These Guys Will Make You Pay

Lots of Internet startups have tried to reshape finance. PayPal Inc. has pulled ahead of the pack by getting three things right: it built an easy-to-use system around email, it learned quickly from its mistakes, and it didn't invent a new currency.

Donna Driscoll waits patiently as a web-site tester wanders through the prototype of a new online bill-paying service. Product launch is just two months away, and things aren't going well. In the right-hand corner of the screen, a blue-and-white image invites visitors to send money. But the tester's cursor hovers aimlessly in a dead zone.

Driscoll isn't flustered. She is a senior usability engineer at PayPal Inc., which, in just three years, has become the dominant player in the new field of moving money by email.

By this month, the company expects to have more than 10 million registered users who generate transactions at a rate of more than $3 billion a year. Already, PayPal has become a favorite way to settle bets and shop online with small merchants, but now the company has more markets that it wants to conquer. Need to pay your energy bill? Your phone bill? Even though plenty of long-established commercial banks offer online bill payment, PayPal believes that it can provide this service better than the old guard.

All summer, Driscoll worked inside a tiny demo room at PayPal's headquarters, in Palo Alto, refining the company's most important service extension to date. She listened to and learned from disgruntled users -- skills that she developed through jobs at Netscape and WebTV. After one hour-long session, she conceded that the new BillPay service still had glitches. But she and her colleagues planned to fix most of these flaws by the October launch and somehow sort the rest out later. That's the PayPal way, and it has worked so far.

Fast-Mover Advantage

Minor missteps, rapid experimentation, and strategic zigzags have been PayPal hallmarks ever since founders Peter Thiel and Max Levchin teamed up in 1998. Even the basic mission of the company has changed since its start. Yet for all of its short-lived mistakes, PayPal has always been able to regroup. "We have the first-mover advantage, and, in this instance, that makes us hard to beat," explains Thiel, 34, who started out as an investor and then decided that he wanted to be CEO.

What's more, PayPal has mastered two key insights that, so far, have helped it pull ahead of other startups and potential rivals at big commercial banks.

First, PayPal didn't try to reinvent everything. Its founders realized early on that the rise of email had revolutionary implications for money transfers. But Thiel and Levchin were also humble enough to realize that they didn't need to create a new currency. By contrast, other startups, such as beenz.com, Flooz.com, and various Internet barter ventures, tried to combine email technology with their own form of digital currency. Most of them have either gone out of business or been acquired.

"As far back as 1995, there were a hundred companies that used cool technologies for moving money and that were going to change the world," Thiel recalls. "They had these weird new currencies." Pulling a greenback out of his wallet, he adds drolly, "This is still the biggest competitor to any payment system. Real currency is still really useful."

PayPal's other big edge came from a willingness to launch its system fast -- before all of the bugs had been worked out. Fraud from both small-scale thieves and from Russian hackers has proven to be a nagging and hard-to-eliminate concern. But by moving early, PayPal has been able to attract a huge user base. That has forced major banks to play catch-up, a natural consequence of their risk-averse and planning-intensive culture.

All the same, competition is likely to intensify over the coming year, and there are plenty of opportunities for PayPal to go off course. The company is not yet profitable, and, while it has raised more than $200 million in venture capital in the past two years, last year's market turmoil makes it hard to predict future funding prospects. Some analysts regard PayPal as a takeover candidate. Thiel isn't ruling out anything; he says that he would consider working with partners.

What Business Are You In?

Ironically, PayPal wasn't even supposed to be in its current business. Levchin, 26, was an online-security maven who in 1998 wanted to start a company that specialized in safeguards for transferring money through wireless devices. At that time, Thiel was running a hedge fund, and Levchin approached him as an investor.

"We thought that it would be cool and fun to build a company," Thiel recalls. Things looked even cooler when they got a $3 million investment from Nokia -- and convinced its executives to beam the money to a PDA. The only problem with the original idea, Thiel admits, was that "consumers showed no interest in it."

For a time, Thiel ignored the market's feedback. But then he and Levchin, who is PayPal's CTO, regrouped. They noticed that while pretty much anything could be bought online, paying for it was another matter. As late as 1998, some 90% of eBay purchases were settled with checks or money orders, Thiel says.

The more Thiel and Levchin thought about payment problems, the more they knew that moving money through the Net had to be as easy as taking a dollar out of your pocket and handing it to a friend. What could be simpler than emailing a friend a dollar? PayPal was born.

"We bootstrapped off of existing networks: the dollar, which everyone accepts; and email, which everyone has," says David Sacks, executive vice president for product at PayPal. "Why build a system off of new networks?"

So in October 1999, PayPal put up a simple home page to change the way money moved through cyberspace. All a user needed was a recipient's email address, a credit card or a bank-account number, and a Net connection. VoilĂ ! The recipient would receive money in a new account, and PayPal would debit the sender's credit card or bank account.

Not only was PayPal easy to use, but it also spread virally at a breakneck pace. After all, everyone who received money automatically became a new user with a PayPal account. At the end of 1999, there were just 10,000 users. By February 2000, PayPal had recruited 100,000 customers. Thiel and Levchin realized that they had unwittingly created a giant, and they decided to set up a customer-service unit that now employs more than 400 people.

PayPal's growth was helped along by generous promotions that continue today. Initially, PayPal offered people $10 to sign up and a $10 bonus for every person that user recruited. Now PayPal offers a $5 sign-up bonus, but there are several steps to take -- including the transfer of $250 into a PayPal account -- before the $5 is credited to the user's PayPal account.

Both critics and competitors -- some of whom spent millions of dollars on television ad campaigns -- scoffed that PayPal was paying for people to use its service instead of the other way around. Although PayPal was free (and remains free for personal use), Thiel initially planned to make money off of the float of the currency in the system. But in the beginning, building the network was more important to PayPal executives. "It was valuable to the first person who ever used it," Sacks says. "We didn't have to solve the-chicken-and-the-egg problem: Will I have merchants who will take, or will I have consumers who will use?"

PayPal did start attracting merchant attention, especially that of eBay sellers, who realized that it would be a great way to get paid without having to incur the costs and security headaches of accepting credit cards online. While big online sites have no problem with credit-card use, many small and even midsize merchants don't have merchant accounts with credit-card companies because they are so expensive to maintain. PayPal charges business users 2.9% and 30 cents per transaction. Billpoint, eBay's own online-payment system, charges 2.25%. By contrast, credit-card companies may charge small merchants as much as 5% -- far more than the 1.7% to 2% that big stores enjoy.

"EBay is the secret to PayPal's success," says Avivah Litan, vice president and research director at Gartner Inc. "PayPal was the first solution for eBay, and it gave PayPal a great advantage. It helped that PayPal was the cheapest and the fastest."

Keep It Simple (and Secure)

From October 1999 to the end of 2000, PayPal morphed from a person-to-person site (people paying each other for last week's dinner) to a person-to-business site that enables almost anything to be bought and sold in cyberspace. "We never knew what the end product was going to be," Thiel says of PayPal's willingness to keep experimenting. Although that philosophy kept them flexible, it also meant that Thiel and his team had to wait for the next mistake to happen. And what happened next wasn't just a mistake -- it could have been catastrophic to the business.

True to its commitment to keep PayPal as easy to use as pulling a dollar out of your wallet, the company didn't have an online verification system in place when it put up its home page. "We wanted to discourage theft," Thiel says, "but we didn't want to compromise the ease of the system."

Even today, the remnants of that philosophy remain. Users still need only a credit card or a bank account, and an email address. In the beginning, users could send $500 bucks a pop with no questions asked.

Thiel knew that they might have problems with stolen-credit-card use. But he didn't realize that PayPal would be liable for the charges. Unlike offline merchants, who can refute fraud charges because they have signatures and face-to-face contact, PayPal is considered a "card-not-present" merchant -- meaning that, rather than the issuing bank, PayPal is liable.

Petty theft, which payments analysts contend is still a struggle at the company, wasn't going to be the only problem. PayPal's open system was vulnerable to hackers, who were stealing credit-card numbers in mass quantity and then using them to pay themselves through online-payment systems, including PayPal.

It's Levchin who worries most about keeping the site secure and fraud free. So he created Igor, a software system that graphically visualizes PayPal's usage and helps Levchin's staff spot abnormal patterns. "I am one of the most paranoid people. It's a constant arms race," Levchin says of keeping up with hackers.

Another of PayPal's salvos is bank-account verification, which involves sending small deposits to an account holder. Even so, Levchin says that he remains paranoid about fraud -- sometimes waking up his team at 4 in the morning to work on a problem immediately. "The day we come out of panic mode is the day we aren't doing something right," he says.

Meanwhile, PayPal potentially faces even tougher competition. Wells Fargo and eBay teamed up last year to develop Billpoint, a direct rival. AOL and Yahoo are doing something similar, allying with big banks Citibank and HSBC Group, respectively. Some leading portals are now offering their own gigantic databases of users many, if not all, of the services that PayPal does.

For its part, PayPal is trying to parlay its simple send-money-via-email business into a full-fledged online-payment system. But in acting more like a bank -- it already has a debit card from Bank One in partnership with MasterCard, a credit card from Providian, and a money-market fund administered by Barclays -- PayPal may find itself the acquisition target of a bank.

Along with BillPay, Thiel is betting that international payments could be a solid business. But unlike his early success -- enabled by a banking system that is robust and easy to use -- he has run into major problems that can't be fixed with a simple Web site and viral marketing.

Regulations have kept even larger banks such as Citibank from solving the riddle of how to move money easily across borders. "Every banking system has to be worked out on a case-by-case basis," Thiel says. "And international fraud is much trickier."

Fara Warner (fwarner@fastcompany.com) is a Fast Company senior writer based in Silicon Valley.

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