The unicorn club is ready for one of its first big exits, as Square announced it was going public last week. The payments company's announcement was met with a pretty tepid response from analysts and investors, despite its being on track for more than a billion dollars in net revenue for 2015. Why? Even with Square's strong revenue growth, there are a number of reasons to be worried.
1. Little room for error.
Square's growing topline numbers belie its weak competitive position and razor-thin margins. For starters, Square doesn't occupy a large piece of the payments value chain. As its IPO filing shows, Square operates as a "payment services provider" and has to rely on an acquiring processor to actually connect it to card networks and issuing banks.
Essentially what this means is that Square is a service provider for merchants. Its business model is to charge its merchants a fixed fee of 2.75 percent for most transactions and then try to minimize the actual processing costs for the transaction. Because Square occupies such a small part of the ecosystem, it often ends up paying more than two-thirds of that amount in transaction costs to the acquiring processor, card networks, and issuing banks.
At the end of the day, Square keeps only about 1 percent of all the payments it processes. And that's before operating expenses are accounted for. Square makes better margins on some of its add-on services, which include analytics and marketing solutions, but so far these add-ons haven't made much of a dent. According to Square's IPO filing, payments revenue still makes up 97 percent of its overall business.
2. Square talks like a platform but acts like a services company.
Square has worked hard to brand itself as more than a payment processor, but the underlying business doesn't reflect its image.
While Square talks like a platform that connects consumers and merchants, it acts like a simple product and services company. For example, Square likes to boast about its "network" of merchants, but in practice this network has no substantial network effect.
If other merchants join Square, the company's existing customer base gets no direct benefit. And consumers don't particularly care whether or not a merchant uses Square -- most are still just swiping their credit cards. In other words, Square's "network" is not so much a real network as just the aggregate of its merchant customers.
Now that it has to go on the record for its public offering, the company has had to admit where its business really stands. As Square's IPO filing says, "We derive substantially all of our revenue from payments services. Our efforts to expand our product portfolio and market reach may not succeed and may reduce our revenue growth."
In other words, Square is really just a service provider to merchants. Any hopes that it could be more than that are so far just aspirational. The company has made several attempts to bring consumers into the fold, but they have met with little success.
3. High burn rates with no end in sight.
Why does this matter? Well, it's all about the money. Platform companies typically enjoy substantially better profit margins than equivalent product or service companies, especially at scale. And when you look at the numbers, Square looks a lot more like the latter.
While Square grew its transaction revenue by 124 percent from 2012 to 2013, its transaction costs grew almost in lock step, at 120 percent. The next year saw a similar result, as year-over-year revenue grew by 63 percent, from $433 million to $707 million, while its transaction costs increased by a nearly identical 62 percent percent, growing from $277 million to $450 million.
In other words, there's little evidence that scale will substantially improve the company's profits. If there's any sign of a network effect here, I can't find it. Square's high burn rate (it lost $154 million in 2014) isn't going away any time soon.
When you compare Square with a true payments platform like PayPal, the difference is even clearer. Square's cost-to-revenue ratio is more than 60 percent, while PayPal's ratio for the first half of this year was about 30 percent. It spent $1.2 billion on transaction costs to process $3.9 billion in payments.
Because PayPal is a platform--meaning it owns both the consumer and merchant relationships--it can incentivize both sets of users to adopt less costly ways to transact, such as debit cards, direct withdrawal from bank accounts, or a PayPal-branded card. These payment methods all incur substantially lower transaction costs than traditional credit cards do.
PayPal's ability to minimize its transaction costs as its network grows has been a key part of its sustained success. As a simple services company, it's not clear that Square has a way to do the same.
4. Payment processing is a commodity business.
Square's lack of network effects doesn't just hurt its profit margin, it also diminishes the company's competitive position. While Square is a leading payments processor for small businesses in the U.S., analyst estimates have its share of this market hovering at around 10 percent. That's not a particularly impressive number.
Without a strong network effect, Square has no real moat to defend itself against competition. Payment processing is a commodity business, won and lost on price. And there are now a lot of strong competitors in the industry.
According to Bloomberg, there are more than 80 companies that offer card readers similar to Square's, often for less money and with more features. This includes Amazon's recently introduced Local Register, as well as PayPal, which is now free to focus on the competition after its split from eBay.
Herein lies the rub: Features are easy to copy, while networks aren't. Products get commoditized. Networks don't. Because Square hasn't been able to evolve into a true platform company, its core business is going to continue to get squeezed as more (and better capitalized) competitors enter the market.
So why now?
With all this in mind, why did Square decide to file for an IPO now? Well, rumor has it the company was unable to garner much interest in another round of private financing. Given its high burn rate, the company needs to raise more money to shore up its balance sheet.
An IPO also creates a liquidity event for employees who own a lot of stock. Going public will likely make it easier for Square to retain key employees and executives.
From Square's point of view, the decision to go public makes sense. However, it's not clear that investors will feel the same. Smart money usually doesn't like to be someone else's exit strategy.
Senior Inc. editor Maria Aspan's article The Big Problem With Square's IPO reflects a similar point of view about Square's prospects as a public company.