Commentary

Who Killed PayPal?

This article originally appeared on Reason.com
The PayPal Wars: Battles With eBay, the Media, the Mafia, and the Rest of Planet Earth, by Eric M. Jackson, Gardena, Calif.: World Ahead Publishing, 344 pages, $27.95

In September 2004 Bill Quick received a notice from PayPal, the online payment company that facilitated reader donations to his Daily Pundit blog. The notice warned Quick that his account was on hold, and that it would be terminated unless he removed “hate” content from his site. This appeared to be a reference to Quick’s link to a video of a terrorist beheading. PayPal sent a similar letter to Jarlaynn Merrit’s civil liberties blog Talk Left. Neither site is at all hateful, and both linked to the beheading video for reasons that, while controversial, were certainly within the realm of civil discussion.

Both letters came a month after PayPal announced an abrupt shift in its terms of use. The company would no longer permit customers to use the service for purchases associated with “mature audiences,” gambling, hate paraphernalia, or prescription drugs, along with a long list of other prohibitions. It would also fine its customers up to $500 for attempting such transactions. Those terms apparently applied to donations to blogs with content PayPal found objectionable.

That’s a far cry from the libertarian vision founders Peter Thiel and Max Levchin originally had for PayPal, an online payment service that enables account holders to send money to anyone in the world with an e-mail address. Thiel and Levchin had hoped PayPal would grow to become an extra-governmental system of currency, something reminiscent of the world described in Neal Stephenson’s novel Cryptonomicon, in which programmers use encryption to create an offshore data haven free from government control.

Eric M. Jackson documents the story of PayPal in his lively new book, The PayPal Wars. Jackson’s engaging narrative reads in turn like a spy novel, a business text, and an insider tell-all. One of PayPal’s earliest employees and savviest marketers, Jackson documents the full spate of challenges and obstacles faced by start-ups and entrepreneurs, and how visionaries often have to abandon big ideas to keep competitors at bay and to satisfy petty bureaucrats and politicians.

Thiel is a philosophy major who drew inspiration from Aleksandr Solzhenistyn; Levchin a Ukranian Jew who grew up in the former Soviet Union and immigrated to Chicago with his family in 1991. They met in Silicon Valley in the late 1990s and over a series of lunches began to collaborate on marketing a method of data encryption that would let users safely send information between two personal digital assistants (Palm Pilots, for example). Thiel and Levchin eventually decided that the most practical application of the technology was money—specifically, the ability to “beam” funds between PDAs without currency, checks, or credit cards. At a conference in July 1999, representatives from Nokia Ventures and Deutche Bank used the encryption technology to send Thiel $3 million in venture capital via a Palm Pilot. Confinnity, later to become PayPal, was born.

In the book’s first chapter, Jackson recalls a speech Thiel gave to Confinnity employees, just a few days after he began work, in which he described his hopes for PayPal to become a borderless private currency. He saw PayPal facilitating trade in currency for anyone with an Internet connection by enabling an instant transfer of funds from insecure currencies to more stable ones, such as U.S. dollars. Thiel explained to his young staff how governments had historically robbed their own citizens through inflation and currency devaluation. The very rich could always protect themselves by investing offshore. It’s the poor and middle class, Thiel explained, who get screwed. “PayPal will give citizens worldwide more direct control over their currencies than they ever had before,” Thiel predicted. “It will be nearly impossible for corrupt governments to steal wealth from their people through their old means because if they try the people will switch to dollars or pounds or yen, in effect dumping the worthless local currency for something more secure.”

Though he touches on brushes with nearly a dozen would-be competitors to PayPal, much of Jackson’s book follows the continuing tug-of-war between PayPal and eBay, the online auction behemoth. Early on, Jackson had smartly identified eBay users as ideal potential PayPal customers. Jackson recounts how, as his marketing overtures began to bring in high-volume eBay sellers, PayPal struggled to innovate, adapt, and scale up its customer service support to meet their needs. When PayPal’s early success began to overwhelm its own customer service staff, for example, the company didn’t have the capital to hire additional help. Executives temporarily staved off the problem by sending the company’s reps to post answers to common problems on high-traffic message boards frequented by online auctioneers. The strategy reduced call volume without much additional labor.

PayPal was again challenged when hackers, sophisticated crooks, and even international mobsters began to use the service for fraud and money laundering. The company’s tech team responded with an ingenious yet simple way to distinguish human beings opening accounts from mechanized “bots” designed to open hundreds of fraudulent accounts at once. The “Gausebeck-Levchin” test imposed an image of black letters set against a yellow background with crisscrossing lines, and asked the new user to enter the letters he saw on his monitor to proceed. Human customers could discern the letters easily, but programs pretending to be human couldn’t. The test is still in wide use today among e-commerce sites plagued by automated fraud.

At the same time, eBay was aggressively pushing its own online payment system, called Billpoint. Jackson recounts several episodes in which eBay issued new policies specifically designed to give Billpoint an advantage over PayPal, such as demanding smaller logo sizes from outside vendors or changing auction procedures and settings in ways that transparently favored Billpoint. PayPal’s challenge was to respond to the new policies, win any ensuing public relations war that might result from them, and keep its own customers happy and loyal along the way.

What’s interesting is that though the eBay struggles are the most frequent source of conflict in The PayPal Wars, it’s during these battles that PayPal is at its most competitive, its most innovative, and its most responsive. When Billpoint entered into a partnership with Visa, for example, PayPal responded by offering its customers a PayPal debit card and giving them cash back each time they used it. Each eBay policy change aimed at outside vendors pushed PayPal not only to comply and adapt on the fly but to find new ways to communicate the new policies to its users quickly.

PayPal ultimately won the battle with Billpoint, despite the decided disadvantage of having to compete within the framework of Billpoint’s parent company. For months, Billpoint’s listing share (the percentage of eBay auctions accepting Billpoint payments) hovered around 25 percent, while PayPal’s climbed to more than 70 percent.

By October 2001 PayPal was at the brink of escaping the dot-com peril. It was the preferred payment method for just under half of all eBay auctions, its registered users numbered more than 12 million (after just 22 months of operation), and more than a third of its payments came from sources other than auctions, demonstrating the company’s ability to broaden its user base. More important, despite burning through capital on payroll, bonuses for users who brought new accounts, and marketing, profits soared, and the company achieved its first positive cash flow for that month. It would go on to turn its first profit in the fourth quarter of 2001.

PayPal consequently decided it was time to begin filing for its initial public offering. That’s when the regulators, lawyers, and politicians moved in.

The first shots came from the media, which were skeptical of the new economy after the NASDAQ bust and agitated at having been duped into hyping so many failed dot-coms. Industry publications hinted that the IPO was PayPal’s way of shopping for a savior, while one Silicon Valley lawyer wrote in the California legal publication The Recorder that PayPal was an ideal money laundering mechanism for “drug dealers and domestic terrorists,” despite the successful anti-fraud devices concocted by Levchin’s tech team. Having already entered the mandatory pre-IPO “quiet period”—a relic of Depression-era reforms—PayPal was prohibited from responding to its critics.

Next came a rash of lawsuits. Some came from competitors who Jackson says sought to cash in on a company keen to deflect negative publicity so close to its public offering. The first lawsuit, for example, was from a company called CertCo, which claimed PayPal’s payment system violated one of its patents. It was settled for what the terms called a “non-consequential” payment.

But class action suits followed—four during one four-month stretch of 2001 alone. Some illustrated the damned-if-you-do, damned-if-you-don’t dynamics of running a small business. MasterCard, for example, fined PayPal $313,600 for excessive credit card “charge backs” (that is, credit refunds), a good indicator that the service was being used for fraud. As mentioned, Levchin and the company’s tech team had addressed those problems and cut fraud by a third. But those anti-fraud measures triggered more scrutiny. One class action suit accused the company of mistakenly freezing the accounts of several users for up to a week while it investigated suspicious activity.

Finally, the politicians and regulators came calling. Just hours before PayPal was set to go public, the state of Louisiana ordered it to terminate all business in that state, asserting that the company had failed to obtain a “money transfer license,” which many states require from anyone in the businesses of cashing checks, transmitting money, or exchanging currency. New York threatened a similar order. The Louisiana decree was issued under the pretense of “protecting consumers,” though terminating service in that state would have left all of Louisiana’s PayPal-using auctioneers in the lurch.

The company managed to negotiate its way through these obstacles, and in early 2002 PayPal successfully launched its IPO. Salomon Smith Barney priced the initial 5.4 million shares available to the public at $12 to $14 each. The entire company consisted of 60 million shares, giving PayPal a market value of $720 million to $840 million. On the first morning of trading, under the ticker symbol PYPL, PayPal opened at $13 per share but jumped to $18 within minutes. Shares peaked at $22 in the mid-afternoon before settling at a little more than $20 at the close of trading. The 50 percent increase represented the first successful IPO since September 11 and a significant achievement for an e-commerce company in the post–tech bubble market.

But PayPal’s regulatory troubles persisted. The banking industry had tried and failed several times to set up competitors to PayPal and Billpoint. As entrenched industries often do, it turned to government when its efforts in the marketplace failed. Oregon, California, Illinois, and Louisiana subsequently sent Billpoint notices that it had failed to get a money transfer license. A director from the American Banking Association told CNET that online payment services should be classified and regulated as commercial banks—a move that likely would have killed off all online payment services except those run by existing banks.

More class actions followed. New York Attorney General Eliot Spitzer cited PayPal for posting a user agreement that “wasn’t clear enough.” He also subpoenaed all documents pertaining to PayPal’s use in online gaming sites, suggesting the company was in violation of New York gambling laws. Spitzer’s investigation was followed by a U.S. Justice Department determination that PayPal’s use by gaming sites was a violation of the USA PATRIOT Act.

The financial pressures of battling aggressive government officials and opportunistic class action lawyers, all while trying to stave off a better-funded competitor, soon became too much for the still-young company to bear. “It was clear,” Jackson writes, “that PayPal now faced many challenges outside the marketplace. Entrepreneurial nimbleness may have helped us survive the company’s post-merger internal turmoil and Billpoint’s fierce competitive charge, but these new threats would require a different approach.”

In July 2002 PayPal executives sold the start-up firm to their longtime nemesis, eBay. Jackson notes that the sale had some obvious benefits. The company’s new parent already had a formidable, well-funded legal team in place to deal with PayPal’s litigation and regulation troubles. Also, eBay promised to do away with Billpoint, essentially securing PayPal’s position as the premier online payment provider.

But there were significant drawbacks too—most of them for consumers. Instead of allowing its customers to transact voluntarily with anyone they please, eBay, whose conciliatory approach is touted within the company as its “culture of community,” settled the PATRIOT Act charge with the Justice Department for $10 million and agreed to bar its customers from using the service for online gambling. Shortly thereafter, PayPal announced the even stricter policy that ensnared Quick and Merritt (though both accounts were later reactivated). The new terms of service prohibited the use of PayPal not only for adult-oriented purchases but for “non-adult services whose Web site marketing can be reasonably misconstrued as allowing adult material or services to be purchased using PayPal.”

PayPal today is a far cry from Thiel and Levchin’s dream. It’s a far cry even from pre-IPO PayPal. Most of the bright young minds Thiel brought in to get the company airborne left shortly after the takeover. Safely nestled within the belly of the eBay monopoly, and without Billpoint to foster a competitive itch, PayPal is far removed from the market forces that sparked the rapid innovation and entrepreneurial fire that marked its early days. Blogs bristle about PayPal’s unfriendly terms of service, its difficult account management, and its tendency to freeze accounts and bar access to the assets in them. Two popular sites, paypalsucks.com and paypalwarning.com, have sprung up to document user frustrations.

PayPal’s story is a sad but instructive lesson in how this country treats its entrepreneurs. PayPal is huge and growing. With eBay branding, it now boasts 73 million users, making it by far the largest online payment service. But it’s nothing like what it was intended to be: a way for people to protect the money they earn from greedy governments and protect private purchases from the prying eyes of regulators. Greedy governments and prying regulators saw to that. The company sold out to eBay not because eBay beat it in the marketplace, not because eBay offered a better product, and not to reap a financial windfall for PayPal employees. PayPal sold out because, after the beating it took from those claiming to represent the interests of consumers, selling itself was the only way to keep the company alive. Exactly how consumers benefited from that isn’t clear.

Radley Balko is a policy analyst for the Cato Institute.