Paypal in 2015 reshaping the financial services landscape

CASE: E-572 DATE: 11/12/15

Henry Lippincott (MBA 2014), Lecturer Robert Siegel, and Professor Robert Burgelman prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright © 2015 by the Board of Trustees of the Leland Stanford Junior University. Publicly available cases are distributed through Harvard Business Publishing at hbsp.harvard.edu and The Case Centre at thecasecentre.org; please contact them to order copies and request permission to reproduce materials. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means –– electronic, mechanical, photocopying, recording, or otherwise –– without the permission of the Stanford Graduate School of Business. Every effort has been made to respect copyright and to contact copyright holders as appropriate. If you are a copyright holder and have concerns, please contact the Case Writing Office at cwo@stanford.edu or write to Case Writing Office, Stanford Graduate School of Business, Knight Management Center, 655 Knight Way, Stanford University, Stanford, CA 94305-5015.

PAYPAL IN 2015: RESHAPING THE FINANCIAL SERVICES LANDSCAPE

The histories of the largest companies are that their biggest impediment to their future success is their past success

1 —Dan Schulman, CEO, PayPal

In 2015, PayPal sat at the epicenter of digital commerce, which expected to account for $2.3 trillion in global purchase volume by 2017 (see Exhibit 1). The company provided payment solutions to over 170 million active customers across more than 200 markets and was on track to process over five billion payments that year. PayPal was founded in 1998, at a time when e- commerce was the driving force behind digital payments, but the market had since grown in size and complexity over the subsequent 17 years. By 2015, PayPal’s platform spanned the entire digital financial system, offering services that included payment processing, digital wallets, merchant accounts, peer-to-peer money transfers, single touch transactions, consumer and merchant credit, risk analysis, fraud prevention, and regulatory compliance. On July 20, 2015, PayPal CEO Dan Schulman was excited to ring the opening bell at the NASDAQ Stock Exchange. PayPal was relisting on the exchange as an independent company after an absence of more than a decade, having last traded 13 years earlier before its acquisition by eBay. While excited about the company’s many new opportunities now that it was no longer owned by one of the world’s largest online marketplaces, Schulman pondered the changing landscape of financial services for global consumers. Individuals were now able to conduct transactions from their smartphones, loans could be sourced outside of traditional banking infrastructures and the very method of determining consumer credit worthiness was changing—

1 Interview with Dan Schulman, CEO of PayPal, September 8, 2015. Subsequent quotes are from this interview, unless otherwise noted.

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especially in emerging economies. PayPal, with its unique size and position as a global leader in digital financial services, had the chance to disproportionally impact the lives of people all over the world. Schulman had joined PayPal nine months earlier to prepare for its separation from eBay and ultimately lead PayPal into the next phase of its journey as an independent company. With the daunting task of decoupling PayPal from eBay’s business behind him, and the monumental task of guiding PayPal’s transformation in front of him, Schulman reflected on the previous nine months.

SEPARATION FROM THE MOTHER SHIP

Even before Schulman joined PayPal in September 2014, there were discussions of a split between eBay and PayPal. After a decade under eBay’s roof, PayPal’s business had fundamentally changed. PayPal was originally a payments provider for e-commerce transactions, many from within eBay, but had transformed alongside an increasingly complex digital payments industry. The share of PayPal’s business derived from eBay had steadily declined from 60 percent in 2002 to under 30 percent by 2014.2 With PayPal’s lessening dependence on eBay and the accelerating changes within the digital payments industry, many began to wonder whether PayPal could innovate fast enough within eBay’s walls. Carl Icahn, activist investor and 0.82 percent eBay owner, told a Forbes reporter in early 2014, “PayPal’s a jewel and eBay is covering up its value.”3 In February of that year, Icahn published an open letter to eBay shareholders urging PayPal’s spinoff (see Exhibit 2). Icahn claimed that a split would unleash unrealized value within both businesses, providing each with independent boards and sharper focus. He questioned the ability of eBay’s board to effectively manage two distinct businesses, which continued to decouple year after year. Icahn also believed separate businesses would make each more appealing to work for. Former PayPal CEO Elon Musk agreed with Icahn. “It doesn’t make sense that a global payment system is a subsidiary of an auction website… it’s as if Target owned Visa…”4 PayPal’s business had indeed blossomed under eBay (see Exhibit 3). In 2013, eBay’s marketplace brought in $9.9 billion in revenue compared to PayPal’s $7.2 billion, but PayPal would likely eclipse eBay in the coming years with a projected 19 percent growth rate compared to eBay’s 10 percent.5 Not everyone agreed with Icahn and Musk. The eBay board, in particular, believed that eBay and PayPal should remain together because of the inextricable link between commerce and

2 RBC Capital Markets, “PayPal Holdings, Inc.,” July 20, 2015, p. 37. 3 “Elon Musk And David Sacks Say PayPal Could Top $100B Away From eBay,” Forbes, February 18, 2014, http://www.forbes.com/sites/stevenbertoni/2014/02/18/elon-musk-and-david-sacks-say-paypal-could-top-100- billion-away-from-ebay/ (September 10, 2015). 4 Ibid. 5 “eBay CEO: Why we're spinning off PayPal,” Fortune, September 30, 2014, http://fortune.com/2014/09/30/ebay- ceo-why-were-spinning-off-paypal/ (September 10, 2015).

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payments (see Exhibit 4). In a CNBC interview, eBay CEO John Donahoe responded to Icahn’s open letter:

What that argument is missing is the very strong synergies between the two businesses. It’s noteworthy that there has not been anyone else who has created another PayPal since PayPal was created. And that’s because commerce and payments are converging into one thing. A payments network needs a commerce network like eBay… As more online payment and commerce services converge into a more seamless experience, the growth of mobile shopping makes that trend even more important.6

Less than six months later, on September 30, 2014, eBay announced its plan to split the two businesses. According to Donahoe, eBay’s board concluded that a split would be best for both businesses. “The synergies which helped fuel [PayPal’s growth] are declining over time.”7 The eBay announcement highlighted the increasing competitiveness and speed of innovation within the markets of each business, requiring sharper strategic focus for both—and the belief that the relationship between the two companies could be optimized in arm’s-length operating agreements between the companies. Investors responded positively to the news, with eBay’s stock price jumping 7 percent that day. As part of the announcement, Schulman was named president of PayPal and CEO-designee once the separation from eBay was complete. Before Schulman had the opportunity to chart PayPal’s future as a separate company, he faced a monumental challenge: decoupling all of PayPal’s businesses and technologies from eBay, and building the new systems necessary for PayPal to stand as an independent Fortune 100 company, all within a nine-month span. Schulman took the opportunity to study PayPal’s history during those nine months while in the process of separating the firm’s past from its future.

BEGINNINGS AND EXPANSION WITHIN E BAY

PayPal began as the money transfer service of Confinity, a start-up founded in 1998 by Max Levchin and Peter Thiel.8 With a convenient and simple setup process (only a verified e-mail address and credit or bank card number were needed), a user could within minutes send and receive money to and from other PayPal users. The ease and convenience of PayPal registration quickly attracted eBay sellers, many of whom were too small to qualify for merchant accounts with credit card companies and thus lacked commercial credit histories. In March of 2000, with over 1 million accounts, Confinity merged with X.com, an online banking business founded by Elon Musk, with Musk taking the helm as chairman and CEO.

6 “PayPal is stronger staying with eBay: EBay CEO John Donahoe,” CNBC, January 23, 2014, http://www.cnbc.com/2014/01/23/paypal-is-stronger-staying-with-ebay-ebay-ceo-john-donahoe.html (September 10, 2015). 7 “eBay CEO: Why we're spinning off PayPal,” September 30, 2014, Fortune, http://fortune.com/2014/09/30/ebay- ceo-why-were-spinning-off-paypal/ (September 10, 2015). 8 PayPal Press Centre, “History,” https://www.paypal-media.com/au/history (September 10, 2015).

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PayPal became popular among eBay sellers because it covered their credit card processing fees. Importantly, PayPal served both sides of every transaction, enabling it to verify that both the buyer and seller had reputable histories, unlike traditional credit card transactions where different banks represented each party in a transaction. PayPal reduced the frequency of fraudulent transactions, requiring not only a credit or debit card number to complete a transaction, but a username and password combination as well. This “dual factor” authentication reduced dispute rates by as much as a factor of six.9 In addition to being popular among eBay sellers, PayPal was also popular among buyers because buyers did not need to disclose their credit card or bank account numbers to sellers when using PayPal, reducing the risk of fraud. By the end of 2001, more than 60 percent of PayPal’s business occurred between buyers and sellers on eBay and over 70 percent of eBay auctions accepted PayPal’s payments.10 PayPal’s presence did not go unnoticed at eBay headquarters. In an effort to capitalize on the opportunity that PayPal had uncovered, eBay launched Billpoint, its own payment service, in March of 2000. Billpoint never gained enough traction to become a viable alternative to PayPal and was shut down in 2002. PayPal went public in February of 2002 with 12.2 million personal accounts and 3.2 million business accounts, handling roughly 124 million transactions worth $6.8 billion.11 Just five months later in July of that year, eBay acquired PayPal for $1.5 billion.

BEYOND EBAY—MERCHANT SERVICES

Over the next several years, PayPal continued to be the preferred payment option for the majority of eBay transactions. By 2005, eBay represented 13 percent of all U.S. e-commerce transactions, making it the largest e-commerce company in the world, fueling PayPal’s concurrent growth.12 While PayPal was used in 78 percent of all eBay transactions, it processed less than 4 percent of all “off-eBay” U.S. e-commerce transactions.13 In an effort to pursue the $143 billion “off-eBay” opportunity, PayPal launched Merchant Services in late 2003.14 Merchant Services provided similar payment solutions to merchants outside the eBay auction community as PayPal had provided those within eBay. The company targeted small-to-medium and large online merchants ($250k to $5 million + in annual online sales), which collectively represented a $116 billion annual opportunity. Despite the dominant position of credit and debit cards as the main payment option for these merchants, PayPal offered a number of significant benefits to merchants and to their customers, which enabled the widespread adoption of Merchant Services. Like those within eBay, many small to midsized merchants “off-eBay” were too small to qualify for merchant accounts with credit card companies and were searching for alternative payment

9 For further information, see “PayPal Merchant Services,” HBS No. 9-806-188, p. 5. 10 For further information, see “eBay (C): PayPal Merger,” HBS No. 9-603-042, p. 2. 11 PayPal, Inc., March 31, 2002 Form S-1 (filed June 12, 2002), via Securities and Exchange Commission (September 10, 2015). 12 For further information, see “PayPal Merchant Services,” HBS No. 9-806-188, p. 1. 13 Ibid. 14 “Annual desktop B2C e-commerce sales in the United States from 2002 to 2014,” Statista, http://www.statista.com/statistics/271449/annual-b2c-e-commerce-sales-in-the-united-states/ (September 10, 2015).

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solutions. At the time, many consumers were still fearful of sharing credit and debit card information online. PayPal’s Merchant Services enabled merchants to reach those customers in addition to online shoppers who didn’t have credit or debit cards. By 2005, PayPal launched Website Payments Pro, which offered Express Checkout and Direct Payments API, both of which enabled sellers to accept credit card payments from buyers without PayPal accounts. This optionality enabled merchants to reach more shoppers and potentially increase sales. PayPal initially offered its payment services for free to both consumers and merchants, hoping to earn interest on users’ PayPal account balances. Unfortunately, users rarely kept balances in their PayPal accounts and funded most payments using credit cards. PayPal also covered the 2 percent card processing fees for merchants, which soon became unsustainable. Beginning in 2001, PayPal users receiving more than $500 worth of payments funded by credit cards were upgraded to “business accounts” and charged $0.25 per transaction in addition to 1.9 percent of transaction value.15 Over time these fees varied by market segment, and in the United States they grew to $0.30 per transaction and 2.9% of total transaction value. By 2014, these fees generated 89 percent of PayPal’s $8 billion in revenue for the year, with the remaining 11 percent driven by other services including subscription and gateway fees, and credit loans.16 PayPal’s continued success within and outside of eBay was celebrated in Silicon Valley and the broader business world. Many competing products and services backed by some of the world’s most renowned companies emerged to rival PayPal, but without success—Citigroup’s c2it, First Data Corp.’s BidPay, Yahoo!’s PayDirect—to name a few. Many thought PayPal’s dominance would end with the 2006 launch of Google Checkout, a service that enabled customers to store their payment and shipping information in their Google accounts to make purchases from participating online vendors with the click of an on-screen button. Google Checkout closed in 2013, never having gained substantive market traction. While PayPal continued to extend its e- commerce footprint within and outside of eBay, the digital payments industry was about to experience a fundamental change.

THE MOBILE REVOLUTION

With the introduction of Apple’s first iPhone in 2007, the smartphone era and its corresponding impact on mobile computing took off. Within a year, smartphones drove 11 percent of all mobile phone sales and reached 40 percent market share by 2011. Soon after the wider adoption of smartphones came their use in making digital payments. Consumers began to use Web browsers on their smartphones to shop online, giving rise to mobile commerce, or m-commerce. By 2012, Walmart reported that 40 percent of all visits to their website were from smartphones.17

15 For further information, see “PayPal Merchant Services,” HBS No. 9-806-188, p. 3. 16 Deutsche Bank Markets Research, “The Way to Play Digital Payments,” July 12, 2015, p. 4. 17 “Mobile chief predicts 40% of Wal-Mart’s holiday web traffic will be mobile,” Internet Retailer, November 12, 2012, https://www.internetretailer.com/2012/11/12/40-wal-marts-holiday-web-traffic-will-be-mobile, (September 10, 2015).

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By 2011, just four years after the release of the first iPhone, m-commerce generated $10 billion annually and represented 7 percent of total e-commerce.18 Over 10 percent of PayPal customers had completed transactions on their smartphones and by 2014, PayPal was processing $27 billion in mobile payments (see Exhibits 5 and 6).19 With the phenomenal penetration rate of smartphones and growth in m-commerce, merchants began launching smartphone applications to enhance the customer browsing experience and wanted to add checkout functionality to drive more sales.

Mobile “In-App” Payments

When smartphones initially launched, consumers used the Web browser within their smartphones to shop on merchant websites. However, using a four-inch screen to browse a website designed for a larger computer monitor was challenging, evidenced by the fact that checkout conversion was significantly lower in mobile than on desktop devices. To solve this problem, merchants developed smartphone applications (apps) that provided a shopping experience optimized for smartphone use. As part of this process, merchants wanted payment solutions integrated into their applications to offer a seamless shopping and checkout experience without leaving the app. These “in-app” payment features offered customers convenience, with increased transaction speed and ease of use without having to pay by card. Merchants hoped in- app payment functionality would increase checkout conversion as well. Integrating a frictionless mobile payment experience within an app was incredibly complicated and building custom solutions were prohibitively expensive for all but the largest merchants. As a result, a new class of companies capitalized on this opportunity, providing both “payment gateway” and merchant account services for m-commerce merchants and mobile app developers. Braintree Founded in 2007, Braintree offered a platform of white-label tools for mobile app developers and m-commerce merchants to easily and securely accept payments within their mobile apps. Braintree could store credit and debit card credentials, authorize payments, and process them securely with a user’s merchant account (see Exhibit 7). Customers could experience a complete, frictionless shopping and checkout experience, all without leaving the app. Unlike traditional payment gateways including Visa’s Authorize.net, which were cumbersome to integrate, Braintree offered an extensive set of application programming interfaces (APIs), which were available more than a year before other alternative solutions and meant the company’s technology could easily be embedded within a mobile app with just a few lines of code. As a result, developers could quickly implement payment solutions on their websites or in their mobile apps. Braintree also found an opportunity to offer payment solutions to companies wanting to digitize the payments of historically offline physical transactions, such as paying a taxi driver or booking a last-minute hotel room. Braintree was responsible for building the payment platform that

18 “Q2 M-Commerce Explodes to 47% Y/Y Gain: What it Means for the Growth of Mobile,” comScore, August 19, 2014, https://www.comscore.com/Insights/Blog/Q2-M-Commerce-Explodes-to-47-YY-Gain-What-it-Means-for- the-Growth-of-Mobile (September 10, 2015). 19 “PayPal Processed $27 Billion in Mobile Payments in 2013,” Bank Innovation, January 23, 2014, http://bankinnovation.net/2014/01/paypal-processed-27-billion-in-mobile-payments-in-2013/ (September 10, 2015).

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enabled mobile payments in many of the apps that shaped the beginning and growth of mobile commerce, including Uber Technologies’ ride-hailing app launched in 2009, Airbnb’s room booking app in 2009, and Hotel Tonight’s last-minute hotel booking app launched in 2010. In-app payment revenue reached a mere $712 million in 2011, but was expected to balloon to $37 billion by 2017.20 By 2013, in-app payment revenue accounted for 70 percent of U.S. iPhone app revenue and 90 percent of iPhone app revenue in Asian markets.21 One of Braintree’s main competitors, Stripe, also gained traction within the market after Braintree launched, and by 2015 was valued at $5 billion (see Exhibit 8). To capitalize on this opportunity, PayPal acquired Braintree in 2013 for $800 million. PayPal’s acquisition extended its reach to in-app payments in addition to Braintree’s list of significant customers, which included OpenTable, LivingSocial, Uber Technologies, and Airbnb, among others. Braintree’s then-CEO, William Ready, went on to become PayPal’s senior vice President and global head of product and engineering.

From “In-App” to “In-Store”

Traditional brick-and-mortar merchants also found use in smartphone devices as replacements for the age-old physical point-of-sale (POS) cash registers. In 2009, Twitter cofounder Jack Dorsey launched Square, which offered a small, square-shaped piece of hardware that plugged into a smartphone’s audio jack and translated the information from a credit card’s magnetic strip into an audio signal that was then processed by a downloadable smartphone app (see Exhibit 8). The customer would then sign for the purchase on the smartphone using his or her finger. The device, affectionately known as a dongle, essentially transformed a smartphone into a mobile POS (mPOS) cash register. When PayPal launched its competing mPOS product in 2012, Square was already processing $4 billion worth of transactions annually.22 PayPal Here relied on the same technology as Square and at its launch, the only notable difference between the two products seemed to be their shape—PayPal’s was triangular. PayPal Here had the added ability to accept checks and could be directly linked to a PayPal account. mPOS terminals like Square and PayPal Here became popular among small to medium-sized brick-and-mortar merchants as well as sole proprietorships. Unlike traditional POS systems which were expensive, most new mPOS terminals offered customers no upfront cost and were ideal for wireless transactions in temporary locations like conventions, mobile repair businesses, and other professional services.

20 “Gartner Says Worldwide Mobile Payment Transaction Value to Surpass $235 Billion in 2013,” Gartner, June 4, 2013, http://www.gartner.com/newsroom/id/2504915 (September 10, 2015). 21 “In-App Purchase Revenue Hits Record High: Accounts For 76% Of U.S. iPhone App Revenue, 90% In Asian Markets,” TechCrunch, March 28, 2013, http://techcrunch.com/2013/03/28/in-app-purchase-revenue-hits-record- high-accounts-for-76-of-u-s-iphone-app-revenue-90-in-asian-markets/ (September 10, 2015). 22 Ibid.

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The market for mPOS terminals was growing rapidly at the time—sales grew from 4.5 million terminals in 2011 to 9.5 million in 2012, and were forecasted to reach annual sales of 38 million terminals by 2017.23 mPOS penetration in the broader POS market was deepening quickly as well, from 17 percent in 2012 to a forecasted 47 percent by 2017.24

The Wallet Wars

As digital payments continued to integrate more seamlessly into the smartphone experience, companies attempted to develop products for smartphones that would securely store a user’s payment information to be used anytime and anywhere for payments and transfers. Digital wallets, as they came to be known, securely stored multiple payment credentials and could be used online, on mobile devices, in mobile apps, and at physical POS locations. Many digital wallets in development had the ability to store loyalty cards and coupons as well. In addition to aggregating and storing payment credentials, most digital wallets relied on an embedded technology (Near Field Communication [NFC] chips, QR codes, or Bluetooth Low Energy [BLE], for example), which enabled users to complete transactions without actually having to swipe their cards at physical POS locations. Depending on the embedded technology used, instead of swiping, users would tap or scan their mobile smartphones on a physical payment terminal to complete a transaction. Convenience and security were seen as the clear benefits for consumer adoption of digital wallets, and the potential for superior customer engagement, loyalty, and higher checkout conversion were seen as the benefits for merchant adoption. With the successful digitization of payments in e-commerce and mobile, it only seemed intuitive that one of the next advances in digitization would be found in the consumer’s back pocket when shopping in stores. The year 2010 marked the beginning of an era for various digital wallet products from a variety of different companies (see Exhibit 8). Internet companies including Amazon; payment gateways including Stripe; the major payment networks including Visa, MasterCard, American Express, and Discover; acquirers including Vantiv and Global Payments, Inc.; and phone manufacturers including Apple and Samsung all entered the race to build the market-leading digital wallet. Even mobile carriers including AT&T, T-Mobile, and Verizon were drawn to the potential of digital wallets, developing their own digital wallet platform known as Softcard (formerly Isis). Despite all of these efforts, digital wallet platforms had been unsuccessful at gaining traction in stores among merchants and consumers alike by 2014. The significant majority of POS terminals in use at the time were incompatible with the embedded technologies used by most

23 “Research Reveals Growth and Challenges of Mobile POS,” April 23, 2013, Hospitality Technology, http://hospitalitytechnology.edgl.com/news/Research-Reveals-Growth-and-Challenges-of-Mobile-POS--86071 (September 10, 2015). 24 Ibid.

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digital wallets. NFC technology in particular was not an industry standard at the time. Even by 2014, less than 3 percent of POS terminals were NFC-enabled.25 Upgrading to NFC-enabled terminals was expensive for retailers and consumers seemed ambivalent towards digital wallets. A 2014 survey conducted by Thrive Analytics showed that while 80 percent of consumers were aware of the existence of digital wallets, less than a third used one.26 As Braintree CEO Bill Ready phrased it, “In the life of a consumer, there are few things a consumer will ever do that are easier than swiping their cards at checkout. Consumers adopt solutions to pain points very quickly. Tap and Pay wasn’t really solving a pain point for consumers with credit cards. No one’s waking up saying ‘you know if only I could tap my phone instead of swipe my card.’” Additionally, the competing interests among the various players inhibited widespread adoption of digital wallets. Mobile carriers and smartphone manufacturers blocked operating system (OS) platforms, and OS platforms blocked PayPal. PayPal Mobile Payments In 2012, PayPal launched PayPal Mobile Payments in stores. Users could download the PayPal app onto their smartphone devices and use their smartphone cameras to scan product bar codes within participating stores to authorize payment. Within the app, the users would then choose which stored payment method to use for transactions and tap a button on their smartphones to pay. PayPal also piloted a number of other in-store payment methods for its digital wallet including the use of PIN pads, mobile bar code readers, and QR codes, to a name a few. By January 2013, PayPal was available at 18,000 retail locations around the United States with 23 major retailers as customers including Home Depot, Office Depot, Toys “R” Us, Abercrombie & Fitch, Barnes & Noble, and Foot Locker.27 Unlike Apple, Microsoft, and Google, all of which had competing operating systems, PayPal had the potential to offer a digital wallet that was OS-agnostic. And unlike Apple, Samsung, and PC manufacturers, all of which manufactured competing smartphone devices, PayPal could offer a digital wallet that was hardware-agnostic. Consequently, PayPal had the potential for widespread adoption, particularly among consumers who used multiple devices from multiple companies. Perhaps expectedly, Apple and Samsung decided not to natively support PayPal functionality on their iPhone and Galaxy devices. Paydiant In an effort to strengthen and broaden its position among competing digital wallets, PayPal acquired Paydiant for $280 million in April of 2015. Founded in 2010, Paydiant offered a patented cloud-based digital wallet and payment platform, which allowed merchants and banks 25 “Apple Pay Is Here — and There’s Just One Big Problem,” Money, September 9, 2014, http://time.com/money/3311917/apple-pay-iphone-iwatch-passbook/ (September 10, 2015). 26 “Why Amazon, Google and Apple Haven't Been Able to Crack the Code of Digital Wallets,” Inc., July 23, 2014, http://www.inc.com/jeremy-quittner/amazon-digital-wallet-is-latest-entrant-in-crowded-field.html (September 10, 2015). 27 “Startups clear out cash registers to usher in retail revolution,” Venturebeat, March 28, 2013, http://venturebeat.com/2013/03/28/startups-clear-out-cash-registers-to-usher-in-retail-revolution/ (September 10, 2015).