how-does-paypal-make-money

How Does PayPal Make Money? The PayPal Mafia Business Model Explained

 

PayPal makes money primarily by processing customer transactions on the Payments Platform and from other value-added services. Thus, the revenues streams are divided into transaction revenues based on the volume of activity or total payments volume.

And value-added services, such as interest and fees earned on loans and interest receivable. As of 2017 PayPal generated over $13 billion in net revenues and almost $1.8 billion in net income. 

You might not see PayPal's business model as the most interesting one. Yet, the story of PayPal is compelling as this is the place where the so-called PayPal mafia was born.

This group of talented individuals would create among the most valued companies in the Silicon Valley. Let's start with the deal that made this possible.

The financial information provided in this article is in no way meant as an investment advice. The financials are simply a way to dissect PayPal business model.

Who owns PayPal?

Before we dive into the PayPal business models, it is important to notice that as of the time of this writing PayPal is a sub-organization of eBay, purchased for $1.5 billion in 2002.

That was the deal which made rich people like Peter Thiel, Elon Musk, and Reid Hoffman, which respectively founded companies like Founders Fund, Tesla and LinkedIn.

The deal was sealed just a few months after PayPal went public. In fact, at the time eBay customers made up up the bulk of PayPal's users.

As reported on cnet.com "63 percent of dollar volume for transactions in the first nine months of 2001 came from settling auction purchases, particularly on eBay."

It is interesting to dive a bit into PayPal origin story, as it uncovers some critical strategic insights on its early growth and users acquisition, until its deal with eBay.

PayPal origin story

PayPal founded in 1998 by a company called Confinity. In fact, just in 1999 PayPal was launched as a money transfer system.

At the time Confinity had a fierce competitor, called X.com. This was a company founded by Elon Musk (yes that Musk!). The companies rather than compete with each other, they just merged to take over the payment industry.

Once the company merged, they could finally focus on the commercial strategy. Rather than boiling the ocean, PayPal started with a small niche at the time, until they monopolized it and grew further.

Little business strategy note: If you're familiar with Peter Thiel's book Zero to One, he explains how the business world is about monopolies rather than competition. In fact, if you attended even for a day business school, you might have learned about the myth of market competition and how this is what makes capitalism work. In reality, how Peter Thiel pointed out capitalism is way more about monopolizing a market to grab most of its profits. In fact, in a situation of perfect competition, margins are so thin that companies can go easily go bankrupt. The real market dominator is the one that takes it all. Thus, the reason why many are not aware of this can be attributed to the fact that monopolies reframe their market position to hide the fact that they control a particular market. They do it because this is the secret that makes them successful. The moment when regulators and market players will find out about a monopoly they'll try to bring it down. 

PayPal's first growth hack: The bot that gave the company a bit of traction

In his book "The PayPal Wars" Eric M. Jackson, part of the so-called PayPal mafia (the group of people that would be part of PayPal before its acquisition by eBay) were looking for a way to grow their users' base, fast. 

PayPal management understood they had to acquire users, quickly on an already established platform. At the time they identified eBay as the place where "power users" would help PayPal scale up.

There was an issue though. They were trying to use a classic growth hacking strategy, called OPN (others' people network). In other words, when you start a venture and can't leverage yet on your branding (it'll take years), you need a faster route.

One way is to leverage on distribution agreements with large platforms. However, it's very hard at the beginning to close any of those deals. Why? For several reasons. First, as your start-up is still small, you don't have yet anything to offer to the distributor.

Second, a distribution agreement requires at times a certain level of organizational structure to handle the deal, which a start-up might not have. Third, and most important. A large corporation like eBay at the time has a strong brand.

This is an asset but also a liability. In short, getting into a distribution agreement with a start-up that is now yet "known" would represent a too high risk to bear for the established companies.

As PayPal could not leverage on a distribution agreement with eBay, it had to find a "growth hack" to scale up. In short, an unofficial way to use eBay to grow their users' base.

At the time eBay had purchased a startup, named Billpoint, to make the transactions on the website smooth.

However, also covering the transactions side of the site for eBay was still too risky, as fraud detection was a primary concern. As Eric M. Jackson explains in "The PayPal Wars" this was too much of a concern for eBay as a listed company.

This, in turn, gave PayPal time to come up with a strategy before Billpoint could be rolled out. 

The strategy was meant to wipe out competition and take over the payment market. At that point, one idea came to mind, which was to enter in as many actions as possible and then convince the other part of the transaction to use PayPal as payment.

This strategy would be expensive but a good marketing acquisition tactic. How to scale this up? One option was to hire a web farm in Asia. Or, employ a bot (a computer program) that would look for specific auctions and bid on them.

In the end, they went with the bot, on charity auctions with the aim of exposing PayPal to as many eBay users as possible. The bot together with other marketing and product initiatives brought PayPal to over 10,000 users per day.

Growth picked up yet the competitive landscape was still very challenging, with companies, like X.com that were threatening PayPal existence.

A little caveat: the story of this paragraph was inspired from the book "The PayPal Wars" a self-published book, based on account of a marketing employee at PayPal. Take this story as a reference, not as history as the account of the author might bias it.

The merger that brought together PayPal and X.com

As reported by Julie Anderson on Quora:
After the merger everyone tried to play nicely together at first, but - as has been widely chronicled from various perspectives - it took just a few months before the differences in opinion turned ugly.  Elon took a vacation that year and I've always hated that I didn't realize they were going to oust him as CEO in time; he called that day from somewhere in Africa and asked "How bad is it?" and I said "Not that bad. I think it's going to be okay." Middle of the night I sat straight up in bed and headed back to the office; the lights were blazing and everyone was there. It was done by morning, the company became known as PayPal, and that was that. 
Whether or not the merger was painful and whether or not it created conflicts it also brought together a group of very smart people, the so-called PayPal Mafia.

The PayPal Mafia phenomenon

the-paypal-mafia

Sourcetelegraph.co.uk

A group of people that were called PayPal Mafia after the eBay deal went on to create many prominent start-ups that would contribute in the later years to the Silicon Valley scene:

  • Jawed Karim (Youniversity Ventures),
  • Jeremy Stoppelman (founded Yelp with Russel Simmons),
  • Andrew McCormack (partner at venture capital firm Valar Ventures),
  • Premal Shah (non-profit organization Kiva),
  • Luke Nosek (Founders Firm),
  • Ken Howery (VP at Clarium Capital),
  • David Sacks (produced "Thank You for Smoking"),
  • Peter Thiel (created hedge fund Clarium Capital and Founders Firm),
  • Keith Rabois (held senior positions at LinkedIn, Slide),
  • Reid Hoffman (LinkedIn),
  • Max Levchin (Slide. Google bought it for $182 million in 2010),
  • Roelof Botha (Sequoia Capital),
  • Russel Simmons (Yelp),
  • Elon Musk (Tesla, SpaceX).

The PayPal acquisition by eBay

Finally in 2001, after a few months from PayPal IPO, eBay decided to buy the payment company. We don't know the "real reasons" for eBay to acquire PayPal.

It seems though that at the time most PayPal users were coming from eBay. As reported by a release on July 2002:

The agreement also should benefit eBay shareholders. The combination of the two networks should expand both platforms while minimizing shared operational costs. Strengthening the marketplace and realizing the efficiencies made possible by the acquisition will increase the value of both businesses.

In other words, on the one hand, eBay users were already accustomed to PayPal. On the other hand, PayPal could allow eBay to tap into a new audience as reported in the same press release:

PayPal, which will continue to operate as an independent brand, is a leading online payments solution. Approximately 60% of PayPal’s business takes place on eBay, making it the most preferred electronic payment method among eBay users. The remaining 40% occurs primarily among small merchants who constitute a potential new audience for eBay. Likewise, eBay’s community of 46 million users worldwide represents a growth opportunity for PayPal. eBay’s current payment service, eBay Payments by Billpoint, will be phased out after the close of the transaction.

It is important to notice here that the acquisition of Billpoint that was to meant to allow eBay to have its own transactions system to speed up payments and enable fraud prevention was not successful.

As it failed, this might also have been a critical reason for eBay to purchase PayPal at that price.

PayPal business model dissected

We're going to see the ecosystem the company was able to build throughout the years via acquisitions and international expansion. We'll also look at the overall business model.

The PayPal family: the galaxy of payment systems and apps around PayPal

PayPal, as part of eBay over the years, has created an ecosystem of payments that comprise platforms and mobile gateways that allow it to penetrate several markets. Around PayPal there are other four primary brands:

What is Braintree?

braintree-acquired-by-paypal

Source: crunchbase.com

In 2013 Braintree, a company that allows acceptance and processing of payments got acquired by PayPal in 2013. This was an all-cash deal of $800 million, and as reported by Tech Crunch after the acquisition, eBay Inc.

President and CEO John Donahoe said: “Bill Ready [CEO of Braintree] and his team add complementary talent and technology that we believe will help accelerate PayPal’s global leadership in mobile payments."

What is Venmo?

Venmo has become so prominent among millennials that it has become a verb ("venmo me money"):

venmo-me-verb

When your brand name becomes a verb (just like "Google it") that company might be on the right path to success. Braintree acquired Venmo in 2012:

braintree-acquired-venmo

Source: crunchbase.com

Thus, before Braintree would become part of PayPal, it acquired Venmo, an app that allows users to share and make payments with friends for a variety of services.

The social aspect of this app is critical, and it is also what makes Venmo so successful among millennials. 

What is Paydiant? 

The Paydiant Platform is a white label mobile wallet solution. Thus, it provides solutions for merchants and banks, as well as for resellers and distributors, and point-of-sale and ATM providers.

In short, they can deploy branded mobile wallet apps that work at the point of purchase at retail, restaurant, fuel site, cash access atm, and other in-person locations.

What is Xoom?

Xoom is a PayPal service that provides worldwide money transfers. It allows consumers to send money, pay bills and reload mobile phones from the United States to 52 countries.

As pointed out by PCmag "Xoom lets you send money to recipients in 66 different countries, as well as top up cell plans and pay utilities abroad. It's a convenient and well-designed service, though its rates are less favorable than some of the competition."

Revenue streams

PayPal revenue streams are classified into the following two categories:
  • transaction revenues: Net transaction fees charged to consumers and merchants primarily based on the volume of activity, or Total Payments Volume 
  • Other value-added services: Net revenues derived principally from interest and fees earned on loans and interest receivable
As pointed out in the 2017 annual report:
Transaction revenues grew more slowly than both TPV and number of payment transactions in 2017 due primarily to a higher proportion of person-to-person (“P2P”) transactions, primarily from our PayPal and Venmo products from which we earn lower rates and foreign exchange hedging losses. The percentage growth in transaction revenues was lower than the percentage growth in TPV and payment transactions in 2016 primarily due to a higher proportion of P2P transactions (including our Venmo products) for which we earn lower rates, and a higher portion of TPV generated by large merchants who generally pay lower rates with higher transaction volume. The impact of increases or decreases in prices charged to our customers did not significantly impact transaction revenue growth in 2017 or 2016 .

If you don't measure it, you can't improve it: PayPal key metrics to measure its business success

As Peter Drucker would put it, "if you can't measure it, you can't improve it."

This principle applies to any business model. In a way, the metrics a business picks up to measure its success as a business are also indicative of its culture and values that it tries to create. Of course, financial metrics have to be easy to measure.

Which in some ways allow them to be very actionable. On the other hand, a business model will have several kinds of metrics that might in part be disjoined from the bottom line. In PayPal's cases we have a few KPIs (key performance metrics):

  • Active customers accounts
  • Payment transactions
  • Total payment volume

Source: 2017 PayPal 10K

What are active customer accounts?

An active customer account is a registered account that successfully sent or received at least one payment or payment reversal through our Payments Platform, excluding transactions processed through our gateway and Paydiant products, in the past 12 months. 

This is the definition of active customer account given by PayPal. As of 2017 PayPal had 227 million active customer accounts, a 16% growth compared to 2016.

What is the number of payment transactions?

Number of payment transactions is defined as the total number of payments, net of payment reversals, successfully completed through our Payments Platform, excluding transactions processed through our gateway and Paydiant products.

As of 2017, 7.6 billion payment transactions went through PayPal, up of 26% compared to 2016.

What is TPV?

TPV is the value of payments, net of payment reversals, successfully completed through our Payments Platform, excluding transactions processed through our gateway and Paydiant products

The total payment volume was $451 billion, up of 27% compared to 2016.

Strategic partnerships 

For PayPal success it is crucial the company keeps building new strategic partnerships to provide better experiences to customers, offering greater choice and flexibility. In short, the value of PayPal is given by the strength of the ecosystem it creates. 

Seeking new areas of growth

PayPal growth is also part of the long-term plan. Tha growth can be driven by international markets expansion and innovation in the digital technology landscape.

What is the PayPal value proposition?

As highlighted in the annual report PayPal focuses on trust and simplicity, providing risk management and insights from our two-sided Payments Platform and being technology and platform agnostic. 

Two-sided Platform

PayPal is a classic example of a two-sided platform. The platform connects merchants and consumers. Thus, it gains valuable insights into customer behavior through data.

The aim is to keep the platform both brand and technology agnostic. This aspect is critical as it leverages on trust.

Branding

Branding is a critical building block of PayPal overall strategy. In fact, over the years the company has been able to build a trusted brand. There's no transaction without trust and PayPal is at this stage a globally recognized brand.

Competition

The competitive landscape shows several challenges:

  • retain and engage both merchants and consumers part of the two-sided platform;
  • show merchants incremental sales via end-to-end services;
  • safety and security of transactions
  • the simplicity of fee structure;
  • ability to develop products and services across multiple commerce channels
  • trust in dispute resolution and buyer and seller protection programs;
  • customer service;
  • brand recognition and preference;
  • the website, mobile platform and application onboarding, ease-of-use, speed, availability, and dependability;
  • the technology and payment agnostic nature of Payments Platform;
  • system reliability and data security;
  • ease and quality of integration into third-party mobile applications and operating systems;
  • quality of developer tools 
  • other vital challenges are related to the regulatory landscape:

A quick glance at PayPal financials

In 2017 the company recorded over $13 billion revenues and almost $1,8 billion in net income.

Total operating expenses increased $1.7 billion, or 18 %, in 2017 and $1.5 billion or 19% in 2016. Operating income increased $541 million, or 34%, in 2017 and $125 million, or 9% in 2016. Net income increased by $394 million, or 28%, in 2017 and $173 million, or 14%, in 2016. 

PayPal business model explained in an infographic

how-does-paypal-make-money

Key takeaways

PayPal started out as a service launched by Confinity, and it eventually became a service offered by the merger between Confinity and X.com.

The team behind the initial traction phase and before PayPal arrived at the deal with eBay comprised brilliant people, the so-called PayPal Mafia. Many former PayPal employees would take part in the development of new startup that became critical in the Silicon Valley landscape.

After the deal with eBay, PayPal has grown to become a giant that comprises other companies like Braintree and Venmo. Today PayPal is a two-sided platform which success depends on its ability to cope with the competitive and regulatory landscape.

[wp-rss-aggregator]

Published by

Gennaro Cuofano

Creator of FourWeekMBA.com | Head of Business Development at WordLift.io | International MBA

Leave a Reply