Strategies: Getting Beyond Square

 

By Jane Adler

 

Rightly or wrongly, lots of investors are mesmerized by the high-profile startup Square. But it’s not the only newbie transforming the payments industry as venture-capital firms scramble to find the next big idea.

 

 

 

Some startup companies get all the attention.

 

The latest payments darling is Square Inc., a mobile-payments merchant processor targeting small, often part-time, businesses. Glowing press reports and lots of industry buzz have generated plenty of investor interest. The company raised $100 million just last June, led by the Silicon Valley venture-capital firm of Kleiner Perkins Caufield & Byers.

 

Earlier, Visa Inc. put some change in Square, which Twitter co-founder Jack Dorsey launched in late 2009 as a way for individuals and businesses to accept payments on their smart phones and iPads using a small card reader and software application. The company says it is processing $4 million in mobile payments a day with plans to double that volume by this month. Square has shipped more than 500,000 credit card readers, which are now sold in Apple Inc.’s stores. And Square plans to expand next year overseas.

 

Square’s quick success has boosted the company’s valuation to reportedly more than $1 billion. But Square isn’t the only payments startup shaking up the market. A number of startups are attracting interest from private individuals and venture-capital firms alike.

 

Huge Startup Market

 

As with Square, many of the latest ventures involve mobile payments, due to the rapid growth of smart phones. Startups also are targeting couponing and discounts at the point of sale, often using a smart phone for redemption.

 

Other startups are introducing payments-related services, such as prepaid cards, and instant micro loans for those without bank accounts. Companies also are emerging in person-to-person payments, data analytics, and security. Merchants and banks want new ways to reach consumers while easing fears about conducting transactions either online or by smart phone.

 

“There’s a lot of investment money out there looking for startups,” says Bob Hyer, managing director in the New York office of Houlihan Lokey, the investment bank that advised PayPal back when it went public in 2002. The payments giant was snapped up by eBay Inc. later that year.

 

The payments industry is ripe for investment, experts say. An industry once marked by well-defined roles is undergoing a transformation. Google Inc., for example, recently introduced an electronic wallet, edging ever closer to the payments space.

 

Three big mobile carriers—AT&T Inc., T-Mobile USA, and Verizon Wireless—reportedly just invested $100 million in their new Isis mobile-payments joint venture.

 

“The next three or four years, we will see more change than we have over the last 20 years,” says Hyer.

 

The market for startups in general is huge. A study by the University of New Hampshire estimates that early-stage investments last year totaled $20.1 billion.

 

No one knows the total size of the payments-startup market. But industry watchers agree that the payments business has been very active lately. One industry insider estimates that about 10 to 15 payments startups are launched each month, with a total worth of about $25 million to $50 million.

 

New Tech

 

Startups are generally defined as new, quickly growing companies. The first stage of funding, also called the “seed” or “angel” stage, typically provides financing of about $100,000 to $500,000. New products are developed during this stage. Entrepreneurs also often rely on friends and family for financing at this point.

 

The next stage of funding is the “A” round, which provides from $1 million to $5 million. The A series typically is for companies that already have a product, but usually no profits. Subsequent rounds of funding could be as much as $20 million or more, depending on the sales forecasts.

 

SparkBase Inc., a gift and loyalty processing company, is an example of a payments startup with new technology. The Cleveland-based business recently launched its PayCloud product, a mobile-wallet application that allows consumers to redeem offers and awards from their smart phones.

 

PayCloud uses a technology that completes transactions with ultrasonic sounds. Merchants purchase a sensor for about $50 that plugs into the back of a point-of-sale terminal.

 

Customers sign up for the service by downloading the application and then clicking on a merchant icon to enroll. Users wave their phone over the sensor to redeem rewards. “It’s a neat way to conduct a transaction,” says Doug Hardman, chief executive at SparkBase.

 

SparkBase tested PayCloud in the Cleveland area. The service is now being launched at 35 Chicago merchants—all located within a six-mile radius. Hardman expects to roll out the service city by city and to be operating in 20 to 30 cities by the end of the year.

 

SparkBase has always been profitable, though Hardman declines to provide figures. He does say corporate income has doubled twice this year. And, since the introduction of the PayCloud product, the company has been adding 15 new independent sales organization partners a month. ISOs offer the service to their merchants.

 

Also, the company had 11 employees last November and now has 40 staffers. Hardman expects to add 20 to 30 to the head count over the course of the next six months.

 

SparkBase has raised about $4 million since its 2009 launch. The company’s initial round of funding came from private investors. “We avoided venture capital,” says Hardman.

 

The company’s investors are local executives, who, like Hardman, would prefer to keep the company based in the Cleveland area. Startups that take money from venture-capital firms usually must relinquish some ownership and decision-making control over the company.

 

Filling a Void

 

What do investors want?

 

“Investors are looking for traction,” says Hardman. “You have to be able to show your model works.”

 

SparkBase started with four ISOs as partners. Once the product worked for them, SparkBase added five to 10 more customers. After another three months, the company’s client base quickly grew to more than 150.

 

SparkBase now gets daily inquiries from investment banks because the company has a good product and rising revenue, Hardman says. “Once you have a track record, it’s easy to raise money,” he notes.

 

About a third of venture-capital investments fail, experts say. Another third return about 1.5 times the amount of capital invested. The others return about four times the amount of the investment on average. Big winners can earn as much as 20 times the capital invested over a period of three to seven years.

 

Of course, investors like big ideas with the potential for a big pay off.

 

“There are so many flavors of next-generation payments,” notes Brian McLoughlin, partner at GRP Partners, a venture-capital firm in Los Angeles. “We like novel ideas that could be highly disruptive in a big established market.”

 

For example, GRP has backed Wave Crest Holdings Ltd., a startup based in Gibraltar with U.S. offices in Fort Lauderdale, Fla. The company offers an electronic-wallet platform and recently partnered with O2, the United Kingdom’s second-largest mobile-phone carrier. The e-wallet handles m-commerce, contactless and near-field communication (NFC) payments, and peer-to-peer payments.

 

O2 plans to re-launch its prepaid Visa card product with contactless capabilities. The new O2 Money prepaid cards also will operate on the banking platform and systems provided by Wave Crest.

 

A big plus is that O2 already has 5 million customers, McLoughlin notes. In the long run, it’s possible that mobile carriers with a huge customer base such as O2 could become their own card issuers, he adds. “Who knows what the industry will look like?” he says.

 

Micro lending is another payments-related area attracting investor interest.

 

GRP Partners has invested in ZestCash Inc., whose service allows users to apply online and get cash in 24 hours. It’s something like a payday loan, but instead of repaying the loan in a couple weeks or rolling it over and being subject to high interest charges, ZestCash sets up a manageable weekly payment due over the course of four months. Technology allows quick underwriting to determine which applicants are likely to repay their loans.

 

GRP provided seed capital of about $250,000 to ZestCash. GRP also recently co-led a second round of funding with two other investors for $11 million.

 

Another GRP-backed venture is BillFloat Inc. BillFloat allows customers to borrow money online to pay a bill, and recently received its second round of funding.

 

Investors favor companies that fill a market void. Financial Technology Partners, a San Francisco-based investment bank, recently arranged for $50 million of funding for Yapstone Inc. Yapstone targets vacation and apartment rentals. Consumers pay the property manager via credit card through the Yapstone application.

 

“Property management is a potentially huge credit card market,” says Steve McLaughlin, founder and managing partner at FT Partners.

 

Strings Attached

 

Almost as important to investors as carving out a new niche is the startup’s management team. Successful teams typically have industry experience and a reliable track record.

 

Paul and Daniel Kim, who are brothers, run the startup KreditFly Inc., Santa Clara, Calif. In 2010, Paul Kim launched the company. Like a lot of entrepreneurs, Kim has started other ventures. He founded BilltoMobile, a mobile-payments company that he sold in 2010.

 

Kim was seeking a new opportunity and wanted to create a different type of mobile-payments company to increase merchant sales. The idea for KreditFly came from the fact that online consumers using PayPal must pre-register or leave the merchant site in order to conclude a purchase. “That’s a potential friction point for the sale,” says Daniel Kim, KreditFly’s chief financial officer and chief operating officer and a former PayPal executive.

 

To get around the problem, KreditFly grants the customer a micro credit at the point of sale. An algorithm determines a user’s creditworthiness from his phone number. KreditFly launched its product for online gaming and currently has 12 customers. “There’s no reason why this wouldn’t work for other retailers,” says Daniel Kim.

 

KreditFly received its first round of funding from two venture-capital firms and Silicon Valley Bank. “Venture-capital firms invest in teams of people,” notes Daniel Kim. The brothers knew the industry and Paul had started another successful company. They also had the technical expertise to win the confidence of investors.

 

Of course, investment money comes with strings attached. Venture-capital firms not only want a healthy return on their investment, but they typically also want to own a piece of the company—which is why some startups steer clear of venture funding.

 

The Kim brothers gave up an ownership interest, though they decline to say how much. Daniel Kim points out, however, that the philosophies of venture-capital firms differ. Some help with business development. Others tend to stay out of the way.

 

Venture-capital firms typically want to own at least 12% of the company, but often as much as 25%, experts say. In syndicated deals, the lead investor with the most at stake usually demands the highest percentage of ownership.

 

Shunning Venture Capital

 

Some entrepreneurs chafe at venture capital’s demands. “We don’t need venture capital,” says Wenlock Free, vice president of business development at SecurityMetrics Inc., Orem, Utah. The company recently introduced a new product called PANScan that searches merchant databases for unsecured credit card information.

 

But at some point, most startups need outside capital to expand. RosterWire LLC has shunned venture capital so far, but that could change soon. RosterWire is a Greenwood Village, Colo.-based startup that consolidates loyalty programs and discounts on a single card with a magnetic stripe such as a credit or debit card.

 

Its system communicates with merchants, alerting them about which customers to contact based on previous buying patterns. “The system makes the merchant smart about customers,” says Stan Kropp, president at RosterWire.

 

Some 25 merchants in Denver are testing RosterWire. The product is not sold through ISOs but directly to merchants. RosterWire plans to develop an iPhone application next, and take its business model nationwide next year.

 

An individual investor funded RosterWire’s startup. Kropp wants to make sure the system works, and works well, before approaching venture-capital firms. “We are starting to talk about that,” he says.

 

 

 

Sorting the Winners from the Losers

 

Here’s how venture-capital firms decide which payments companies to fund.

 

Simplicity sells. A venture-capital firm may or may not have expertise in payments. A startup’s management team should be able to describe the basic business model in easy-to-understand terms. SparkBase founder Doug Hardman has honed his so-called elevator pitch to last only as long as a short ride, about 30 seconds.

 

Unique proposition. “Me-too” business models are difficult to fund. Investors want startups that approach the market in a different way, or offer a new twist on an existing payment platform. “Commodity-type businesses are of no interest to investors,” says Bob Hyer, managing director at Houlihan Lokey, New York.

 

Fast growth. A company with sales below the industry’s overall growth rate probably won’t be a winner. Investors look for quickly growing companies.

 

Market mastery. The management team must demonstrate deep market knowledge. A lot of companies unfamiliar with the payments industry are jumping into mobile payments, and some investors are growing wary of the category, according to Kevin Kidd, a partner at the law firm of Waller Lansden, Nashville, which represents payments companies.

 

Security-related startups can be a tough sell too because the products can be so complicated. Kidd says: “Investors have to understand the idea.”