Fluent Essays

9 - 7 2 1 - 3 7 8 A U G U S T 1 9 , 2 0 2 0 Professor Michael Porter, Senior Lecturer Mark Kramer, and Case Researcher Annelena Lobb (Case Research & Writing Group) prepared this case. It was reviewed and approved before publication by a company designate. Funding for the development of this case was provided by Harvard Business School and not by the company. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2020 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School. M I C H A E L P O R T E R M A R K K R A M E R A N N E L E N A L O B B PayPal: The Next Chapter The responsibility of corporations has moved beyond simply delivering shareholder profits. The growing expectation from stakeholders is that companies need to take action to affect positive social and environmental impact. Purpose and profit are becoming increasingly intertwined. — Dan Schulman, President and CEO, PayPal PayPal, founded in December 1998, was one of the earliest Internet payment companies, enabling money to be transferred securely between and among people and businesses online. In February 2002, the company went public and eight months later it was acquired by eBay for $1.4 billion. After 12 years as an eBay subsidiary, PayPal was spun off as an independently traded company in July 2015 with a new management team, led by Dan Schulman as President and CEO. By 2015, digital financial services for consumers (known as fintech) had become a highly competitive industry. In addition to numerous well-funded start-ups, many of the world’s largest retailers, banks, credit card companies and Internet titans, such as Google and Apple in the U.S. and Alibaba, Tencent, and Baidu in China, had their own digital payment services. Schulman recognized that PayPal needed a distinctive position to compete effectively. He proposed that the company adopt a social purpose based on “democratizing financial services” by providing fast, secure and inexpensive money management tools to financially underserved consumers and small businesses. Articulating and consistently acting on this purpose spurred innovation and growth, but also incurred additional costs. PayPal further differentiated itself by embracing the idea of “stakeholder capitalism,” investing heavily in initiatives that would create value not only for shareholders, but also for employees, consumers, merchants, regulators and communities. By 2020, the strategy appeared to have paid off: as of the second quarter of 2020, PayPal was processing 3.7 billion payment transactions a quarter,1 or roughly 40 million transactions per day, in 100 currencies and 200 markets. In the five years since its IPO, the number of active user accounts had grown from 170 million to 346 million as of the second quarter of 2020, the average annual transactions per user had increased from 27.52 to 39.2,3 and its stock price had quadrupled. For the exclusive use of E. Lemus, 2020. This document is authorized for use only by Edel Lemus in 2020. 721-378 PayPal: The Next Chapter 2 Early in 2020, the world economy faced a profound recession because of the COVID-19 coronavirus pandemic. Hourly workers were among the hardest hit and many small businesses failed. People of color in the U.S. and other marginalized populations around the world faced the most disastrous health and financial consequences, raising public awareness of deeply entrenched racial inequities. As stores and restaurants shuttered and people quarantined at home, digital commerce expanded dramatically. PayPal reported impressive growth in its Q2 2020 results. The company handled over $220 billion during the quarter. Net new user active accounts grew 137% year-over-year to 21 million, net revenues for the quarter increased 25% to $5.2 billion, and free cash flow more than doubled to $2.2 billion. Schulman and his team pondered how much the company’s sense of purpose had driven this growth, and how to further expand their competitive edge in the rapidly evolving global market for digital payments. (For financial statements, see Exhibit 1a and Exhibit 1b; for share price over time, see Exhibit 2; for net number of payments and active registered user accounts, see Exhibit 3a and Exhibit 3b.) The Digital Payments Ecosystem Although most consumer and merchant transactions still relied on the use of cash, the shift to digital payments had been growing steadily over the past two decades and accelerated with unexpected speed as a result of the COVID-19 pandemic. PayPal competed in a complex ecosystem that included four types of digital financial services: person-to-person payments, point-of-sale (POS) payments for purchases, international remittances, and lending to consumers and merchants. These transactions could occur online, in-app, via mobile device, or in-store. Historically, most transactions had been handled by financial institutions such as banks and credit card companies. However, major Internet platforms, retailers, cellphone carriers and fintech start-ups all began to develop their own offerings that were generally less expensive and more convenient than the offerings from financial institutions. These new players recognized that payment services could be a competitive differentiator, increase user engagement, and provide valuable customer data. Past purchases could be used to tailor consumer recommendations, and fine-tune advertising or search results, as well as to adjust pricing and merchandising. Financial data and behavior could also be monetized by selling it to other companies, although PayPal elected not to do so. In person-to-person transfer, PayPal subsidiary Venmo was by far the largest player in the U.S., although the free service did not generate any revenues for the company. POS payment systems had originally been designed differently for in-store purchases, online shopping and payments through apps on mobile devices, but all players were moving toward a single omni-channel platform. (See Exhibit 4 for expanding competition across platforms.) Amazon dominated ecommerce with a 44% market share and the most sophisticated ability to use past purchase data to optimize performance.4 Each of the major cellphone manufacturers had developed its own payment software or digital wallet—ApplePay, Google Pay, and Samsung Pay.5 AT&T, T-Mobile, and Verizon joined together in 2010 to develop their own digital POS system, which was discontinued in 2015. In 2019, American Express, Discover, MasterCard and Visa joined together to create a new click- to-pay option for use on vendor websites.6 Major retailers, such as Walmart and Target, developed their own systems as well. (See Exhibit 5 for an example of the competitive ecosystem.) In China, the Internet giants Alibaba and Tencent also offered a full range of digital payment and financial services. By 2017, Tencent had over 600 million active annual users while Alibaba subsidiary Ant Financial had more than 450 million active annual users for the entire range of digital financial For the exclusive use of E. Lemus, 2020. This document is authorized for use only by Edel Lemus in 2020. PayPal: The Next Chapter 721-378 3 services. Although these companies were early in their international expansion, they were able to follow Chinese tourists and workers abroad and were aggressively acquiring hundreds of fintech companies around the world. By 2020, more than 10% of Alibaba’s ecommerce revenue occurred outside China, and Tencent’s WeChat had more than 100 million users outside China. Payment services were not central to their business models, but were important for gathering user data and increasing engagement. Remittances involved payment sent by immigrants back to their families in their country of origin. The roughly $600 billion market for remittances was dominated by Western Union and MoneyGram with a 15% and 5% market share respectively.7 Services such as saving, investing and borrowing proliferated online. Fintech companies had much lower costs than conventional banks with no need for branch offices, reduced regulatory requirements, and the use of automated transactions and algorithms rather than loan officers to assess credit.8 Annual venture capital investment in fintech had jumped from $1.89 billion in 2010 to $53.3 billion in 2019.9 Leading fintech players included Chime and SoFi.10 Newer fintech competitors such as Stripe ($3.4 billion in 2019 revenues11) and Square ($4 billion in 2019 revenues12) enabled small businesses to engage in ecommerce.13 (See Exhibit 6 for the relative scale of different platforms.) Underserved Customer Segments Despite the growth of digital payments, traditional retail banks still dominated the market for financial transactions. Retail banks favored higher-income customers who kept larger cash balances, paid interest on loans, credit cards and mortgages, and utilized a wider range of fee-generating services. Banks served customers in person at retail-branch locations, each of which typically required $20 million in deposits to be profitable. Less affluent branches made up for their costs through higher fees. In 2019, for example, U.S. banks collected more than $11 billion in overdraft fees; just 9% of all customers paid 84% of these fees.14 Retail and commercial banks also offered loans to businesses, although lending to small and medium-size enterprises (SMEs) was not very profitable and generally depended on the personal credit rating and guarantee of the business owner. Interest and fees on small loans under $25,000 rarely covered the underwriting and processing costs. Most consumers in developed countries still used retail banks for their financial transactions, although 1.7 billion people, or about 22% of the global population, were considered unbanked.15,16 One analyst estimated that giving unbanked consumers in developing countries access to traditional financial services could create $100 trillion in financial assets over the next 50 years.17 In the U.S., 6.5% of all U.S. households were unbanked and 18.7% were underbanked,a representing a potential market of $144 billion.18 These consumers had widely fluctuating weekly income and little capacity to maintain the minimum bank-account balances needed to avoid fees and service charges.19 Nearly one-third of U.S. households had less than $400 in savings.20 a Underbanked consumers had a bank account but still relied on costly financial services outside of the banking system, such as payday loans. For the exclusive use of E. Lemus, 2020. This document is authorized for use only by Edel Lemus in 2020. 721-378 PayPal: The Next Chapter 4 Expensive payday loansb and credit-card debt were often the only sources of credit available to those without a home as collateral or a steady and predictable salary. Interest on payday loans averaged 391% annually,21 typically consuming 36% of the average borrower’s gross paycheck, leading to multiple loan extensions and roll-overs. Seventy-five percent of payday loan borrowers took out 11 or more payday loans annually.22 Overall, the working poor spent an estimated $170 billion a year in fees and interest to manage their money.23 The unbanked population heavily skewed toward women and people of color, most of whom did not own a home.24 A history of federally institutionalized residential mortgage lending practices, known as redlining, intentionally restricted people of color from buying homes in neighborhoods populated by white families.25 Lower rates of homeownership among black families was the biggest contributing factor to the nearly ten-to-one wealth gap between black and white households in the U.S.26 Lacking home equity, black households had far less borrowing power to invest, start a business, pay for higher education, or recover from temporary financial setbacks.27 Although redlining and other forms of explicit racial profiling had become illegal, there was considerable evidence that women and people of color still had less access to financial services and paid more for the services they received.28 For example, research showed that the minimum opening deposit to establish a bank account was 40% higher in communities with majority black populations when compared to majority white communities.29 Entrepreneurs of color paid interest rates that were, on average, 32% higher than those paid by their white counterparts.30 Only 1% of venture capital funding went to black-led businesses. According to a 2016 report, the financial services sector overall was barely servicing over 1.1 million businesses owned by people of color.31 In the aftermath of the Great Recession of 200832 banks faced new regulations, higher capital requirements, and reduced fee income. Consequently, many banks closed less profitable branches (especially in lower-income neighborhoods) and raised credit requirements for individuals and small businesses. Small business lending decreased substantially and, by 2020, still had not recovered to pre- 2008 levels. Many fintech companies used online data, from utility bills to social media, to predict the creditworthiness of borrowers, enabling them to grant credit to those who would not have qualified otherwise. While these startups could help equalize financial opportunity, they could also end up preying on consumers who had few alternatives. One observer wrote: [F]intech platforms can afford to serve harder-to-reach customers who need small loans—something that traditional banks won’t do. But the same data and efficiency [. . .] can just as easily allow them to be exploited. Predatory lenders can target a larger, often less financially savvy audience, providing easy access to capital that comes with lots of strings attached like hidden fees and high interest rates that lead to a cycle of over- indebtedness.33 PayPal History (1998-2015) In August 1998, hedge fund manager Peter Thiel and Max Levchin founded Confinity, later renamed PayPal, as a company that offered person-to-person money transfers online.34 At the time, b Payday loans were short-term loans with high fees and interest rates, designed to provide the borrower with needed cash until his or her next payday. The borrower incurred new fees every time he or she extended the loan. Source: “Payday Loans,” Federal Trade Commission, https://www.consumer.ftc.gov/articles/0097-payday-loans, accessed April 2020. For the exclusive use of E. Lemus, 2020. This document is authorized for use only by Edel Lemus in 2020. https://www.consumer.ftc.gov/articles/0097-payday-loans PayPal: The Next Chapter 721-378 5 there was little demand to transfer money online. It found a niche, however, as an easy way for purchasers to pay for items bought on the online auction site eBay.35 PayPal offered an alternative to small merchants and individual sellers who could neither afford the fees required to use major credit cards for paymentc nor wait for checks to arrive by mail, as well as to early online buyers who were reluctant to share personal credit card or bank account information with strangers. In 2000, the competing online-payment company X.com, led by entrepreneur Elon Musk, merged with PayPal. The merged entity began to offer $10 credits that could be used as cash to new users and to those who referred them. With this incentive, eBay sellers began to promote PayPal as their preferred payment mechanism, and the company grew rapidly, leaping from 12,000 accounts to 2.7 million accounts in less than one year.36 PayPal’s losses increased to $10 million per month, however, and the company was spending as much as $100,000 per day in incentive payments. PayPal did not charge for its services, intending to make money from interest on the funds held in customer accounts. Purchases made with those funds or by automated clearinghouse (ACH) transfersd cost PayPal nothing, and PayPal’s software automatically defaulted to those no-cost payments. Customers withdrew their funds more quickly than expected, however, and many chose to pay for purchases with credit cards, leaving PayPal to absorb the 1.9% processing fee. PayPal also had to cover the costs of numerous fraudulent transactions. And in 1999, eBay threatened PayPal’s major revenue stream by purchasing the competing payment system Billpoint and featuring it as the preferred option on eBay’s checkout screen. By 2000, PayPal had improved its fraud detection software. Unlike other payment processors, PayPal represented both the buyer and seller in the transaction, and was therefore able to further reduce fraud by monitoring the past transactions and creditworthiness of both parties. The company also began to charge merchants $0.25 plus 1.9% of the sale for credit card transactions, bringing the company to profitability. In 2002, banking regulators in 13 states alleged that PayPal was acting illegally as an unregistered bank, because it had taken deposits for use in paying bills. PayPal argued that it was merely a money transmitter, similar to Western Union. The Federal Deposit Insurance Corporation (FDIC) ruled that PayPal was not a bank as long as customers’ money sat in banks outside of PayPal. A successful IPO followed in February 2002 at $13 per share.37 eBay transactions then accounted for more than two-thirds of PayPal’s revenue.38 Eight months later, eBay discontinued Billpoint and acquired PayPal in a stock exchange valued at $58 per share.39 After the acquisition, PayPal developed a merchant services division to support non-eBay transactions. By 2013, merchant services was generating 70% of PayPal’s revenues.40 The same year, PayPal also acquired online payment processing company Braintree, including its subsidiary, Venmo. By 2019, Venmo was processing $100 billion in transactions annually.41 PayPal was making efforts to monetize the free service, but had not yet found a way to generate significant revenues. Activist investor Carl Icahn took a position in eBay stock and pressured eBay’s management team to spin off PayPal as an independent public company.42 In June 2014, Schulman joined PayPal as c Average credit-card processing fees were about 1.95% to 2.00% for Visa, Discover, and MasterCard swipe transactions at retail businesses. At online merchants, and in other transactions lacking the card itself, fees rose to 2.30% to 2.50%. Source: “Average Credit Card Processing Fees,” CardFellow.com, April 6, 2020, https://bit.ly/3h92vvN, accessed April 2020. d ACH transfers were electronic money transfers between accounts at different banks. Source: Rebecca Lake, “ACH Transfers: What Are They and How Do They Work?” Investopedia.com, https://bit.ly/3fCabXi, accessed July 2020. For the exclusive use of E. Lemus, 2020. This document is authorized for use only by Edel Lemus in 2020. https://bit.ly/3h92vvN https://bit.ly/3fCabXi 721-378 PayPal: The Next Chapter 6 President and CEO, when eBay announced its decision to spin off PayPal. Schulman had been the founding CEO of Virgin Mobile, before having taken charge of mobile and online payments as Executive Vice President at American Express. He also served as Chairman of Symantec. Schulman commented: “What attracted me to PayPal was the opportunity to redefine a company. There was a platform to leverage, unburdened by old baggage, and eager for its next chapter. It was a substantive company at the time, but we needed to have a new vision.” In July 2015, PayPal launched its second IPO at a valuation of $47 billion, considerably larger than eBay’s post-transaction valuation of $34 billion. For calendar year 2014, PayPal had $8 billion43 in revenues with 170 million users, each of whom averaged 24.544 transactions per year. In November 2015, PayPal completed its acquisition of Xoom for $890 million, a remittances service that allowed for the transfer of funds, bill payments and currency conversions in 40 countries.45 PayPal: A New Strategy and Purpose In preparing for the 2015 IPO, Schulman knew that he had to bring a fresh vision to the company. He explained: I think leaders define reality, inspire hope, and then create the path between those two things. We needed to clearly define why we needed to move into the next chapter. Business was slowing down; parts of our business were commoditizing. Our subscriber growth was slowing and engagement was low. PayPal was seen as a dinosaur. We had antiquated software—it took us six months to make a change on our website. Also, we had very high attrition rates and could not attract the right talent. According to Jonathan Auerbach, PayPal’s chief strategy, growth and data officer, two decisions drove the company’s post-IPO strategy. Until 2015, PayPal had focused almost exclusively on online payments, but, as Auerbach observed, “You’re never offline anymore. I may be in a physical store, but I’m still online, so we decided that we would have the right to move into the offline environment. And that really changed the way we were thinking about where we had permission to offer services.” The second decision came from analysis of the highly competitive payments ecosystem. Auerbach continued: We had approximately a billion credit and debit cards on file—but our economic model led us to steer customers to make payments from their bank accounts instead of using cards because that was where we made the most money. So, the card networks and banks saw PayPal as potentially their largest competitor, and they weren’t supportive of PayPal’s success as an independent company. How were we, as an independent company, going to succeed against these huge competitors? Forcing customers to pay from their bank accounts when they preferred to use a credit or debit card was a bad customer experience. Giving customers free choice would increase PayPal’s transaction costs but, Auerbach continued, “We decided to live up to our aspiration to be a true customer champion. We believed that giving customers complete choice in terms of how they wanted to pay would build trust with our customers. That decision also enabled us to fully align our motivations with those of card networks and card issuers, and this allowed us to sit down with the card networks and banks and say ‘we are no longer your biggest potential enemy. We are now your largest digital channel. We should partner.’” For the exclusive use of E. Lemus, 2020. This document is authorized for use only by Edel Lemus in 2020. PayPal: The Next Chapter 721-378 7 By 2017, PayPal had 38 partnership agreements to process payments for retailers, financial institutions, credit card networks, and telecom and technology companies, including MasterCard and Visa, Walmart, Paymentus, and HSBC, representing 75% of all U.S. credit card volume, as well as with Google and Facebook. In 2017, there were almost 40 bank-led marketing campaigns to encourage their customers to pay with PayPal.46 PayPal further expanded through “white label” services, offering their technology to be used under their partners’ brands. According to Schulman: Not many people truly want to move into financial services—it’s fast moving, highly regulated, and fully global. It has balance sheet implications, and the fraud potential is enormous if you don’t know what you are doing. Most of these businesses want to use financial services to keep people on their platform to monetize in other areas. Our decision to partner rather than compete with these other players unleashed all the energy of that ecosystem to work with us. Five years ago, you would never have imagined banks incentivizing their customers to sign up for PayPal. On the consumer side, PayPal was searching for an opportunity to offer additional financial services and expand its user base. Auerbach explained: We spent a lot of time thinking about competitive advantage, asking, ‘What is it that I do that others really don’t do as well that makes a difference?’ And we realized that, outside of China, we’re the largest two-sided network, in the sense that we serve and know both the buyers and the sellers. Our competitive advantage is that we can bring hundreds of millions of buyers and tens of millions of sellers together in whatever context they want to transact safely, securely, and in an increasingly personalized way. And the more buyers I have in our network, the more merchants want to participate. So, it’s mutually reinforcing. Schulman added: Having a two-sided network at scale gives you a large competitive moat. We have a group that looks at consumers and a group that looks at merchants and then they look at the intersection together, because that’s where the secret sauce is made. No merchant is going to put a checkout button on their site if customers aren’t using it. Some of the largest banks tried to come in with their own digital wallets and then shut them down. Scale begets scale. It’s hard for a merchant not to have PayPal now because we have almost 350 million consumers who use it. In 2018, PayPal began to offer additional financial services for consumers, including direct-deposit options, the ability to deposit a check on a smartphone, a consumer debit card for use at ATMs, and FDIC-insured balances.47 PayPal provided these services through “a hodgepodge of small banks that stay anonymous and behind the scenes.”48 PayPal did not charge a monthly fee or require a minimum balance.49 Schulman claimed that PayPal should be able to do things at a cost 80% lower than a traditional bricks-and-mortar financial services institution, enabling the company to serve “millions of people and businesses around the world, including those who have been underserved by the traditional financial system.”50 At first, some managers doubted that targeting financially underserved customers was a viable strategy. Schulman proposed an exercise: He divided the senior management team into groups of four, and gave each group a $100 check with instructions to do three things: first, cash the check without using a bank account; second, buy a prepaid credit card; and third, transfer $50 to another team member. Cashing the check carried a $6 fee, and the bank had to be able to call the issuer on the phone For the exclusive use of E. Lemus, 2020. This document is authorized for use only by Edel Lemus in 2020. 721-378 PayPal: The Next Chapter 8 to confirm the validity of the check. The prepaid card cost $3 and sending the money to another teammate cost $5. A few transactions added up to 14% in fees. Schulman concluded: Through this exercise, the team understood that the people paying the highest fees are those who can least afford it. They also realized that these transactions take a lot of time and are completed in person, and that time costs money. These financial services are available at branches everywhere in middle-class neighborhoods, but they are nowhere in low-income neighborhoods. We saw a huge opportunity. The exercise really got people to buy in to say, ‘Hey, wait a second, a social mission at the center of the strategy actually makes a lot of financial sense for us.’ It became clear to the PayPal team that they had found a massive underserved market, but also one that would experience social gains from the expansion of PayPal’s business as well. Schulman said: So, we laid out this vision of using technology to ‘democratize access to financial services.’ How do we allow everyone to be able to manage and move their money at low cost, easily, and with the highest security, as opposed to that just being a province of the privileged? On the seller side, how do help small businesses compete against large global online merchants? Only 7% of small businesses in the U.S. had international sales, but our technology enabled 77% of those using PayPal to have international sales. It was a really expansive and inclusive vision, and it was exciting because it was tangible and doable. We called it ‘PayPal, the Next Chapter.’ In 2019, PayPal expanded its vision further by acquiring Guofubao Information Technologies (GoPay), the first foreign payment platform licensed to provide online payment services in China offering cross-border payment solutions to China’s merchants and consumers. According to Schulman: We put ourselves in the position of being a very trusted brand. PayPal customers are 57% more likely to complete their purchases when there is a PayPal check-out button …