PayPal Inc., a subsidiary of online auctioneer eBay, Inc., provides users with a means of exchanging funds via the Internet, a revolutionary step in the development of electronic commerce. By obtaining a PayPal account, consumers and businesses may send and receive payments vie e-mail. PayPal users make payments securely online using credit cards or bank transfers, as well as by maintaining funds in personal interest-bearing PayPal accounts. PayPal handled approximately $3.1 billion in payments in 2001, with an average daily volume of about 189,000 payments totaling $9.6 million. Its user base that year included 10.2 million personal accounts and 2.6 million business accounts in 39 countries.
Late 1990s Origins
The company which later became PayPal was founded by Max Levchin, an online security specialist, and Peter Thiel, a hedge fund manager. The two met in 1998 when Levchin approached Thiel in New York for financial backing for a company that would develop a system for transferring money using such wireless devices as cell phones and palm pilots. Levchin and Thiel joined forces, obtained $3 million in backing from the Nokia Corporation, relocated to Silicon Valley, and opened Field Link, a firm which produced encryption software for handhelds. Unfortunately, what seemed to be a good idea in theory evoked next to no response from consumers.
So Thiel and Levchin regrouped. The company was renamed Confinity, and in October 1999, with six employees and two computers, it launched PayPal, a service by which money could be sent electronically by handheld devices. PayPal met with just as little interest as Field Link had.
The tide turned when the two partners realized that no means of electronic payment had been developed to handle the buying and selling that was starting to boom on the Internet. Sales on eBay, the online auction site, to name one of the most successful examples, were being paid for by checks and money orders sent through the regular U.S. mail. What electronic business lacked, according to Levchin and Thiel, was a simple, convenient payment system tailored specifically for the World Wide Web, a system that would enable a person to email money to someone else. Other companies--most notably beenz.com and Flooz.com--were trying to establish themselves in the electronic payment field at the time, launching new electronic currencies they hoped would replace the dollar as the medium payment on the Internet. However, despite costly giveaway promotions, these e-currency companies encountered massive walls of resistance from both consumers and merchants. Merchants were reluctant to accept a new, unproven currency; consumers hesitated to give up their tried and true dollars for currency no one might ever accept.
PayPal, on the other hand, relied on existing, universally accepted institutions. The U.S. dollar was PayPal's medium of exchange; email, which virtually everyone shopping online used, along with banking networks, comprised its medium of transfer. The PayPal system was launched quickly online. Potential buyers opened PayPal accounts which were linked to a credit card or a bank account; alternatively, money could be deposited in the account, where it earned interest until it was needed for a purchase. Not much later, after it was discovered by online auction aficionados, PayPal's fate was linked inextricably with eBay's.
In March 2000 Confinity was acquired by X.com Corporation, a Silicon Valley firm involved in online banking projects, led by Elon Musk. Under Musk, X.com took the PayPal corporate name and initiated aggressive marketing plans, including one promo offering $10 to new sign-ups for PayPal accounts.
In just eight months time, between January and August 2000, PayPal surged from 12,000 accounts to 2.7 million. The company's transaction process helped tremendously to fuel the growth. Money could be transferred to anyone who had an email address, even those who did not have to have a PayPal account. However, recipients did have to open a PayPal account in order to claim their money. The system's convenience and cost won over eBay shoppers. They no longer needed a credit card to buy online, and the service cost them nothing. It was cheaper even than a postal money order and stamp. Sellers were required to pay 1.9 percent of the sales price.
Success Through eBay
In June 2000, PayPal introduced a new type of account for businesses. PayPal business accounts were intended for high volume individual and commercial accounts. These customers were required to pay a fee of 30 cents plus 2.9 percent for each transaction, significantly less than many smaller stores pay to handle credit card sales. Business accounts could accept an unlimited number of credit card payments through PayPal every month (consumer accounts were limited to $500 in credit card business every six months) and received access to PayPal's special e-commerce features, such as Web Accept, with which PayPal payments could be processed directly from Web sites. By the end of 2001, more than one-fifth of PayPal's 12.8 million accounts were business accounts.
EBay was the motor that drove PayPal's success. In July 2000 approximately 2 million eBay listings accepted PayPal payments--five times more than BillPoint Inc., eBay's own payment service. By the following October, PayPal was being used to pay for 25 percent of all eBay transactions. The company had grown to 500 employees who were processing over 120,000 transactions, worth in total about $6 million, every day. In the fall of 2001 PayPal also introduced its first consumer guarantee: consumers who failed to receive goods bought from verified PayPal sellers would be fully reimbursed by the company.
PayPal's strong growth continued in 2001. Online auctions continued to account for a large percentage of the firm's annual revenues, over 60 percent. However, PayPal was also establishing a strong Internet presence among users of adult sites and online gambling. By summer 2001, its customer accounts had swelled to over 9 million. With about 500,000 accounts outside the United States, the company was taking its first steps toward establishing itself in the international online marketplace whose worth was expected to reach about $10 billion by 2005. Its great promise was reflected in its roster of investors, including Spain's Bankinter, the Japanese Internet bank eBANK, ING Group, Providian Financial and Credit Agricole, all of whom in spring 2001 put an additional $90 million into the company, slated for foreign expansion.
Other companies tried to challenge PayPal--unsuccessfully. Western Union launched MoneyZap in fall 2000 with a fee structure similar to PayPal's. Around the same time Citibank introduced c2it. Partnered with giants AOL and Microsoft, c2it seemed to present a formidable threat. However, c2it charged higher fees than PayPal--$2 per transaction--and it was not able to make significant inroads into PayPal's customer base. eBay had also attempted to break PayPal's hold on its auction market with its own Billpoint Inc. However, by the end of 2001 PayPal seemed firmly lodged in front of its competitors. It continued to hold a 65 percent share of the online payments market. "Big players tend to not be innovators," Peter Thiel told Information Week in June 2001. "While Western Union and c2it have been adept at trying to copy what we do, thus far, they haven't gotten a lot of traction. I'm much less scared than I was a year ago, when they were first announced."
When PayPal announced On September 28, 2001, that it would make an initial public stock offering (IPO), the investment community was stunned. The move was unexpected for a number of reasons. First, as a result of the recession in the Internet economy that began in 2000, there had been but a single Internet stock offering in all of 2001. Second, the terrorist attacks on the World Trade Center and Pentagon which had occurred less than three weeks prior seemed to be fueling a general U.S. recession. Third, although PayPal had boosted its revenues from $5.6 million for the first three quarters in 2000 to $64.4 million for the same period in 2001, its losses still totaled just under $90 million, and it had never had a profitable quarter. Equally puzzling was the fact that, besides being leagues ahead of its competitors, the company did not seem to need money. Thanks to hefty infusions of venture capital early in 2001, PayPal had sufficient operating funds for two more years. Some observers, like those at Business Week, speculated that the company was still concerned about its powerful competitors and hoped the IPO would help secure its leading market. A specific concern was that eBay would ban PayPal from its site to strengthen its Billpoint service. Analysts considered PayPal's unsuccessful attempts to sell itself to eBay, Citibank, or other companies earlier in 2001 as another motivation for the offering. The IPO was seen as an attempt to pressure potential buyers to meet PayPal's asking price.
Going Public and Gaining New Parentage
The IPO was first scheduled to take place in late January 2002, but events conspired to delay the stock offering. First, CertCo Inc. sued PayPal for patent violation. More threatening, however, was that banking regulators in 13 states, including Louisiana, California, and New York, accused PayPal of acting illegally as a bank in accepting deposits for the purpose of paying bills. PayPal was forced to suspended service in Louisiana pending a resolution of the problem, and its status in the lucrative New York and California markets was cast into doubt. PayPal denied its status as a bank in that it did not make loans; it termed itself a "money transmitter" on the order of Western Union. Although each state would have to rule on the question individually, a February 15, 2002, ruling issued by the Federal Deposit Insurance Corporation (FDIC) stated that for purposes of the Federal Deposit Insurance Act, PayPal was not a bank as long as it placed its customers' money in separate accounts in an outside bank. The ruling was interpreted as a sign that PayPal would eventually be allowed to continue its business in most states.
These questions would not be resolved until after the IPO, however, and they were expected to hold down the price the company could ask for its 5.4 million shares. Despite PayPal's legal difficulties and the problematic experiences of Internet stocks in general, the first day of trading was hugely successful. From an opening price of $13, PayPal shares rose to $21.61. Investors were apparently convinced of the company's potential to become the Internet payment network of the future, one that might even challenge the big credit card companies. Unlike many earlier dot com IPOs, PayPal's had gained the confidence of investors that it would eventually earn money.
More difficulties arose after PayPal went public. The company was targeted by a class action suit which charged it had illegally restricted customer access to accounts. PayPal had a history of customer service woes, which arose in large measure from a fundamental dilemma inherent in the firm's business model. PayPal was committed to having service that was as quick and uncomplicated to use as possible. However, because it enabled virtually anonymous transfers of money, it was prey to fraud, which occurred when Russian criminals used PayPal accounts and stolen credit cards to steal thousands of dollars. To the company's distress, PayPal, as a "card-not-present merchant" (it had neither signatures from the cardholders nor face-to-face contact) was responsible for the stolen money, rather than the credit card company.
As a consequence, PayPal introduced a security system, which it dubbed Igor in honor of the unknown Russian thieves. Igor verified the existence of bank accounts by sending small amounts of money to applicants. It also analyzed buying and selling patterns in PayPal accounts. If it noticed an apparent irregularity--for example if an account that had previously made sales under $50 suddenly made a sale of $1,000--funds in the account would be frozen. Igor worked. It cut fraud on PayPal to 0.85 percent compared to an Internet average of 2.64 percent. Unfortunately PayPal tended to err on the side of caution and innocent buyers and sellers were too frequently denied access to the money in their PayPal accounts. To make matters worse, once cut off, PayPal users found it extremely difficult to clear up misunderstandings with the company. PayPal continued to struggle with consumer service woes in late summer 2002.
Rumors circulated in the summer of 2002 that PayPal would be the target of a buyout by a bank, a credit card company, or eBay, the operator of its main competitor, Billpoint, since renamed eBay Payments. In July, the rumors came true. PayPal announced that it had agreed to be acquired by eBay Inc. for $1.5 billion in eBay stock. EBay's strategy was clear. Try as it might, Billpoint had been unable to make up significant ground against PayPal, even on its home eBay turf where, according to PayPal's statistics, 70 percent of sellers accepted PayPal compared to only 30 percent for Billpoint. The acquisition was beneficial for both companies: it gave eBay full control over a significant portion of its payments and increased the amount it took from each transaction from 7 to 10 percent. It also made it possible for eBay to shutter the unprofitable Billpoint operation, which it did as soon as the PayPal acquisition was finalized. For PayPal, the merger signaled the end of a period of uncertainty about steps eBay might take to cut it out of its auction market. While the company remained an independent entity under its former management team, its service was integrated directly into eBay's online software, enabling sellers to offer it more easily and prominently.
Not everyone was pleased by the sale however. Some PayPal shareholders felt the company had been strong-armed by eBay into selling for only $19 a share, a price they considered low. As a result, at least four lawsuits were filed, in Delaware and California, in an attempt to block the deal. A more likely explanation for the quick deal, in the view of the Wall Street Journal, was an awareness on the part of the PayPal board that several venture capitalists with sizable holdings were likely to sell their stakes soon. EBay, with five times more outstanding shares, could absorb a large volume of insider selling much better than PayPal could have on its own.
The sale had other disadvantages for PayPal as well. PayPal began, as one analyst told the New York Times, as "a unique payment platform on the Internet and is ending up a company whose focus is a niche market"--namely the eBay auction market. EBay quickly announced that PayPal would no longer be available for online gambling, a decision made after the attorney general of New York State subpoenaed PayPal for records of its business with online casinos. Some major credit card companies, including Citibank, Bank of America, and Chase Manhattan Bank had already agreed to block their customers from using cards for online gaming. Internet gambling accounted for $117 million of the company's $1.46 billion in revenues, approximately 7 percent, during the first half of 2002. Nonetheless the company had once considered online gambling an important enough revenue source to spend $80,000 in 2001 lobbying Congress to approve online gambling. EBay elected to let PayPal continue to operate in the area of online pornography, which unlike gambling, was legal.
At the end of August 2002, regulators at the Department of Justice had decided there were no antitrust factors that would block the merger with eBay. At the same time PayPal reached a formal agreement with the New York attorney general to pay a $200,000 fine for allowing its service to be used in online gambling and to ban users from paying gambling debts with PayPal in the future. In addition, the company agreed to monitor users and report possibly illegal activities to law enforcement agencies. A similar lawsuit, filed by the U.S. District Court in St. Louis, proved more costly to PayPal and eBay, however. In August 2003, PayPal agreed to settle the suit, which alleged that it had violated offshore online gaming laws, for $10 million. Also during this time, citing high fraud rates, PayPal discontinued the offer of its services on adult-content websites. Amidst the legal wrangling and the constant efforts to maintain its security, PayPal was lauded by industry observers for successfully addressing its consumer service issues.
Key Dates:
1998: Peter Thiel and Max Levchin found Field Link, soon renamed Confinity.
1999: Confinity launches first version of the PayPal electronic payments system.
2000: Confinity is acquired by X.com Corporation.
2001: X.com makes initial offering of stock on NASDAQ; firm is renamed PayPal Inc.
2002: eBay Inc. acquires PayPal for $1.5 billion in stock.
Source: www.footballshirtculture.com
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