CASE STUDY

PayPal Has Company

PayPalthe online payment processor now owned by eBaywas the first truly successful Internetbased e-commerce payment system. Its origins were quite simple. On November 16, 1999, Peter Theil sat with friends at a restaurant. When the bill arrived, Theil used his Palm Pilot to "beam" his share to a friend sitting across the table. Theil and fellow co-founder Max Levchin had built a system that would allow them to send money to one another via a Palm Pilot's infrared links. From this idea sprang one of the first "peer-to-peer" payment systems: a system that allows individuals to send money to one another via email. PayPal emphasizes ease of use for both senders and receivers of cash. Here's a brief synopsis of how it works. First, you create a PayPal account at the PayPal Web site by filling out a one-page application form and providing credit or debit card or bank account information. Only PayPal is privy to this information, not the receiving party. Then, when you use PayPal to pay for a purchase, money is drawn from the credit card or bank account and transmitted to the Automated Clearing House (ACH) Network, a privately operated financial intermediary that tracks and transfers funds between financial institutions.

The party who is to receive the payment is notified via e-mail that money is waiting. If the receiving party has a PayPal account, the funds are automatically deposited into the account; if the person does not have a PayPal account, he or she must set one up, and then the money is credited to his or her
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account. Once the funds are in the PayPal account, the recipient can then transfer them electronically to a checking account, request a paper check, or use PayPal to send the funds to someone else. Levchin and Theil originally conceived of PayPal as a method for "beaming" money to users of handheld PDAs. When this idea did not pan out, they changed their target to arranging payments between individuals who knew one another. However, they quickly realized that it would also work for a company such as eBay, providing purchasers and sellers with a way to short-cut the time-consuming and cumbersome process of mailing checks and money orders and waiting for checks to clear before shipping items. Moreover, for small merchants selling items on the Web, it is difficult and expensive to obtain the capability to accept credit cards. Credit companies extend these merchant services only to bona fide businesses, usually requiring a physical place of business as a requirement. Today, PayPal is the largest and most popular online payment service, growing from a handful of users when it launched in late 1999 to over 165 million in 2007, of which about 40 million can be characterized as active users. In 2007, PayPal processed $45 billion in payments. About 70% of this gross volume ($30 billion) is tied to eBay users, and $15 billion comes from non-eBay transactions. One reason PayPal has grown so fast is because it experiences the benefits of network economics or the "viral effect": the more people who accept and use PayPal, the greater the benefit to the consumer. If I send you a PayPal payment via e-mail, then you are incentivized to open a PayPal account to receive the funds. If PayPal is to continue growing, it will have to break out of the eBay marketspace and find new payment opportunities. PayPal earns money in many different ways. First, online sellers (who may be individuals or small businesses that do not want the difficulties associated with obtaining a merchant credit card account) pay a transaction fee for the service (30 cents plus 1.9%-2.9% of the proceeds of the transaction). This generally works out to 3.3% of the transaction on a $100 transaction. Credit card firms generally charge about the same or 0.3% more due to their higher customer acquisition costs. PayPal, in other words, can be slightly less costly than credit cards for merchants. One advantage for merchants on eBay is that they are not required to have a merchant bank account, which is required by credit card issuers. Merchant banks clear credit card transactions and charge fees. Consumers are not charged directly for the use of their PayPal account although they do pay ultimately because retailers need to recover the costs of the transaction by raising the prices on goods sold using PayPal. Second, PayPal earns revenue by collecting the interest earned on consumer funds not yet transferred out of the PayPal system. PayPal has charges for transferring funds to foreign banks, converting currencies, and new financial products such as a PayPal credit card. Part of the strength of PayPal lies in its simplicity: it piggybacks on existing credit card and checking payment systems. This is also one of its weaknesses, however. PayPal reportedly suffers relatively high levels of fraud related to the credit card system on which it relies. To protect against fraud, PayPal requires special authorization for payments over $200. In 2002, PayPal went public and issued shares in an initial public offering. One of the main reasons PayPal grew so rapidly was because of its popularity on eBay. In an effort not to lose this lucrative transaction business to PayPal, eBay spent over $100 million promoting its own similar system called Billpointbut to no avail. In October 2002, eBay purchased PayPal for $1.5 billionabout $20 a share. At the time, analysts felt the price was too high, but eBay has had the last laugh. Today, PayPal is valued at $7-$8 billion, and, according to the company, has a 10% share of the U.S. consumer e-commerce payments market and a 5% share of the global market. In 2006, PayPal generated $1.4 billion in net revenues for eBay. Although this only accounted for about 25% of eBay's revenues, the growth rate of PayPal revenues (40%) exceeded that of the rest of eBay's Marketplace segment (24%) by over 15%. For a brief period, PayPal enjoyed its position as the only widely adopted online platform (aside from the
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credit card companies). But this is changing rapidly. The largest direct competitor is Google's Checkout system, an online digital wallet. Google Checkout stores a user's financial information, including credit card information, and then presents this information to merchants when the user checks out. The customer does not have to fill out forms or reveal credit information to online merchants. Checkout does not support peer-to-peer payments, at least not yet. Google has been careful not to directly challenge PayPal in the P2P market, if only because eBay (the owner of PayPal) is the largest single advertiser on Google, and Google directs a significant traffic volume to eBay. They need one another. Google will also use Checkout to support its advertising network. Ads for online stores that accept Checkout are highlighted with an icon, increasing the chances that users will click on those sites. Once users click on an ad, they are more likely to purchase. Merchants who accept Checkout on their sites receive more traffic simply for offering the convenience of the service, and Google has frequent promotions where it eliminates all processing fees for periods of time, saving merchants the 2% plus 20 cents it charges for transactions. An even more direct challenge is coming from unlikely sources: cell phone carriers such as ATT and Verizon, especially in P2P payments. PayPal and Google Checkout are both built upon the existing credit card system. What if you could eliminate the credit card intermediaries? In June 2007, Verizon announced a deal with mobile payment company Obopay, Inc. to allow subscribers to transfer money and make purchases through their cell phones. Users can send money to anyone with a cell phone on any wireless network. Now let's see: there's a billion PCs in the world, but around 4 billion cell phones. Around 250 million people in the U.S. have mobile phones. Currently, Verizon customers will have to load their Obopay accounts at the Obopay Web site with a credit card. But in the future, Obopay hopes to integrate its service with Verizon's own monthly billing service, thereby eliminating credit card companies altogether from the payment loop, reducing transaction costs merchants and customers, and making it easier to use the service (there's no sign needed as long as you have a Verizon cell phone account). PayPal also faces other challenges. PayPal's brand is closely associated w smaller merchants, P2P money transfer, and low-cost auctions. As a result, sot larger firms might not want the PayPal brand image associated with their brands. PayPal's business makes it a natural target for fraud, both by merchant s that not deliver goods or services paid for by its customers, and from outside forces will send fraudulent e-mails to its customers, attempting to steal the customers' password credit card numbers, or other personal information. PayPal has been forced institute a number of costly measures to combat fraud in the attempt to enhance customers' confidence in its services. PayPal's protections for consumers are weaker than what credit card companies are required to offer. For instance, you can deny credit card charge and have a $50 maximum liability if your credit card information is stolen and used in commerce. With PayPal, you may or may not receive you: money back, depending on whether PayPal can receive its money back, and a host 0: other conditions. PayPal has developed a consumer protection program, but it also settled in 2006 with 28 state attorneys general involving concerns about certain business practices. Chief among these practices was encouraging users to allow PayPal to directly debit consumer bank accounts, because PayPal can avoid paying credit corn-, panics a 2% funds transfer fee, making the direct deduction option more profitable for PayPal. If you have given PayPal both your credit card information and bank account' information, the default payment method used by PayPal is your bank account. Once funds are withdrawn from your bank account, they cannot be recovered, unlike credit card transactions. Hence, the risk to consumers is substantially greater. Credit card companies can retrieve funds from misbehaving merchants more quickly by simply reverse-crediting their merchant bank accounts, which generates a hefty penalty payment for them as well. To cope with emerging new competitors, including the cell phone carriers with deep pockets, PayPal is pursuing a number of other growth initiatives. PayPal signed up both Napster and Apple's iTunes Music Store as merchants in its first foray into the micropayments market. The experience proved so successful that PayPal is now investigating similar deals for other micropayments markets, such as
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downloadable games, electronic greeting cards, and other online content. PayPal introduced a new micropayment pricing plan designed to increase and encourage the purchase of low-priced digital goods. PayPal is also pursuing an overseas expansion strategy. It has added localized Web sites in China, Australia, Italy, and Spain to a list that already included Canada, Austria, Belgium, France, Germany, the Netherlands, Switzerland, and the United Kingdom. In 2007, businesses or consumers with e-mail could use PayPal to send online payments in 190 countries, and receive payments in 65 of those countries. Payments can be made or accepted in any one of 17 different currencies. PayPal is attempting to expand beyond eBay sales by setting up preferred merchant relationships with other large Internet retailers such as Yahoo and Amazon, with mixed success. Amazon has its own credit card and preferred methods of payment, but Yahoo uses PayPal as a recommended payment method. In 2006, PayPal also introduced its mobile text message payment system, which allows cell phone users to pay for goods and services by texting PayPal payments to merchants. Despite the challenges, however, the future for PayPal appears bright. In fact, some analysts believe that PayPal may someday become an even bigger phenomenon than its acquirer, eBay.

Case Study Questions 1. What is the value proposition that PayPal offers consumers? How about merchants? 2. What are some of the risks of using PayPal when compared to credit cards and debit cards? 3. What strategies would you recommend that PayPal pursue in order to maintain its growth over the next five years? 4. Why are cell phone networks a threat to PayPal's future growth?*

SOURCES: "Verizon Announces Deal with Mobile Payment Firm Obopay," Wall Street Journal, June 20, 2007; eBay Inc. Form 10-K for the fiscal year December 31, 2006, filed with the Securities and Exchange Commission, February 28, 2007; "PayPal Plans Mobile Payment Service," by Vauhini Vara, Wall Street Journal, March 23, 2007; "Google Steps More Boldly Into PayPal's Territory," by Miguel Helft, New York Times, December 20, 2006; "How to Make PayPal Your Friend," by Ron Lieber, Wall Street Journal, October 7, 2006.
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2008 E-commerce business, technology, society Kenneth C. Laudon and Carol Guercio Traver Pearson Prentice Hall.