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March 2000 |
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CyberSource, software merchant turned payment services vendor, knows from fraud
By Michael Menduno
Bill McKiernan’s customers were downloading thousands of copies of software from his new Web business, just as he’d imagined they would. Yet McKiernan was downloading a nightmare beyond imagining: hundreds of bogus credit card transactions. “The business was going to fail,” recalls the founder and CEO of Software.net, now known as CyberSource. “We were despondent.”
When McKiernan launched his pioneering Internet venture in 1995, selling software over the Web seemed like no-lose proposition. Rather than taking software orders and shipping the boxes, McKiernan figured he could field online orders and ship the software over the telephone line. But on a gloomy Monday just four months later, McKiernan came to grips with the realization that merchants are 100% liable for a fraudulent transaction when the buyer’s card is not present.
Huddled over the printer in their tiny two-office suite above a barbershop in Menlo Park, Calif., McKiernan and his colleagues grimly sorted through reams of credit card orders that had poured in over the weekend. “We could see just by looking that more than half of our orders were fraudulent,” he says. “Some of them were obvious. People were downloading our software with fake names and addresses that the address verification system missed.”
Yet even while pondering the potential chargebacks, McKiernan began to see a new—and even bigger—opportunity. “I realized if we could pick out the bogus orders by sight, we could teach a computer to do it.” Within a month, the company had its first fraud screening system up and running.
Flexibility learned firsthand
In 1997, the company was split into two businesses, each with market caps currently surpassing $1 billion: Beyond.com, at 45,000 titles, became the world’s largest online software store, while CyberSource focused on providing Web merchants with a suite of back-office e-commerce services that range from its flagship fraud screening system to payment processing. The evolution from Web merchant to purveyor of Internet services was a logical outgrowth of the Software.net experience, says William Donahoo, vice president of marketing at CyberSource. “As a merchant, we lived and died by our own system. We understood the problems firsthand.”
More importantly, retailing in the digital frontier consistently forced the company to come up with solutions. When the Federal Trade Commission threatened to shut down Software.net over potential software export violations—buyers in restricted countries were downloading antivirus software—the company created an export control service to satisfy government regulations. The software polices who’s entitled to order which products and from where, then routes shoppers wanting to purchase restricted items to customer service. Another transaction service, this one designed to manage product distribution, grew out the needs of Microsoft, a major supplier to Software.net. The software giant wanted CyberSource to implement its distribution policies on Microsoft’s Web site. An order from Germany, for example, would be routed to its in-country software distributor. “We cut our teeth on digital goods,” says Donahoo. “By doing that, we were able to solve many of the problems faced by online merchants.”
Apple pays a visit
The strategic turning point came in early 1997, when several suppliers, including Apple, Adobe and Symantec, asked Software.net for help in building a “buy” button for their Web sites. That led McKiernan and his team to explore creating a separate division to provide Internet services. They first planned to sell software outright, but McKiernan thought the company could better leverage the power of the Internet by selling transaction services online. At the time, the concept of an application service provider was still new to the online industry. “We looked closely at selling our server software, but we were hesitant to get into that business,” says McKiernan. “Software like Fraud Screen would be hard to sell as a stand-alone. It’s continually being tweaked and updated.” Fortunately, McKiernan’s initial customers liked the idea of buying the services per transaction.
Others were quick to follow. In less than 12 months the company had signed up nearly 40 customers for its online transaction services. McKiernan then convinced his board to split Software.net into Beyond.com and CyberSource, now based in San Jose, Calif. McKiernan, who still serves as chairman of both companies, brought in Mark Breier, head of marketing at Amazon.com to run the renamed software retailer, and turned his attention to CyberSource.
His efforts at CyberSource have paid off. By the end of 1998, the company had 300 customers, and transactions had grown exponentially—from 800,000 in 1997 to 8.6 million a year later. The company entered strategic partnerships with Visa International and GE Equity, which provided additional funding.
But the good times have not rolled at Beyond.com. The e-retailer has struggled to set itself apart in a crowded market and suffered a heavily publicized outage last fall. In January, with revenue below expectations, the company revealed plans to cut its staff by 20% and focus on the business-to-business market. Breier resigned.
Suite success
CyberSource is a different story, having consistently expanded both services and revenue. Today, the company offers merchants a wide range of back-office services, including payment processing, fraud screening, tax calculation, delivery address verification, distribution control and fulfillment messaging. Like Fraud Screen, each transaction is a unit of service, with discounts for volume and the number of services used. The customer roster has swollen to more than 800 and includes big-name brands like Amazon.com, Buy.com, Casio, Intuit, Compaq, Nike and Microsoft.
The biggest challenge, says Donahoo, is keeping up with the boom in Internet retailing. During the first nine months of 1999, CyberSource, booked $7.9 million in revenue, a 343% increase over the same period in 1998. Net losses were $17.8 million compared to $6.6 million last year. Transactions over the period climbed to 25.5 million compared to 4.5 million in 1998. Its IPO last June raised $44 million.
CyberSource’s marketing strategy is to offer merchants a buffet of bundled back-office services. The value proposition is simple: If you’re Nike, your specialty is shoes, not e-commerce software. The services that CyberSource provides are mission-critical, says Donahoo, but they don’t differentiate a merchant’s site. “No one goes to Amazon because they have a great tax calculator or payment processor. But if their buy button doesn’t work, everything else is for naught. It’s something that they can only mess up. That’s what makes transaction services perfect for outsourcing.”
CyberSource Fraud Screen is a starting point for many customers who later go on to buy other services. The offering is further strengthened by CyberSource’s relationship with Visa International. Visa has its own fraud modeling group and maintains an historical database of fraudulent transactions that allows the two companies to compare predicted fraud with actual occurrences, fine tuning the system.
Facing fraud
According to a recent study commissioned by CyberSource and Visa International, 75% of Web merchants consider online fraud a problem. On average, the respondents estimated, about 5% of total transactions on their systems are fraudulent, though the numbers ranged up to 25%, depending on location, industry and type of product. In terms of dollar volume, International Data Corp., a market research firm in Framingham. Mass., calculates that in 1998, 2.3% of all Web sales were bad payments or fraudulent transactions. The results are costly for merchants. Along with the lost cost of goods stolen, excessive fraud can raise merchant’s discount rates, cause chargeback penalties and introduce costs for settling disputes.
Representing more than 70 man-years and millions of dollars in software development, Fraud Screen 4.0 is arguably one of the most sophisticated identity verification tool on the market today. The artificial intelligence based software, which resides on CyberSource’s servers, performs real-time data analysis on more than 150 variables in several stages.
Bonafide buyers
When a consumer clicks on the merchant’s buy button, the data he or she inputs, along with merchant data regarding the item, quantity and product risk profile, is routed to CyberSource’s servers. Fraud Screen first performs a series of checks for consistency, scrutinizes the consumer’s Internet identity and geographical information, compares the transaction against an historical database to look for high-risk patterns, and analyzes the velocity of the consumer’s past purchases: Has the customer been buying similar goods every 15 minutes for the last two hours?
After completing its analysis, Fraud Screen sends the merchant a score that represents the likelihood that the consumer is legitimate and whether the transaction is valid. It also provides a risk profile code to explain how the score was compiled. The merchant then decides whether to accept the order or divert it for special handling. “We have an aggregate view of the bad guys,” explains Donahoo. “You don’t get that as a single merchant. We take our cumulative learning and apply it to their site.”
Across the payment services market, CyberSource’s competition is cumulative, too. The company squares off against single point providers such as HNC Software, which offers neural network-based fraud detection software widely used by credit card issuers, as well as integrated service providers like CyberCash and ClearCommerce. In addition to offering a suite of payment services per transaction, ClearCommerce sells its merchant software outright. But CyberSource’s biggest competitor is in-house software, Donahoo acknowledges. According to a CyberSource survey, only about 40% of Web merchants outsource or plan to outsource their payment services.
Jupiter Communications, a market research firm based in New York, estimates that online transactions will increase elevenfold by 2003. Over the next year alone, the number of online merchants is expected to grow from 1 million to 5 million. The skyrocketing transaction volumes—hence transaction fees—will drive down prices and force merchants to look more closely at bringing these services in-house, says Jupiter analyst David Schatsky. “We see it as a real choice point. Merchants are going to take a hard look at the fees that they’re paying out.”
Price pressure
Joseph Marino, an e-commerce analyst at Current Analysis in Sterling, Va., agrees with Schatsky’s assessment. “Payment services are rapidly becoming a commodity. The transaction vendors like CyberSource, ClearCommerce, Signio and others are all trying to figure out how to make money,” he says. “There will be lots of pressure on prices.”
New and enhanced services will become increasingly important as this squeeze occurs. And that’s an opportunity CyberSource plans to capitalize on. The company’s current focus is to develop a host of new services, including gift certificates, new payment methods, affiliate programs and e-mail support.
But McKiernan and his colleagues will have lots of company. Marino expects to see growing competition from banks and credit card companies entering the market as e-commerce grows. “Third-party vendors are taking over their business,” he contends. “There will soon come a point when the credit card companies will have to become more aggressive.”
But the prospect of increased competition—wherever it comes from—doesn’t seem to worry CyberSource’s top brass. “The Internet is a level playing field. And we have more experience than anyone else,” says Donahoo. “If we continue to provide solutions for our customers, we’ll have a very successful business.”
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