Square / PayPal: Part 1
If you found yourself in 2009 with the vision of one day dominating payments, where would you start? For most, I suspect it would be P2P payments or point-of-sale software or some other bits-based service with the conventional trappings of network effects, virality and scale. Square instead launched with what must have seemed the most commoditized part of the ecosystem, credit card readers. That co-founders Jack Dorsey and Jim McKelvey began here reflects their prioritization on what small merchants needed over what venture capitalists could pattern match to. Rather than experiment with custom hardware to circumvent Apple’s dock connector rules and build integrations into the antiquated COBOL software powering the US payments system, all the while wondering whether Visa and Mastercard would allow Square to plug into their networks, it really would have been much less stressful to launch another point-of-sale or small biz management SaaS, as many others had before. But no, they saw that small vendors paid 45x as much as large ones to process card transactions and attacked this disparity in the most direct way possible.
In payment terminals, Jack and Jim saw a foundational commodity that was made more expensive, difficult and opaque to install and manage than it needed to be. Before Square came along, a merchant would spend thousands installing heavy point-of-sale hardware. After taking into account fraud, dispute resolution, and PCI fees, they would often be paying 3%-5% of sales1. Square came to market with a cheap but elegant card reader2 that could be affixed to an iPhone, and bundled dispute resolution and PCI fees into a flat 2.75% take (now 2.6% + 10c). The product was a hit with small businesses, who could accept in-store payments within minutes, without perusing opaque vendor agreements or locking themselves into multi-year contracts.
Charlie Munger has this great line: “take a simple idea and take it seriously”. In business, this credo manifests as a set of interlocking practices that naturally evolve as a consequence of taking a simple idea seriously. A classic example of this, frequently cited in business schools (this is where I first learned about it) and recounted in Jim McKelvey’s book The Innovation Stack, is Southwest Airlines taking seriously the simple idea that the key to running a profitable airline was keeping planes in the air and off the tarmac. From this obvious realization emerged a set of unorthodox policies: doing away with assigned seating and in-flight meals to hasten turnaround times at the gate; standardizing on a single aircraft model to reduce maintenance costs, procure volume discounts and reduce pilot and crew training costs; and basing at Tier 2 cities to avoid congestion and negotiate lower landing fees from neglected airports seeking foot traffic. Part of the resulting cost savings were passed through to lower ticket prices, which combined with Southwest’s leading on-time performance and customer service culture, attracted the passenger volumes that enabled still more bargaining power vs. airports and plane manufacturers.
Likewise, Square took seriously the simple idea of making it cheaper, easier and faster for small business owners to accept payments. Embedded in this objective was a series of problems, whose resolution required an interrelated set of solutions, “Innovation Stack”. From The Innovation Stack:
An Innovation Stack isn’t simply a list of independent changes to an existing business model. The innovation is integrated. Each block in the Stack only works in conjunction with all the others, and the entire Stack fails if one block is missing. For example, regarding Square’s Innovation Stack, online sign-up is great, but it only really works if you dispense with traditional FICO underwriting, and you can only do that if you’ve developed new ways to model risk, and you can only develop those models with high volume, which necessitates a number of the other blocks in the Stack.