has gone from strength to strength to become the de facto standard for online payments, and today’s PayPal statistics are pretty impressive:

• PayPal’s revenue totaled $417 million in Q4 2006, up 37%, and $1.441 billion for the year.
• PayPal transacted $37.75 billion of ecommerce in 2006, a 37% increase over the $27.5 billion of 2005, which was a 45% hyke over the $18.5 billion volume of 2004.
• That’s about $1,384 being transacted every second.
• PayPal is one of the most phished and targeted sites for hackers and fraudsters, but maintains a low loss rate of less than one half of one percent (0.41%) versus the average online fraud rate of about 1.5% for the top 150 online merchants.
• PayPal in the USA claims 14 million merchant accounts, which is more than the total number of US merchants registered with MasterCard, Visa and American Express combined.
• Total payment volume for PayPal’s Merchant Services business was $3.9 billion in Q4 2006, up 57% year over year, and $11 billion for 2006, up 36% over a year earlier. PayPal payments accounted for $3.9 billion of that volume.
• Over a third of PayPal’s payment volumes are non-eBay payments.
• PayPal has over 133 million registered customer accounts, which is the equivalent of the total number of retail customers for Citibank USA, Bank of America, Wells Fargo, Barclays Bank and Deutsche Bank combined.

The last point is particularly interesting in that, as you look at PayPal outside the USA, the business metrics are rapidly changing. For example, in eBay’s latest Q4 results for 2006 presentation, the figures shoqw PayPal is rapidly ascending overseas but at a decreasing run-rate. However, with a growth rate of new account openings that any bank would die for, they are doing pretty well for an 8 and a 1/3rd year old.

PayPal in Europe

One of the really interesting things is how PayPal has expanded its footprint around the world, and especially in Europe. For example:

• PayPal has offices in fifteen countries outside the U.S. including the UK, Canada, Australia, Austria, Belgium, France, Germany, Italy, Spain, Ireland, the Netherlands, Switzerland and China.
• PayPal has offices in fifteen countries but operates in 103, virtually the whole world in other words.
• PayPal operates seventeen currencies including U.S. Dollars, Canadian Dollars, Australian Dollars, Euros, Pounds Sterling, Japanese Yen, Chinese RMB, Czech Koruna, Danish Krone, Hong Kong Dollar, Hungarian Forint, New Zealand Dollar, Norwegian Krone, Polish Zloty, Singapore Dollar, Swedish Krona, and Swiss Franc … in fact, at one recent PayPal presentation a member of the audience was heard to say, “Who needs Sepa when you’ve got PayPal?”.
• PayPal’s international business represented 40% of all revenues in Q4 2006, up from 35% the year before.

In Europe, PayPal has 35 million customer accounts processing $8.4 billion of total payment volume in 2006 alone and, of those 35 million accounts, 15 million are in the UK representing over a third of adults and half of all internet users.

PayPal's popularity is reflected in high penetration rates among online shoppers in the major European markets including the UK, Germany, France and Italy, with Forrester Research estimating that 23% of European online shoppers prefer paying with PayPal.

PayPal has also developed relationships with many leading European merchants, including Boots, DHL, Harrods, Meetic and Pixmania.

This leads us to the most interesting development within PayPal right now – PayPal Mobile.

PayPal Mobile

I have spent a long time expounding the fact that mobile telephones would become popular as a payments mechanism. Many have scoffed at this idea over the years. For example, at a US tradeshow in November 2004 I was told by bankers that mobile payments were too insecure and it would be about a decade before they would take off, probably driven by a Wal*Mart or Virgin.

Well, it took about fifteen months and it was PayPal who were in there first with PayPal Mobile.

PayPal Mobile was announced in February 2006, the first major such announcement in the USA, and was launched in the USA and Canada in April and the UK in June 2006.

The take-up has been pretty slow, but the first movements towards PayPal Mobile have been created by promotions such as “Text to buy Depeche Mode’s Live CD of this Concert now”. This was a PayPal promotion run at a recent gig and, surprise surprise, nearly ten percent of the audience texted the number to buy the CD.

How does it work?

PayPal Mobile’s folks call it “physical hyperlinks”. The idea is that you are on the train or walking down the high road and you see the poster for the latest Robbie Williams, Artic Monkeys or Lily Allen CD. The poster then has the line “Text to buy” on it, the PayPal Mobile logo and a code, such as RWRDJ for Robbie Williams' track “Rock DJ”. You then text the PayPal Mobile number with “RWRDJ” from your phone, get a call back to authenticate your transaction by entering your PIN and that’s it. A bit like seeing ‘click to buy’ online as a hyperlink, the ‘text to buy’ is a physical hyperlink.

The thing is that people do not realise how simple it is until they try it. As Roy Vella, head of PayPal Mobile Europe says, “consumers and merchants are happy to comment on the value of mobile services without hesitation, but it's not until they actually try it that you see the light come on.”

In fact Roy equates this to almost a religious experience. “With PayPal Mobile, there's a definite user epiphany that happens the first time that they text to buy an item or text to send money to a friend. No amount of marketing can replace the impact of that experience.”

I got prompted to buy into PayPal mobile because of an e-mail saying my mortgage would be paid if I used PayPal Mobile to donate 25 pence to the homeless charity, Shelter, and happened to be the lucky person drawn out of the hat. Sure enough, I texted the number and that was it: hooked on PayPal Mobile.

So why has PayPal Mobile not taken off big time?

Because it has very limited merchant uptake right now, and this is why those relationships with the merchants are key to PayPal Mobile’s strategy, with a number of early markets kicking off the business such as music and charities.

Music is key for the reason stated above, as in you walk down the street, see the poster, get the music. It’s instantaneous gratification and impulse purchasing with immediate satisfaction is a great way to shift digital goods.

It’s also a great way to shift other goods, such as perfumes. After all, why do you never purchase perfume from an advert? Because the perfumeries do not have stores. They sell everything through third parties, such as airport duty free lounges.

With PayPal Mobile, all of that changes. Now, you see CK, DKNY, Dior, Chanel advertised in Vanity, GQ, Vogue or similar and “Text to buy” delivered to the home the next day. What could be simpler?

The other focus of PayPal Mobile is charities. Why charities? Because you walk past the adverts for the charity today, and by the time you get home you have forgotten the Website, the telephone number and the moment your heartstrings were being pulled to give. Now, with PayPal Mobile, you walk past the poster, see the cause and give.

Giving in real-time there and then.

That’s why PayPal Mobile will work.

Why Bankers don’t get it

Now, if PayPal could see the future of mobile payments and bankers couldn’t, wouldn’t or didn’t, then how come bankers didn’t get into mobile first? I mean PayPal was the first major to launch a mobile payments service in the USA.

The reason is that traditional bankers generally don’t get PayPal because they live in the old world of payments – cash, card and cheque – whilst PayPal live in a new, brave world of social networking and person-to-person payments. All of this stuff is new to many bank decision makers. Take a look at my earlier comment around mobile payments being a decade away from US banks in 2004.

In the same year, Heidi Miller, head of the treasury and securities services businesses at JPMorgan Chase, made these comments at the international banking payments jamboree Sibos 2004:

“Wouldn't you think that banks should be facilitating payments transactions for eBay? We have the customer relationships. We have the accounts. We have the clearing and settlement systems. In fact, PayPal transactions ride on the very same systems we banks have spent billions of dollars building. And yet the banks lost the deal, despite our natural advantages. In less than one year, PayPal built a person-to-person payments solution that met the needs of the market better than any built by banks in the past five years.”

Ms. Miller is right. PayPal built a solution better than banks could build and made it work. And that is the vital difference because, you see, many banks trial and pilot new services … but that’s as far as it goes. They are not committed. They are just putting their toe in the water to see what it is and how it works, not trying to make it work. That’s why it is a trial, a pilot … a suck it and see.

Equally, many traditional bankers think that by the time it is working if they aren’t the first to be there then they can always copy it because they trialed it. For example, one banker from a major European bank said to me in 2006: “The real reason PayPal works is the consumer’s perception that they are safe. If I said, ‘any time you buy something on the Internet using our card, I will not allow you to be defrauded and will not hold you to account’, do you think PayPal would work?”

Yes! Of course, it would work.

This guy thought that he could shut PayPal down just by giving a banker’s guarantee for online payments. Mmmmm, now let’s see, by giving a banker’s guarantee you can eradicate this upstart with 133 million user accounts and 14 million merchants?

Too late, my friend.

In fact, the real insight into PayPal came from Geoff Iddison who heads up PayPal Europe. Geoff made an interesting comment at the Financial Services Club, which I chair, when he was talking about how PayPal started in Europe. At the time, he was looking for a bank partner to work with and took the PayPal European business plan around some of London’s most prestigious banks to see if they would like to partner with him. Now, bear in mind that Geoff is ex-Sotheby’s and Christie’s...in other words, he’s an auctioneer, not a banker...and he was quite surprised by how negative the banker’s reactions were.

Many of them scoffed at the ambition of the plans and said that PayPal would probably achieve their three-year ambitions in about ten years.

PayPal achieved them in nine months.

And Geoff made the comment: “If PayPal was run with a banker’s mentality, PayPal would not exist today."

He’s right as well. After all, you don’t meet many banking people in PayPal but visionaries, Internet aficionados and folks who like being in a brave new world.

That’s why bankers don’t get PayPal or, to be more exact, why bankers have not worked out the brave new world. It is also indicative of how visionary PayPal is, and was, in this new world when you look at where some of PayPal’s founders ended up:

• Peter Thiel, PayPal’s chief executive officer after Elon Musk, is now the founder and managing member of Clarium Capital Management LLC, a global macro hedge fund company managing over $2 billion and a partner in The Founders Fund, a $50 million venture capital firm. Thiel has been instrumental in making early investments in leading Web 2.0 firms Facebook, LinkedIn, Friendster, Rapleaf, and IronPort;
• Max Levchin, PayPal’s chief technology officer in 2000, set up Slide, a personal media-sharing service, as well as co-founding Yelp, an online social networking and review service. Max was also executive producer for the movie Thank You for Smoking, which grossed $24 million in the US;
• David Sacks, PayPal’s chief operating officer in 2000, now produces independent films such as Thank You for Smoking;
• Chad Hurley, PayPal’s user-interface designer in 2000, is now chief executive of YouTube, the leading Internet video-sharing site;
• Roelof Boetha, PayPal’s chief financial officer in 2000, is now a partner at VC firm Sequoia Capital, where he directs startups like YouTube, Meebo and Insider Pages; and
• Reid Hoffman, PayPal’s executive vice president in 2000 is the founder and CEO of LinkedIn, the leading work-based social networking site.

Oh yes, and Elon Musk? He’s flying to the moon, the stars and beyond with SpaceX. Maybe he runs by that old adage: “shoot for the moon. If you miss at least you’ll hit the stars”! With a personal fortune worth over $300 million, he must be doing something right.

PayPal’s future

PayPal’s future is bright and is strongly supported by the statistics. For example, a 2006 study by Booz Allen Hamilton estimates that debit and credit card issuers and acquirers will lose up to 30% of transactions to online retailers offering PayPal.

PayPal also has a driving vision and mission to be the global leader for online payments and to build the Web’s most convenient, secure, cost-effective payment solution respectively. This has now extended to mobile and, in the future, could just as easily head towards other payment services. For example, howsabout using PayPal in exchange for air miles, loyalty programs, even to exchange time units in complementary currencies?

I guess one day, you might even be using PayPal down at the local supermarket with a wave of your phone...now there’s a thought.

Happy one hundredth month birthday PayPal.

Chris Skinner is CEO of Balatro and chairman of the Financial Services Club.

Web links: www.fsclub.co.uk, and www.balatroltd.com
Author's email: Chris Skinner

The Finextra columns are now also released as a book by Wiley, 'The Future of Banking in a Globalized World', which can be ordered from www.wiley.com.