THE BLOG
05/09/2016 03:57 pm ET | Updated May 09, 2016

The Days of Reckoning for Highly Funded Startups: Square.

There will be a day of reckoning. Sooner or later the investment community will begin to expect sustainable profitability from their highly touted investments, regardless of how photogenic the CEO may appear at conferences. Training wheels will be removed as funding levels taper off and it will be interesting to see if some of these high-flying brands will stand on their own.

We have already seen what happens when the screw turns against companies like Theranos, where the promise of easy blood testing was laid bare by a brutal Wall Street Journal investigative piece. Instead of buying more black turtlenecks, their founder Elizabeth Holmes is trying to salvage her battered credibility and keep her business afloat.

As I looked at the jarring events over at Square, I wonder about their long-term sustainability. Questions linger whether or not the organization founded by Twitter's Jack Dorsey will find long-term profitability, like what is expected by credit card houses like Amex, Visa, or MasterCard, banks like Bank of America, or non-bank processors like Worldpay.

On Friday, alarm bells rang loud in the San Francisco tech sector. While Square continues to sustain an ever-expanding growth track in GPV, which is Gross Payment Volume or annual charge volume, (nearly doubling to $10.3 billion in Q1) and its revenues outpaced expectations (adjusted revenues of $146.2 million, again nearly doubling that figure from same period last year) the Q1 loss also doubled to $98.1 Million from the same period in 2015.

Square's senior team was quick to point out that part of the loss stemmed from a lawsuit settlement surrounding its founding technology, the dongle. However, Square has fallen into the classic trap of growing its expense structure far ahead of its ability to generate revenue. Square's CFO replied that the company "(is) still very much in investment mode" and it serves as a signal to the investment community that there will be more red ink to come. Considering that Square remains a tech darling, those comments should suffice for the short term.

Unlike the train wreck over at Theranos, Square's technology works--and works well. The technology of connecting a dongle (as well as a chip-reading EMV card reader) to a smartphone has served to disrupt payment technology in its most fundamental fashion. An iPad or an iPhone can be transformed into a POS terminal--and it can be as mobile as the business owner so long as there is decent cell coverage.

Square remains a great place for a new business to begin to process bank cards and American Express because of its low barrier to entry, minimal underwriting, and ease of use. When you start an enterprise in your garage or on your dining room table, using Square allows you to quickly embrace a plastic-ready audience.

Square opened up credit card acceptance to whole segments of commercial activity, many of them micro businesses. Many were cash-only due to necessity; accepting Visa or MasterCard was often too much of a hassle or not worth the expense. Square has an easy-to-understand pricing model that starts at 2.75% and moves upward depending upon how merchants transact.

For the past couple of years, Square's senior team has been trying to figure out how to move beyond those micro-merchants and attract larger and more profitable merchant clients.

A brand partnership 2012 with Starbucks was announced with a loud splash but died with a whimper. Starbucks invested $25 Million into Square and soon their 7,000 American locations used Square as their exclusive merchant processor. However, Square lost their shirts to the tune of $71 Million and the relationship ended in 2015, proving once again that technical disruption and profitability often travel on different highways. Square learned the hard way that expectations found within large brands are far different than what they've experienced with smaller micro-merchants.

But here's the rub.

In the payments world, bottom line profitability comes from long-term merchant relationships; you sign them and you keep them. As Square's clients grow their annual charge volume to a certain point, they will find better and cheaper solutions with banks like Chase or Wells, or a non-bank merchant processor like Worldpay. So as merchants graduate into the next stage of growth--it also means they will eventually graduate away from Square.

Also as a merchant grows and becomes more sophisticated, they will need better business tools from their payments provider and Square falls short when compared to its peer group. Most businesses will want better reporting, better chargeback management, or a better understanding how they can manage down their processing fees.

A larger "tell" is found within Friday's statement. In it they state, "In the first quarter of 2016, we processed $10.3 billion of GPV an increase of 45% from the first quarter of 2015. GPV growth was driven by ongoing growth in our existing seller base and new sellers added during the quarter. Our larger sellers, which we define as those that generate more than $125,000 in annualized GPV, continue to grow at a faster rate than our overall seller base, with GPV from larger sellers increasing nearly 70% from the first quarter of 2015."

Management also mentioned that 39% of the GPV was derived from Square merchants that generated $125,000 or more in annual volume. By the time a smaller micro-merchant graduates into a small business and generates annual volume above $125,000, any traditional bank or non-bank provider should be able easily beat Square's pricing model. While the larger relationship with Starbucks contained a three-year term, merchants who sign the basic agreement found on the Square site are not bound by a contractual term. That means that a sizable chunk of Square's valued 39% can walk away tomorrow should they find a better deal somewhere else.

At this point, merchants should begin think about "Interchange-plus pricing," which is a more transparent approach to merchant processing and something not found within Square's 2.75% pricing model. With Interchange-plus pricing, a merchant see clearly identify the processor's fees that are passed back to the card associations, alongside any additional fees charged to the merchant by the processor itself.

For all of their internet charm and good looks, Square will continue to be an easy entry point for small micro-merchants who want to attract a plastic ready audience. The technology of turning a smartphone into a POS terminal is beyond clever.

However, Square's desire to move to larger merchants will be met by a brutal reality. Once their profitable clients reach a certain level of annual volume, any economic advantage of working with Square evaporates because the larger players like Chase, Bank of America, and Worldpay can do the job of merchant processing far better and cheaper. That means there is little beyond translucent brand loyalty to keep Square's larger merchants as clients.

Until Square figures out how to keep their merchants happily anchored for the long term, I question the viability of Square as a stand-alone brand for the mid and long term and would not be surprised if they end up on the acquisition block to be gobbled up by somebody else.

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