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Inside Square's Acquisition and IPO Hopes and Its Huge Challenges Ahead

The debt financing raised by Jack Dorsey's payments company has only ratcheted up talk of how the startup is faring.

Jason Del Rey has been a business journalist for 15 years and has covered Amazon, Walmart, and the e-commerce industry for the last decade. He was a senior correspondent at Vox.

Of all the many high-profile Internet companies, perhaps none has attracted more speculation than Square. It makes sense. The payments company has a well-known CEO and founder in tech star Jack Dorsey. It has raised a giant sum of money — more than $200 million in equity financing — from big names, including Sequoia Capital, Visa and Starbucks. It has an ambitious and perhaps overreaching plan to disrupt a massive industry of powerful old-school players like First Data to younger payments giants such as PayPal. No surprise then, the question of where Square is headed has dominated the chatter in industry circles. And news that the company secured a revolving credit line of about $200 million has only ratcheted up the intrigue. Let’s try for some clarity then, answering some of the outstanding questions about the startup.

How Much Is That Online Payments Company With the Register?

The most-asked question, of course, is whether Square is for sale or not. And that answer depends on what you mean by for sale. In the last year, both Apple and Google have considered making acquisition offers for Square, according to industry sources familiar with the situation. (The Information previously reported Google’s consideration.) That makes sense, but it’s still unclear if it was more than a typical business development exercise.

In recent weeks, though, acquisition rumors have run rampant for Square, including chatter among its competitors, with Google being named as the most likely acquirer. This kind of stuff is common in Silicon Valley, but no firm offers have been made so far and people close to the management team at Square said the company is not actively trying to sell the company.

That said, an offer in the $8 billion range — which would mark more than a 50 percent premium over the $5 billion valuation Square secured during a recent secondary offering — would get Dorsey and the board’s attention, one of these people said. One problem: Industry sources say Square doesn’t currently have anywhere near the business case to support such a rich offer. Then again, there was the WhatsApp acquisition by Facebook at $19 billion, a strategic move that most definitely required paying up. It would make sense for Google to be the most interested buyer, because it would want more information on purchases that consumers make, both to help prove how well its ads work and to perhaps better target those ads to individuals. This is part of the reason why it introduced Google Wallet, which has yet to become widely used for in-store payments.

Either way, a sale to Google would disappoint Dorsey, according to multiple people familiar with his thinking. For one, he was reportedly put off by Google after being involved in acquisition talks between his former company, Twitter, and the search giant. He also believes, sources said, that Square’s design aesthetic and values match up much more closely with Apple than Google. That’s not surprising when you consider that Square’s hardware chief Jesse Dorogusker worked at Apple for more than eight years. He most recently was a director of engineering for the iPod, iPhone and iPad accessories, according to his LinkedIn profile. Apple has also sold Square products in its stores, most recently the Square Stand. “Jack does not want to sell to Google,” one source said flatly.

Is Apple another story? Re/code recently reported that Apple is exploring ways to use its software and devices to help people shop both digitally and in physical stores. Square would immediately give Apple built-in distribution at thousands of businesses that use it to manage their payments. A deal with Apple could mean that Square could stop worrying about getting adoption for Square Wallet. Apple already has hundreds of millions of credit cards on file through its iTunes service and could use those, along with its digital wallet, Passbook, as the underpinnings of its own mobile-payments offering for consumers. CEO Tim Cook, without confirming the initiative, talked up the opportunity on Apple’s recent earnings call. “You can tell by looking at the demographics of our customers, and the amount of commerce that goes through iOS devices versus the competition, that it’s a big opportunity on the platform,” he said at the time.

But Apple’s entrance into mobile payments is much more likely to start with services that use its iPhones to help make online purchases easier to consummate rather than moving into offline payments, industry sources say. Square wouldn’t be of much help in that regard. As such, Apple has soured on the idea of making an acquisition offer to Square for now, according to sources familiar with the company’s thinking. Other potential acquirers could pop up in the future, but those two companies seem like the most likely landing spots, according to industry observers and people close to Square. Spokespeople for Apple and Square declined to comment. Google has not yet responded to our query.

Going Public?

With both Apple and Google looking like long-shot acquirers for now, many industry observers still believe that Square’s eventual exit will happen via an IPO. While it seemed at some point like 2014 was potentially the year Square would test the public markets, people familiar with the company’s thinking doubt that’s now the case. One problem the company is facing is that the revenue it makes from payment processing is still the vast majority of sales, while other revenue-generating products have either not yet launched or not yet taken off. For example, the company slashed the price of its Square Stand tablet holder from $299 to $99 within months of its launch, hinting at either bad pricing estimates or lower than expected demand. Square’s search for diversification has also led it to what some consider a controversial offering: Merchant cash advances. But that’s untethered from Square’s core payments business and would provide higher profit margins should it launch out of its pilot program.

The problem with being so dependent on processing revenue is twofold: First, the profit margins aren’t great. Competition and the commoditization of payment pipes have driven down the fees payments companies charge merchants, while the cut paid out to credit card companies has remained largely the same. Secondly, the public markets today would likely be forced to value Square at a lower revenue multiple than if it made revenue from software sales, which typically come with better profit margins.

Square knows this. It has been working to introduce other software tools to help merchants run their businesses that it hopes it can package into a subscription offering, according to several people familiar with the company’s plans. Square’s acquisition of BookFresh, a maker of business booking software, hints at this future, for example. Another tool could help stores manage their inventory, something that some young point-of-sale competitors like ShopKeep already provide.

These initiatives would fall under the leadership of Gokul Rajaram, the product engineering lead Square poached last summer from Facebook. Rajaram is a well-respected product leader; his hire nine months ago was widely seen as a coup for Dorsey’s company. His group is also said to be working on data analytics products to offer to Square’s merchants.

Now, the industry is waiting for the work his team has been doing to be released publicly. If the additional small business offerings see the light of day and achieve some success, Square could convince acquirers or the public markets to value it more as a software company or at least a hybrid payments/software/data company, likely increasing its value. Such new products would also be seen as a way to boost profit margins at the company.

Sources say Square registered somewhere between $500 million and $600 million in gross sales in 2013. But the majority of that gets passed back to credit card companies, leaving Square with net revenue of between $100 million and $200 million. This year, Square is hiring salespeople to go after mid-sized retailers as well, as part of an initiative led by new business lead Francoise Brougher.

Up until now, Square has attempted to build products for consumers, with the thinking that more consumer adoption will convince more retailers to sign up for Square’s payments service. While logical, the consumer side of Square’s business has undoubtedly been less successful than the merchant side. Square Wallet, the iPhone app that allows shoppers to pay for things at Square merchants without using a credit card or cash, hasn’t taken off as expected, which is an industry problem more than a Square problem. So-called digital wallets, in general, haven’t succeeded, since they aren’t any quicker to use than a physical card or cash and haven’t given shoppers enough value to switch over. And no one digital wallet has enough adoption on the merchant side to convince shoppers they can leave their real wallet at home and visit a variety of stores in a day that all accept payments by phone. Square Wallet does not currently rank in the Top 200 free Finance apps in Apple’s Appstore. The company’s new money-transfer app Square Cash ranks 51st. And Square’s new e-commerce marketplace, Square Market, faces the daunting task of going up against established marketplaces for small-business sellers such as Etsy, not to mention giant online marketplaces run by Amazon and eBay.

So while a Square IPO might seem inevitable, pulling one off in 2014 would likely be tough.

Lukewarm Double-Caf?

You can’t talk about Square’s future without wondering what it might look like if the company’s much-hyped deal with Starbucks had gone differently. Inked in the summer of 2012, the arrangement consisted of three main parts: Square would process payments for debit and credit card purchases at Starbucks stores; Starbucks would invest $25 million into Square; and Starbucks CEO Howard Schultz joined Square’s board of directors.

The benefit to Starbucks was that Square would charge it a lower payment processing fee than it had previously been paying. Over time, such an arrangement had the potential to save Starbucks millions of dollars. It was not meant to be a money-maker for Square, and a person familiar with the deal hinted that Square may have actually been losing money on the arrangement at some point. In exchange, Starbucks helped put Square on the map and bolster its credibility. After all, what startup payments company besides Square had such a giant, wildly popular customer? None. It was a huge win by that measure. “The Starbucks relationship early on was a big coup for the company,” said a person familiar with the deal.

But the inking of the deal may have been the high point. The companies announced on Halloween of last year that Schultz would step down from Square’s board after a little over a year, making room for former Goldman Sachs chief financial officer David Viniar. The reason, the companies said, was that Schultz had planned a year-long tenure from the start. But many industry observers thought the move odd, given the depth of the relationship.

For sure, there was more Square was hoping to get out of the arrangement, according to people familiar with the deal. For one, Square expected the deal to help the company promote its Square Wallet phone app. When customers pay through Square Wallet, they, in turn, become a customer of Square, giving the company more data to inform new products. Square also believed that increased consumer adoption would help convince more retailers to sign up for Square’s payments service. It’s not clear why Square thought it would, since Starbuck’s own mobile app has found tremendous success and allows customers to pay through it.

The conversations around the deal also seemed to leave Square believing that there was a decent chance Starbucks or some of its other brands would end up converting some business to Square’s point-of-sale software rather than just having Square handle the payment processing on the back end, according to the person familiar with the deal. That, Square believed, would be a huge stamp of approval that would help it drum up business from other huge brands. But it has not happened.

That failure means more than ever that Square’s future rests solely in its own hands. Many fast-growth private companies have secured debt financing ahead of an IPO, leading some people to believe a Square public markets debut is on the horizon. At the same time, other industry sources have suggested Square simply chose to take on debt because it made more financial sense than potential equity deals available to it. Taking on debt can make a lot of sense for profitable businesses, but is more risky for unprofitable operations. And, according to sources, like many such startups, Square is not yet profitable.

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