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Howard Schultz, CEO of Starbucks Corp., right, welcomes Jack Dorsey, founder and chief executive officer of Square Inc. and cofounder and chairman of Twitter Inc., to the company's Global Leadership Conference in Houston, Texas, U.S., on Thursday, Oct. 4, 2012.

The Secret Success Of The Square-Starbucks Alliance

Jack Dorsey's payments company may have lost $25 million in 2013 on its deal with the coffee giant, but was what it gained more valuable?

When Starbucks invested $25 million in Square as part of a massive August 2012 funding round that valued the commerce startup at $3.25 billion, Starbucks CEO Howard Schultz proclaimed Square to be "the fastest-growing opportunity we've ever seen in terms of customer acceptance." Since then, the partnership has become a Rorschach test for how one feels about Jack Dorsey's startup. Depending on your outlook, the partnership is arguably one of Square’s smartest and boldest bets, or one of its most significant missteps. Earlier this year, as reports surfaced that Square lost $25 million from processing payments at the coffee chain's stores in 2013, the skeptics have been ascendant, citing the Starbucks deal as a prime example of Square's unrealized potential.

The Square-Starbucks alliance is representative of the noise and misconceptions engulfing Jack Dorsey’s company over the last year. That gaudy $25 million loss, though, obscures a more complex reality, one that shortchanges how the deal has helped Square, and at the same time papering over the failures that really matter.

On the surface, the deal seemed like a win-win. To Starbucks, Square represented an opportunity to attach itself to a hot upstart in the mobile-payments space, while gaining an ally in Dorsey himself. To Square, the benefits appeared to be manifold: the capital injection, adding Schultz to its board, and becoming the payment processor at 7,000 Starbucks locations in the U.S.

The real value of the deal, though, would rest with the immeasurable boost it would provide to Square’s reputation among merchants and consumers. If Square’s payments processing technology was good enough for a chain like Starbucks, it would be good enough for any mom-and-pop store. And that is effectively what happened: Once-skeptical merchants flocked to Square’s platform. And the more merchants that adopted Square Register, the more Square’s payment volume grew. As payment volume grew, the more negotiating power Square had with Visa, MasterCard, American Express, and its other financial partners. According to sources, Square’s scale grew so fast that it was able to lower processing rates "across the board," increasing its profit margins.

Here's how Square exercised its newfound might with its card network partners, according to a source familiar with the company's financials. Square routinely lost money on low-dollar debit transactions, like, say, a cup of coffee. This was mainly due to a 2010 U.S. law that curbed debit-card rates; the regulation effectively capped charges at roughly 22 cents regardless of the size of the transaction. Banks responded to the regulation by simply charging the maximum on every transaction, which is manageable in larger amounts but becomes absurd the smaller the exchange. In other words, if a bank charges 22 cents on a $1 transaction, that’s a 22% fee. Thanks to the Starbucks deal boosting Square’s payment volume, though, Square was able to lock in a special rate with Visa to mitigate this cost, because it was bringing in so much business. Few in the industry apparently know this special Visa rate exists.

To lock in the Starbucks deal, insiders say, Square had to agree to a substantially different payment structure with the coffee giant. With typical merchants, Square takes a 2.75% cut of each swiped credit card transaction, and it shares that fee with Visa, MasterCard, and other financial intermediaries. But with Starbucks, the deal was done on a sliding scale based on the results Starbucks returned, and the effect was to all but eliminate Square's margin. Despite the way that Square's $25 million loss has been bandied about in the press, such losses didn’t come as a surprise to Square executives and board members. "All I will say is there was a plan, a conscious decision to do the Starbucks deal, and we decided to place that bet—obviously nobody forced us to do it," says Square investor Vinod Khosla.

According to insiders, Square executives simply saw the Starbucks losses as a marketing expense for Square Register and Wallet, as well as for the Square brand overall. "It was pretty simple math—everyone involved in the deal knew exactly what the numbers were," explains one source familiar with the deal’s structure, who adds that Square "didn’t really discuss" the terms with the rest of the company because the "cost was extremely high. But it made sense: Instead of spending X millions of dollars on marketing, the Starbucks deal legitimized this tiny startup. There was a massive push in adoption."

The problem with the deal lies in what it failed to accomplish for Square's Wallet product. Although the contract between the two outlined how Starbucks would work with Square Wallet, there were conflicts from the outset. Starbucks already had its own digital wallet, a product that, within Starbucks's stores at least, competed against Square Wallet. Worse, baristas often weren’t properly trained on how to accept Square Wallet. So while Starbucks was willing to advertise Wallet on Square’s behalf, Square decided that wasn’t the right route. Wallet, the company felt, wasn’t ready for that kind of massive adoption, in part because it was accepted at so few other places. What would be the point if consumers could only use it at Starbucks, where they were already using Starbucks’s own app? There was no clear vision around solving this issue, insiders say, and the deal didn’t go as planned on this front. Wallet was killed earlier this year in favor of a new product called Order, which lets customers pre-pay for items and skip the line at merchants.

The nuanced nature of the deal is just one example of how complicated the financial space is for startups like Square to challenge. "You have to put the whole thing together to really understand how healthy the company is," says one source. "Yes, there was a $25 million loss on that one deal, but there was also massive growth that came from it, which made many millions of dollars in profit for the company."

So was the Starbucks deal ultimately a success or failure for Square? We will not know until next year, when according to a source familiar with the deal, the alliance will expire and be up for renewal. Meaning, Square will have to decide whether it wants to try to renew a partnership with Starbucks—still a major investor in the company, mind you—or end it altogether.

Check out our profile of Jack Dorsey's Square in the September issue of Fast Company.

[Photo by F. Carter Smith/Bloomberg via Getty Images]

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2 Comments

  • 7/10ths of a point is not "major investor". It's a minority stake. Doesn't it seem like a coincidence that starbucks gave them $25M for investment and $25M was the loss amount? I assume it was part of the deal and in return Starbucks got a bit of the upside...

  • Interesting insights into the motivation and 'success' measurement of this deal for Square, beyond the $25MM loss in processing. My question is, if Square is considering this to be an offset with marketing expenses, especially in the promotion of Square register, what are the sales numbers around that product in terms of units sold, processing volume etc.