Late Wednesday evening, the founders behind Mailpile, a privacy-centric email client that's already raised north of $130,000 on Indiegogo, received a message no crowdfunder wants to hear: PayPal had frozen about one-third of the funds in their account. 

The company's co-founder writes:

Afer four phone calls, the last of which I spoke to a supervisor, the understanding I have come to is, unless Mailpile provides PayPal with a detailed budgetary breakdown of how we plan to use the donations from our crowdfunding campaign they will not release the block on my account for one year until we have shipped a 1.0 version of our product...

This puts us in an incredibly uncomfortable position as we do not feel that it's remotely in their jurisdiction to ask for a detailed budget of our business, any more than it is within our right to ask for theirs.

Mailpile is hardly the first campaign (or small business, for that matter) to suffer from PayPal's seemingly draconian policies directed against crowdfunders. Earlier this month, GlassUP, which is creating augmented reality glasses, PayPal froze its account on Indiegogo. And back in April, PayPal froze nearly $1 million in game developer Lab Zero's Indiegogo account for similar reasons. 

PayPal's Rationale

While writing this story, I reached out to PayPal to see if the company wanted to respond for a comment. Here's what I received: 

We have reached out to @MailPile and the limitation has been lifted. Supporting crowdfunding campaigns is an exciting new part of our business. We are working closely with industry leaders like Indiegogo and adapting our processes and policies to better serve the innovative companies that are relying on PayPal and crowdfunding campaigns to grow their businesses. We never want to get in the way of innovation, but as a global payments company we must ensure the payments flowing through our system around the world are in compliance with laws and regulations. We understand that the way in which we are complying to these rules can be frustrating in some cases and we've made significant changes in North America to adapt to the unique needs of crowdfunding campaigns [emphasis added]. We are currently working to roll these improvements out around the world.

Shortly after I received the email, I spoke with a company representative. I asked him, specificially, what sorts of "significant changes" had been made. His answer was fairly opaque, saying "We're working with Indiegogo to drive best practices."  

Now, back to Mailpile. 

The PayPal representative can't or won't comment on specific campaigns, but it's pretty clear that generally speaking, PayPal's justifications for the frozen accounts stems from an altogether reasonable concern over fraud and chargebacks. Namely, if a crowdfunder fails to deliver the product and/or service, customers will likely file for a refund with the credit card company, which the credit company then passes along to PayPal.

Normally, PayPal will then try to defer that chargeback to the merchant, but in crowdfunding, where a merchant's account might be depleted by the time a chargeback is issued, there's essentially no guarantee that PayPal would be able to recoup the charges. 

PayPal, then, is fairly aggressive in sniffing out projects that might be potentially fraudulent.

One commenter on Hacker News accurately sums up PayPal's crowdfunding dilemma, writing:

Why is Paypal very skeptical of pre-sales? Because, if the business fails (as new businesses often do), customers will file chargebacks. Their banks will hear "Internet merchant did not deliver as promised" and sustain the chargeback automatically. Paypal will lose that argument with the bank, 99.999% of the time, and have to seek restitution from the merchant.

Paypal has to do underwriting--basically, guessing at probable risks and likelihood of partial repayment--for new merchant accounts. What percentage of sales are at risk of chargeback in a pre-sales business? A Very High Percentage (TM). What is the probable chance of failure of a new business in developing a new product? Fairly high. Given product failure, what assets will be available to Paypal (in the Paypal account or the linked bank account) for automatic recovery from the failed business? Very Little (TM). What is Paypal's margin on this business? A fraction of a percent.

PayPal at a Crossroads

Clearly, the growth of crowdfunding and pre-sales presents a new paradigm for PayPal's fraud detection and risk departments. In the past, PayPal's fraud detection alarm bells were largely triggered by anomalous activity--massive inflows or outflows of cash from accounts that don't typically see a lot of activity. (The company literally employs "hundreds of mathematics scholars with Ph.D.s" to monitor activity in the system.) Still, some believe the company has not caught up. Peter McElwee, writing at The Quantum Capital Fund Investment News, writes that PayPal simply doesn't "get" crowdfunding:

The problem lies not in a malicious intent on behalf of PayPal but their lack of understanding of how crowdfunding works.... 

It was somewhat interesting to see how swiftly PayPal reversed its decision against Mailpile. Perhaps they were afraid of yet another PR disaster, like when they shut down a charity Secret Santa campaign. 

It's a critical moment for PayPal, especially as competitors--including WePay, Stripe, and Amazon Payments--are gaining traction amongst entrepreneurs who are, perhaps quite justly, fed up with PayPal's crowdfunding policies.