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Ecosystems Squared

You have probably heard of Square’s first product, launched in 2010. It was a credit card reader that plugged into the headphone jack of your phone:

That little square dongle is simple. The magnetic stripe on the credit card can be read much like an old cassette tape, and that’s what this little device does, with the help of a round battery. At that point, it would have been easy to dismiss Square. “The technology is easy to copy; the incumbents will kill them!”

But let’s inspect the business model: Square provided the dongle and the accompanying software for free, and let anyone with a phone start accepting credit cards in minutes. That’s not something incumbents can easily match, because it’s lower margin relative to their existing business; the market at first glance appears much smaller and inconsequential; and all of their existing incentives and organizational skills are not suited to pursue these types of opportunities.

That is the very definition of disruption.

Let’s hear from co-founder Jack Dorsey about the problem Square was trying to solve:

We started Square because Jim McKelvey, our co-founder and my second boss (after my mother!), couldn’t accept a credit card for his art.
Setting up a merchant account was painful. The application process required lots of paperwork and took months. Banks asked for multiple credit checks and years of financial history. And when we were finally approved to accept cards, we couldn’t decipher the rates we were paying. Then our first deposit was held. The entire process was exclusionary and unfair.
Square was born out of our experience. We built a working prototype: a mobile credit card reader that plugged into the audio jack of an iPhone and an app to enter an amount and process the payment. But it took us a year to convince the financial industry to allow us to make Square broadly available. The problem was not with the technology, but with the system.
We decided to make the entire system faster, more affordable, and more accessible. We gave the card reader and software away for free. We settled funds next business morning, which required us to advance money to sellers faster than we received it. We abstracted away the byzantine maze of interchange pricing to offer a simple fixed rate per swipe, which forced us to find ways to lower our costs immediately. Every one of those decisions carried existential risks that we trusted we’d be able to overcome with time. And we have!
Creating more inclusion and greater equality in the global economy is both a social need and a huge business opportunity. We’ve made it our purpose: empower people with beautifully simple tools that give them an advantage where they previously and unfairly had none. Our strategy to realize that purpose is straightforward: grow our payments service, extend payments into financial services, and extend payments into marketing services.

Square took the early success of its dongle and leveraged its advantages into a business valued at $33 billion today. Nine years later, this is what Square’s flagship point of sale terminal looks like:

That scrappy startup with the magnetic tape reader can now afford to build a custom-designed, Android-based tablet, with its own secure enclave, led by a team of 150 hardware designers and engineers, including ex-Apple employees.

As is often the case, the search for a solution to a problem led Square to stumble upon a much larger business opportunity. As Dorsey noted in a 2011 interview, early customers of the dongle “started taking more and more payments, they started getting bigger and bigger, as you’d expect them to. They were beginning to get more sophisticated about what they needed, and they started asking us for more tools.”

Square is a textbook example of two types of disruption: low-end and new market. Low-end disruptors attack an existing product or service by offering something that is inferior along several factors. In this sense, they are competing with existing consumption of that product or service.

They are lower-cost solutions that grow by picking off the least attractive of the established firms’ customers. Incumbents are often relieved to rid themselves of these lower margin customers. The attacker iterates and improves its solution, moving upmarket, and eventually takes the incumbents’ best customers. There is little that incumbents can do: their business models, organizational structures and incentives are in opposition to the new direction carved by the disruptor.

New market disruption is even more interesting. Here, an attacker competes with nonconsumption: the new product or service is so much more affordable and convenient, it enables an entire new cohort of customers to use it. Incumbents don’t even know disruption is happening, since the new entrant isn’t attacking their customers directly. Over time, the attacker iterates and improves its solution and—like low-end disruption—moves up-market and eats the incumbents’ lunch.

Square’s dongle is a clear example of both low-end and new market disruption. It allows merchants who would never have been able to get a traditional bank or merchant account and point of sale system to start accepting credit cards in minutes. These merchants are by definition not on the map of the incumbents—that is, until they grow and become much larger. But by then, they’re deeply embedded in the Square ecosystem.

And guess what? Even that 2010 dongle wasn’t the first of its kind. Intuit had a product called GoPayment, and PayPal launched something similar shortly after. When was the last time you heard of either of them?

Square also innovated in fraud detection. Competitor Verifone thought they should also get into the small merchant game, but quickly started taking too many losses. From a 2012 Reuters story:

“‘Our experience through 2012 with tens of thousands of these micro-merchants tells us that the standalone economics of micro-merchant acquiring are fundamentally unprofitable,’ Doug Bergeron, chief executive of VeriFone, said during a conference call with analysts.

The cost of tracking down and signing up small and individual merchants, through things like TV and Internet-search advertising, ‘will never justify the razor thin-margins produced by merchants with infrequent volumes and extremely high attrition,’ he added.”

Another source says Verifone was taking a 1 percent loss on every transaction, whereas Square took a fundamentally different approach, using algorithms to vet merchants, and today enjoys a loss of only 0.1 percent.

Square continues to sell its hardware at a loss, but earns high margins on payment processing fees and a fast-growing stream of software subscriptions and services which are quite sticky:

The growth in Square’s software and services business has lifted Square’s aggregate gross margins from 23 percent in late 2013 to 41 percent today. Software and services have a 72 percent gross margin profile, so there’s room for expansion.

In the most recent quarter, Square earned $247 million in transaction gross profits and $158 million in software and services gross profits. It lost $8.7 million in hardware gross profits.

The hardware loss is a customer acquisition device, an on-ramp into the Square ecosystem. Once there, customers spend money on Square’s various software tools like payroll, inventory management, loans and marketing.

These tools help customers grow. Here’s Square’s hardware lead Jesse Dorogusker:

One really powerful way we can help is to grow their business. In the last 12 months [2017], we've sent over 350 million digital receipts, which has allowed us to build the customer directory of 90 million e-mails and phone numbers. We have a loyalty system that can reward and retain returning customers, and we have a marketing program that is unique with two attributes. One, it works. For every dollar you put into Square Marketing, on average, $12 of sales were generated. And second, probably the more profound fact is that, while this is typical in online commerce to be able to close the loop, this is something that we can do uniquely by being in the payments and point of sale of the seller.

Square’s revenues have been growing at a quick pace—up 59 percent year-over-year in the first quarter. Part of this is growth in transactions of existing customers: dating back to the second quarter of 2010, every single customer cohort has grown year over year. This means that despite churn—customers leaving Square or, say, going out of business—the group they belong to in aggregate ends up generating an ever-growing pile of cash for Square to reinvest.

One way Square reinvests is in customer acquisition, and these are very high returning investments indeed. On its sales and marketing expenditures, the company cites a payback period of only 3-4 quarters. It’s clear that Square is earning attractive returns on its investments and needs to pour fuel on that fire, and that’s exactly what the company is doing.

Greasing Square’s flywheel is the ease of getting in: over 90 percent of sellers self-onboard within minutes (this is more than double what is typical in the industry). Large sellers, who usually require a higher-touch sales effort, self-onboard 80 percent of the time.

Once a merchant is in the Square ecosystem, it has access to a suite of tools and services, including loans. The pain Dorsey described going through to accept payments is true for loans: traditional banks require credit scores and extensive paperwork, taking weeks to decide. Nor are they set up to provide micro-loans. Dorsey explains:

We saw an opportunity with Square Capital, because we had this amazing understanding of our sellers. You look at a lot of our competitors, and they only see one part of a seller, usually just the seller name and the category. Hence, they request all this information, but we don't have to request anything at all. We see the sellers' transactions, we see the inventory, we see their employees, we see the trends in their business, we see connections with other sellers. So, we have this really deep understanding of the seller that we can make a good judgment on risk, and without a seller having to do anything at all, we send them an email, one tap, and they get the Square Capital on. That's just magical.

Since launching in 2014, Square Capital has made 650,000 loans for an aggregate of $4 billion, or an average of $6,150 per loan. Merchants use this money to buy equipment, meet payroll, expand their business, and purchase additional services from Square.

Since loans are quite small and typically less than 15 percent of a merchant’s annual payment volumes, Square gets paid back over an average of 8 to 9 months as merchants take new orders (repayments are made off every card transaction). There are no penalties or hidden fees, and sellers have rewarded Square with high customer satisfaction scores. Square Capital revenue is included in subscription and services, and loan loss rates have remained quite small at less than 4 percent.

Then there is the Cash App, which Square describes as an “ecosystem of financial tools for individuals to send, spend, and store money.” Consistently number one on the app store in its category—ranking above Venmo, PayPal and Zelle—Cash App has grown its payment volumes 2.5x year-over-year, with deep customer engagement.

Customers are starting to use Cash App as a primary checking account. Many have their paychecks deposited directly into the app. Square noted this behavior and enabled customers to easily transfer their Cash App balance onto a credit card. The front is customizable with any laser-etched design. The front also lacks a credit card number, a boost for virality. Here’s a customer showing off her card on Twitter, Dorsey’s other company:

Cash App has the potential to become quite impactful to Square’s enterprise value. Here is Square’s chief financial officer Amrita Ahuja:

From an engagement perspective, are we adding daily utility to our consumers, and how they're managing, saving, storing, sending, and spending money.
From a monetization perspective, we think about both unit economics on a per product, and from a customer lifetime basis as well as scaled economics. So, to give you a couple of metrics against each of those three areas: when you look at reach, we're rapidly growing the user base for the Cash App ecosystem. The last figure that we provided as of December was 15 million monthly actives, which doubled year-over-year.
And we're adding that customer base efficiently. If you look through our financials, you'll see that the spend to acquire each of those monthly actives was an average of about $20 per monthly active. That's a fraction of what you see a traditional financial institution spend, to acquire a new user let alone an active user.

In other words, the Cash App is slowly becoming an over-the-top bank account, and it’s being built with economics that are vastly superior to those of traditional banks.

There’s a lot more to Square: we haven’t touched on Weebly (its website and ecommerce creation tool), Caviar (a delivery service integrated into the point of sale of its restaurant customers), its developer API and app marketplace, or Square Card (a card that enables sellers to quickly receive proceeds from their sales directly on to a MasterCard, which they can use for business expenses). Remarkably, 40 percent of Square Card sellers didn’t previously have a business debit card.

The linchpin of all this is Square’s mission-driven management team, ably led by Jack Dorsey. Dorsey’s key principles for Square include ecosystem (the cohesion of design in hardware and software and offering customers ever more capabilities and tools, deeply integrated with Square and the customer’s business), speed (not only in transactions, loans and onboarding, but also in the mechanics: the average chip reader takes between 8 and 13 seconds, while Square can read a chip card in two seconds), elegance (how everything works together) and self-serve (frictionless onboarding).

The size of the markets in which Square operates is almost incomprehensibly large. Here again is CFO Ahuja:

There is $9 trillion of consumer spend in the five markets that we’re in today. And if you look at our trailing 12-months GPV [Gross Payment Volume] of about $90 billion, it's about a 1% penetration of that opportunity, it's a large, growing and fragmented space.

In its 2017 investor day, Visa pointed out that despite decades of waging a “war on cash,” the amount of dollars transacted in cash and checks has grown over the past several years and stands at $17 trillion globally:

One can quibble with Ahuja’s market size definition but what is unquestionable is that the payments space is a vast, growing market. And within that market, Square is well positioned to continue to grow its disruptive business with more innovations for years to come.

Despite making heavy investments in growth, Square is solidly profitable on a free cash flow basis. Management believes EBITDA margins should expand to 35-40 percent as the company continues to scale. We are excited to have been able to make our investment at a price that we believe will deliver a 20 percent compounded return over many years.

[Note: this post is an excerpt from one of our letters to investors, originally published on July 12, 2019. To learn more, check out our investors section.]


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