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Square’s lending business is giving the company a big boost. How long can it last?

Square Capital is critical to the payments company’s future success.

Asa Mathat

As far back as 2014, it was clear that the valuation of Jack Dorsey’s startup Square was way ahead of its business. That disparity isn’t uncommon for venture-backed startups, but it meant Square was going to have to hit it big on new business lines outside of payments — like lending or software subscriptions — if it was going to fulfill its promise one day.

Fast-forward to this week, and the performance of Square’s lending business, Square Capital, is one of the reasons why investors pushed the company’s stock up in the wake of its second-quarter earnings report. If it’s going to be a long-term pillar of Square’s business, though, Square Capital is going to have to evolve.

The business unit, run by former Yahoo executive Jackie Reses, provides loans to merchants in exchange for a fixed cut of their daily sales until the loan is repaid in full. Square typically provides the business with the funds within just a few days of the business’ acceptance of the loan offer — an attraction to small businesses that don’t have the time or patience to wait for a loan from a traditional bank.

Square Capital grew 123 percent year over year in terms of loan origination volume in the second quarter and 23 percent sequentially. That was an important bounce-back quarter after a challenging first quarter saw it only boost its volume 4 percent from the previous three months.

In a call with reporters, Square Chief Financial Officer Sarah Friar said Square Capital should be viewed differently than other so-called alternative lenders. Companies in that bucket, such as Lending Club, OnDeck and Prosper Marketplace, hit headwinds this year as they struggled to find investors to buy the loans — a critical piece of the model.

Friar said Square Capital is able to keep its default rate low at 4 percent because Square only lends to Square merchants, which track their sales with Square software and process payments through the company. That means Square has a direct line into how these businesses are performing at all times.

“Nothing is as good,” she said, referencing underwriting signals that competitors use.

Friar also boasted that Square spends close to nothing to acquire new Square Capital customers, because the company just markets the program to merchants who already use Square’s payment processing service. As a result, Square doesn’t have to invest in expensive advertising campaigns like some competitors do.

Sounds great. But what happens when Square Capital has reached all the Square merchants that are interested in a loan? The pressure to grow won’t go away.

Company executives have hinted that Square could end up expanding the program outside of the Square family, to other small businesses that don’t use any of Square’s other services.

Such a move would come with its own challenges. If these businesses aren’t using Square to process payments, will Square still be able to keep its default rates low without having access to the merchant’s daily sales history?

Secondly, how much worse will the economics of the Square Capital business become if Square has to start spending money on advertising to court new borrowers?

If Square is going to keep its foot on the pedal in lending, it seems likely that we’ll eventually find out.

This article originally appeared on Recode.net.

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