September 30, 2002, 12:00 AM

What eBay Gets from Its New Best Friend

eBay has high expectations for how PayPal can help it expand its market—and not just in auctions.

Sometimes it makes more sense to acquire the competition than to continue waging an expensive battle to defeat it. That was the conclusion San Jose, Calif.-based eBay Inc. reached in July when it announced its intent to purchase PayPal Inc. for about $1.5 billion.

The acquisition, which is expected to be completed by year’s end, closes the book on an unsuccessful, multi-million dollar campaign begun by eBay in 1999 to make its eBay Payments By Billpoint service the leading payment mechanism on its site.

Although the Billpoint experiment proved a costly mistake-analysts estimate eBay had invested more than $250 million in Billpoint-the decision to acquire PayPal for about 25% more than its market valuation as of July 5 is not the equivalent of waving a white flag, analysts say. Quite the contrary; many view eBay’s acquisition of PayPal, which is the preferred online payment mechanism on eBay, as a shrewd tactic expected to achieve three goals: significantly increase eBay’s revenues by reducing its transaction processing costs, boost volume over its site and expand eBay’s e-commerce presence on the web, which will increase earnings from user fees.

Furthermore, PayPal is not your typical highflying dot-com. Since going public in February it has turned a profit, a rare distinction for dot-coms with management teams in their twenties and early thirties. Net income in the second quarter totaled $529,000 after a $1.2 million profit in the first quarter, reversing losses of $27.7 million and $29.3 million for the same periods a year earlier.

Rescuing a failed strategy

PayPal has also demonstrated its staying power in a volatile marketplace by outlasting competing online payment mechanisms such as e-cash and electronic wallets.

“Clearly, Billpoint was losing money and a failure for eBay,” says Shawn Milne, principal for Soundview Technology Group, a San Francisco-based market research firm. “As a public company eBay has high standards for operating margins so they need to keep that going. PayPal has shown it can beat earning projections and eBay decided to go get them. EBay is going to realize a lot more revenue through PayPal.”

PayPal, founded in 1999 by Max A. Levchin, a recent graduate with a degree in cryptology, has become the payment method of choice on eBay and is reaching out now to other e-commerce sites. PayPal represents about a third of all eBay payments, a figure that is expected to grow as eBay promotes PayPal as a preferred payment option. In comparison, Billpoint transactions on eBay are about one-sixth of those for PayPal. Cash, checks, credit cards and other online payment mechanisms account for the remainder of payments on eBay, which expects to phase out Billpoint over the next several months. EBay will operate PayPal as an independent brand.

“PayPal got a big head start over Billpoint and other competitors in the auction community, largely because it offered incentives to buyers and sellers to try its service,” explains Beth Robertson, a senior analyst with Needham, Mass.-based TowerGroup Inc. “With its ownership of PayPal, eBay is getting that market awareness and presence.”

PayPal debuted on eBay in early 2000. That use was an outgrowth of the company’s first application-securely transferring money between Palm Pilots. Levchin, now 26 and PayPal’s chief technology officer, had a notion to launch a company to create an encryption standard for mobile transactions. In the late 1990s, Levchin met Peter A. Thiel, who ran a large hedge fund. After listening to Levchin’s pitch, Thiel, now 34 and PayPal’s chairman and CEO, agreed to provide the funding to form PayPal. The application hit the streets in October 1999 and attracted 10,000 users by year’s end.

Ease of use

PayPal, with 13.5 million consumer accounts, quickly became popular among consumers as an online payment device because it is easy to use. Consumers fund PayPal accounts by transferring money from bank accounts or credit card accounts to their PayPal accounts. A user establishes an account by providing his or her name as it appears on the bank account or credit card, an e-mail address and a home phone number. A user also selects a password to access the account and provides two forms of personal data, such as mother’s maiden name or date of birth, to verify identity. A user who wants to replenish an account simply instructs PayPal to tap the credit card or bank account. Buyers initiate a payment by clicking on the PayPal icon on the merchant’s web site.

One way eBay expects PayPal to add to its revenues is through PayPal’s lower transaction processing costs. PayPal and Billpoint pay a fee for funds transfer every time a consumer replenishes an account. PayPal pays 3 cents to replenish an account from a bank account using the automated clearinghouse system and 3% using a credit card. About 25% of funds coming into PayPal accounts originate in a bank account at 3 cents per transaction. Another 25% are transfers from one PayPal account to another, costing PayPal virtually nothing. The remaining 50% are from credit cards at 3%. Analysts say that mix adds up to a margin of 65% for PayPal.

By contrast, customers replenish almost all their Billpoint accounts through credit cards, making it difficult for eBay to mark up the transactions to sellers enough to make money. “Billpoint transactions are almost exclusively funded using credit cards, which leaves eBay with about a 35% gross margin per transaction after processing fees,” explains Scott W. Devitt, analyst with Baltimore-based Legg Mason Inc. “PayPal’s gross margin on ACH transactions after processing fees is about 95% and about 100% on PayPal credits.”

PayPal’s margin comes in the difference between what it pays for the money to come into the account and what it charges its 3.5 million merchants to receive the payment. Those sellers pay 2.2% plus 30 cents a transaction for a merchant account and 2.9% plus 30 cents for a standard (individual seller) account. Sellers in good standing can get the lower rate after 90 days.

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