These Guys Will Make You Pay

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. Voilà! 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.