The Rise of the Quasi-Merchant

 

Purveyors of card-acceptance services for mobile phones  are booking merchants by the hundreds of thousands.  But many of these merchants present underwriting risks and generate little charge volume. Are they worth it?

 

By Jim Daly

 

Everyman a merchant? Thanks to smart phones and aggressive merchant processors such as Square Inc. and its competitors, it’s not too hard for someone who has something to sell nowadays to start accepting credit and debit cards, even if he or she has little or no business experience.

 

The smart-phone segment of the card-accepting merchant base in its current form is barely three years old, having sprung up after Apple Inc. introduced its revolutionary iPhone in June 2007 and especially after the faster iPhone 3G appeared a year later.

 

It’s difficult to measure its size because processors in this hyper-competitive field closely guard their portfolio secrets. It’s likely, however, that the number of smart-phone-based merchants now well exceeds 1 million, with thousands more being booked each day.

 

This explosive growth has triggered a big debate in the merchant-acquiring industry about whether many of these low-volume merchants should have card-acceptance privileges at all, and whether the whole effort will return a decent profit.

 

“It’s not unlike micropayments,” says Steve Sotis, president of eProcessing Network LLC, a Houston-based gateway provider that began offering mobile merchants swiped transactions on the old Palm Pilot VIIx back in 2000. “This industry can’t support one or two transactions a weekend based on the fee model we’ve had for years.”

 

Boston-based Merchant Warehouse anticipated its Merchantware Mobile for the iPhone would generate low volumes when the service debuted in the first half of 2009. “But we didn’t anticipate how low,” says co-chief executive Henry Helgeson.

 

Merchantware Mobile remains a key product for the independent sales organization, but last year Merchant Warehouse began pulling back from serving the tiniest merchants.

 

Star Power

 

Even partisans of smart phones as payment terminals acknowledge that very small merchants have high attrition rates. High attrition means added expense because acquirers have to book many more new merchants just to stay even.

 

In a new study covering 20 acquirers, First Annapolis Consulting Inc. estimates that merchants with less than $100,000 in annual bank card charge volume have a mean attrition rate of 28% compared with a mean of 20.8% for merchants with annual volume of $100,000 to $500,000.

 

Despite the drawbacks, many processors smell new opportunities with smart phones replacing specialized wireless devices or conventional point-of-sale terminals as a merchant’s primary link to the payment networks.

 

No company has hitched its star to the low-volume, smart-phone-using merchant more than Square, the San Francisco-based processor headed by Jack Dorsey, the social-media superstar who co-founded Twitter.

 

Payments suddenly became sexy when Square came onto the scene in late 2009. Now Square says it has passed out a half-million of its free cube-shaped card readers for smart phones and is generating more than $2 million a day in charge volume.

 

Even Square’s competitors tip their hats to Dorsey & Co. Square started processing transactions last year, and when it did, “That got us to rethink some things we were doing,” says Mary Lunneborg, product manager for Intuit Inc.’s GoPayment service for mobile merchants. She adds that Intuit likes the fact that Square “focused on the low end and demonstrated there is an opportunity,” an opportunity for GoPayment also to exploit.

 

Few payments companies arouse more intense feelings than the unconventional Square. Many industry veterans are quick to criticize it, and VeriFone Systems Inc. a few months ago publicly attacked Square for passing out card readers that don’t encrypt data.

 

In a recent survey, 20 merchant-acquiring executives told Aite Group LLC that they questioned how Square vets prospective merchants. Dorsey has said that among other things, the company considers an applicant’s use of social media in reviewing merchant applications.

 

“Their underwriting may be their weakest link,” says Adil Moussa, an Aite analyst. “They [the survey respondents] think it’s a disaster waiting to happen.”

 

On the other hand, Dorsey’s star power has spawned countless articles, many flattering, about Square in the Silicon Valley press, which previously paid little attention to payments. When Dorsey gave speeches at the NACHA and MidWest Acquirers Association conferences last year, attendees lined up afterward to have their pictures taken with him—a rare sight indeed at payment confabs.

 

And Visa Inc. this spring saw fit to invest an undisclosed amount in Square. Square said it would meet Visa’s security standards, which presumably means it will add encryption to its readers. (Square did not respond to multiple Digital Transactions interview requests.)

 

Most important, the Dorsey brand is attracting merchants. Joshua Zimmerman, a guitar player with the San Diego-based indie band The Silent Comedy, says Dorsey’s association with Square helped him make the decision to accept Square for purchases of CDs and other products the band sells at concerts.

 

“My main concern was security and stability of the company,” Zimmerman says. “Because he was involved, it seemed like it was going to be around.”

 

Unqualified Applicants

 

Below are summaries of the instructive underwriting and portfolio-management experiences of some, by no means all, of the smart-phone-based payments programs aimed at smaller merchants.

 

Our apologies for excluding PayPal Inc., a major mobile-payments player, but one with its thumbs in so many pies that it warrants an entire article in a future issue.

 

 

 

Square

 

Square has taken its share of lumps in its short life, having survived shortages of its card readers, a time-out to refine its underwriting, and VeriFone’s public attack on its security. Nonetheless, Square is on a roll, with Visa’s recent investment just one milestone.

 

In April the company said it was signing nearly 100,000 merchants per month, and, based on tweets from Dorsey and press reports, the company by now may be generating about $800 million in annualized charge volume.

 

Square, which acts as the merchant of record for transactions generated by its clients, funnels its volume into JPMorgan Chase & Co.’s Chase Paymentech acquiring subsidiary.

 

Square’s underwriting secret sauce remains just that, a mysterious blend of the conventional and unconventional. As noted, Dorsey has said that an applicant’s use of social media is one element Square evaluates in deciding whether to book a prospective merchant, though how much that factors in is unclear.

 

Social-media use also is an element Square watches in assessing risk during the transaction process, Square chief operating officer Keith Rabois said in a post on a Visa security conference blog this spring.

 

“Our patented technology cross references real-time transaction data with the social Web, including Twitter, Yelp, Facebook, and Google, to surface patterns and distinguish suspicious activity from legitimate transactions,” Rabois wrote.

 

But the underwriting experience of The Silent Comedy with Square is mostly what you’d expect. The band, which is featured on Square’s Web site, is a perfect example of an intermittent mobile merchant that would find Square useful and that Square seems to be courting.

 

While it sells products online through a specialty e-commerce provider serving bands, The Silent Comedy began using Square in January to sell CDs, T-shirts, shot glasses, and other items on its tours that have taken it through Western states mostly, but also to Alabama and Canada.

 

“Our revenue stream is not, definitely, ongoing and constant,” says Zimmerman, adding that the band uses several of its members’ personal iPhones for Square sales.

 

Zimmerman applied for a Square account in December and doesn’t remember if he answered any questions about social media. He does remember being asked about how long the band was in business and what types of products it sells.

 

“It was completely online,” he says. The approval process took only a few hours, with the band’s accountant providing the bank-routing number and related data.

 

The Silent Comedy is a satisfied Square customer. “We lost a lot of sales” by not accepting cards at concerts, says Zimmerman, noting that the band would be “bombarded” by fans when it met them after a show ended and members personally sold its wares.

 

“It [Square] helped us immensely, especially playing in alcohol-serving environments,” he says. “People usually spend the cash they have at the bar, or on tips.” The band’s young customer base readily accepted their cards being swiped on the Square iPhone reader, Zimmerman adds.

 

So far, The Silent Comedy hasn’t had any fraudulent transactions or chargebacks, according to Zimmerman. “I’ve been really pleased that there have been no problems,” he says.

 

(The Silent Comedy found its way onto a Square merchant-testimonial video through its manager, who knew someone at Square and recommended the band as an example of a Square user.)

 

 

 

Intuit

 

Mountain View, Calif.-based Intuit’s GoPayment service seems to have Square in its cross-hairs. GoPayment’s card-present pricing is close to Square’s, and Intuit professes that low-volume merchants, many of them seasonal or part-time businesses that have never accepted cards before, can generate good returns with acceptable risks.

 

In contrast to Square, Intuit gives each approved applicant a merchant account. Intuit runs full credit reports on applicants, asks them challenge questions and follows “know your customer” procedures.

 

But while the underwriting process is relatively standard, Intuit has tweaked it in order to approve more applicants. Traditional mobile businesses such as plumbers and heating-ventilation-air conditioning (HVAC) contractors were GoPayment’s original market, but Intuit now is looking farther afield. One newer merchant is a woman who sells pictures from her son’s bike races, for example.

 

“In the past, we wanted to be really careful on who we let into the door,” says Lunneborg. Now, she says, Intuit is “being strategic with the risk … we’re trying to minimize the barriers to signup.”

 

GoPayment offers a card reader, and its businesses present little fraud risk, according to Lunneborg. And she says attrition is manageable. “We find that the attrition is definitely within our boundaries.”

 

With its focus on low-volume merchants, how does Intuit make GoPayment go from a profitability standpoint? Answer: automation and volume. While applicants can speak to a live customer-service agent, the account-approval process can now be done entirely online. The new system replaced a manual underwriting process that took two to three days.

 

“Half of our online signups are instantly approved through automated underwriting,” Lunneborg says. She adds that Intuit is launching a “knowledge base” with a frequently-asked-questions section to reduce calls to customer service.

 

While acknowledging that the profit from each small account is correspondingly small, Lunneborg says a decent return can be made in the aggregate. “Margins will definitely go down, but the good news is that there are so many new-to-credit-cards merchants out there that there is healthy growth across the types of merchants,” she says.

 

Intuit has other ways to boost profitability from the GoPayment novices: by encouraging them to use more Intuit Merchant Service products as they grow, and by becoming customers of the company’s core product, the QuickBooks accounting software for small businesses. QuickBooks has 4 million customers.

 

Intuit partially matched Square’s pricing after Square in February dropped its 15-cent transaction fee for card-present sales, making the discount rate a straight 2.75% of the sale. Intuit in May ended its 15-cent fee so that GoPayment’s pricing for card-present transactions became 2.7% for merchants generating approximately $1,000 or less in monthly volume. Higher-volume GoPayment merchants pay 1.7% for card-present transactions and a $12.95 monthly fee. At the time, a spokesperson said Intuit was not acting in response to Square but to market demands for simpler pricing. Both Square and Intuit give away their card readers.

 

Lunneborg wouldn’t say how many merchants use GoPayment, but Intuit Merchant Service has 300,000 merchants in all. GoPayment merchants are generating $21 million a week in volume, or just over $1 billion a year. According to Lunneborg, Intuit is looking for “huge growth.”

 

 

 

Inner Fence

 

Redmond, Wash.-based software vendor Inner Fence LLC claims that its Credit Card Terminal application for the iPhone was the first such app for card acceptance to be sold in Apple’s iTunes App store. Much has changed since Credit Card Terminal debuted in late 2008, but co-founder Derek Del Conte says Inner Fence is adapting.

 

Credit Card Terminal used to go for $49.99, though approved merchants got a $50 iTunes gift card. Now the app is free and the gift cards are gone, but merchants don’t pay for a card reader that enables their smart phones to accept card-present transactions.

 

Inner Fence refers applicants to its ISO partner, Dublin, Ohio-based Merchant Focus Inc., for merchant accounts. The service uses the Authorize.net gateway for access to the payment networks. In addition to the iPhone, Credit Card Terminal has versions for Apple’s iPad and smart phones running Google Inc.’s Android or Microsoft Corp.’s Windows Phone 7 system.

 

Inner Fence differentiates Credit Card Terminal in a couple of ways. Most merchants use the iPhone, and the entire application process can now be done on that device, including signatures.

 

In mid-May, the company began using an imaging application it developed so that applicants can take pictures of a voided check and upload the image as part of the account-approval process. That automates a process that formerly required the applicant to fax a copy of a voided check so that Merchant Focus had the routing and account numbers it needed to deposit funds for the merchant.

 

“We’ve made it so the entire process can happen on the iPhone,” says Del Conte.

 

And in contrast to Square and Intuit, Inner Fence plays up the human-contact angle. A Merchant Focus representative acting on behalf of Inner Fence is assigned to each new merchant.

 

“We assign you an account rep right away, answer all questions right away through your first transactions,” says Del Conte. “The idea is to make that one on one. That’s a big way we differentiate ourselves.”

 

Credit Card Terminal has a wide range of merchant users, but Del Conte says it has significant numbers of professional photographers, taxi and limousine drivers, contractors, and licensed professionals such as accountants and lawyers. Like Square and Intuit, Inner Fence gets many applicants who are new to card acceptance. Del Conte says chargebacks and fraud losses in his portfolio are within bounds.

 

“We obviously don’t approve everyone,” he says. “I don’t find our portfolio is risky.”

 

 

 

VeriFone

 

Leading U.S. point-of-sale payment terminal maker VeriFone has positioned PAYware Mobile and its ancillary services as a major part of its effort to generate steadier revenues from services as a counter to the cyclical POS hardware business. Scott Henry, San Jose, Calif.-based VeriFone’s director of North American product marketing, won’t reveal PAYware Mobile’s number of users or transaction volumes, but does say, “I think it’s met its expectations.”

 

The service, which includes a reader that can be bought in Apple’s physical stores, has several hundred resellers among merchant acquirers, ISOs, and other processors. Each make their own underwriting decisions, and Henry says most users are “already taking payments in one way, shape, or form.”

 

PAYware Mobile’s leading merchant categories include familiar ones such as HVAC contractors and taxis. Barbers and beauticians, who are often independent contractors working with similar contractors in one space, tend to be big users, as are home-based businesses.

 

Also prominent: art dealers and jewelers, who can present an iPhone to the customer in front of a sculpture or jewelry case to close what’s often a big sale that a trepidatious customer can bail on in the mere seconds it takes to walk to the cash register. Henry calls that “an extension of the impulse buy.”

 

 

 

Merchant Warehouse

 

When Merchant Warehouse launched its Merchantware Mobile application for the iPhone in the first half of 2009, it at first thought very small businesses would be a good fit. But in addition to volumes so low that it was hard for the ISO to make a profit, the attrition rates among tiny businesses proved to be “substantially higher” than the rest of the portfolio, according to Helgeson.

 

Merchantware Mobile still gets a fair amount of churn, but the merchants that stick tend to be traditional mobile merchants such as pizza deliverers, plumbers, and construction contractors. Most don’t want to pay for a specialized wireless terminal. “It’s an add-on to existing accounts,” says Helgeson. About 6,500 merchants use the system, which has versions for Android, Windows, and BlackBerry smart phones in addition to the iPhone.

 

One problem with smart-phone payments: they can attract completely unqualified applicants, says Helgeson. He cites a boy who wanted his parents to pay his allowance via credit card. “We have a disciplined [inside] sales force, we can weed those things out,” Helgeson says. But if an ISO using outside agents isn’t careful, some of those unqualified applicants might get booked, he adds.

 

 

 

North American Bancard

 

PayAnywhere, a smart-phone product from Troy, Mich.-based North American Bancard Inc., a big ISO, posted its first full month of service only in February. Volume is growing 300% month over month, says company founder and chief executive Marc Gardner.

 

“The types of merchants we are seeing are very stereotypical of what you’d expect—landscape design, HVAC,” he says. But some seemingly unlikely users take the service for the “cool” factor, he adds, such as a Florida radiologist whose average sale is about $1,000.

 

PayAnywhere does attract its share of brand-new, low-volume merchants. Gardner says NAB draws on its 20 years of experience to keep risk and attrition at bay. Plus, the card reader goes a long way in reducing fraud losses. “We’re being very careful,” he says, adding that NAB is “always enhancing” its underwriting policies and procedures.

 

NAB also markets another smart-phone service called phoneSwipe.

 

 

 

Apriva

 

As with VeriFone’s PAYware Mobile, a large network of acquirers and processors, each with its own underwriting criteria, sells Apriva Inc.’s AprivaPay. Scottsdale, Ariz.-based Apriva’s main payments business comes from transactions generated on made-for-purpose wireless terminals funneled into its gateway. AprivaPay is a supplement to that business line aimed at a wide swath of mobile merchants.

 

“There is no profile, we’re surprised daily by what our resellers bring us,” says Bill Ramsey, vice president of business development. Common merchants include home-delivery services and HVAC contractors, food-service companies, and sellers at art fairs.

 

Attrition rates are only slightly higher than those for merchants using specialty terminals, according to Ramsey, but that’s partially offset by high average tickets. “All of my assumptions [about attrition] have been wrong so far,” he says. “It hasn’t been bad so far.”

 

 

 

MagTek

 

MagTek Inc., a developer of payment-processing hardware, software, and security services, launched its QwickPAY smart-phone solution in May 2010 for Apple products and added an Android version early this year. Andy Deignan, vice president of global marketing and strategy for the Seal Beach, Calif.-based company, says more than 10,000 merchants use the service. Merchants are booked through “hundreds” of resellers, he says.

 

The range of users includes “the smallest of the small,” such as crafts sellers who work out of their homes and sell at fairs on weekends, to plumbers, florists, and even gun shops, says Deignan. “We really do run both ends of the extreme,” he says.

 

Like most of the other services reviewed here, QwickPAY’s resellers require users to get a merchant account. “We’re following the traditional model where you have to be a vetted merchant,” says Deignan.

 

‘A Lab Experiment’

 

The smart-phone payments business is still young enough that even experienced acquirers are learning new things about underwriting, risk, and profitability. “We’ve learned some lessons, some of them the hard way,” says Helgeson of Merchant Warehouse.

 

One lesson: don’t price too low; the payback from merchants expecting a low-ball deal could be higher attrition. “They don’t have any skin in the game,” Helgeson says. “Any time you have a merchant paying you to process, you’re going to have less attrition.”

 

Yet another thing about smart phones: In contrast to the traditional acquiring business where sales agents relentlessly pursue new merchant customers, wanna-be merchants using smart phones often come to the ISO or reseller. That can create compensation issues for sales agents, according to NAB’s Gardner.

 

“If you’re in one of the top positions in the [iTunes] App Store or Android Marketplace, you’re not really picking your merchants, they’re picking you,” he says.

 

Many acquirers view their smart-phone offering as an entry-level product and hope users will graduate to full-line, more complex, and higher-profit services, or as a service for existing merchants that want to get out of the office or shop. But with smart phones enabling part-timers to get into the payment-card acceptance game easily, the rules about who can or can’t be a merchant are changing.

 

“It’s a lab experiment in many ways,” says Apriva’s Ramsey.