How Square rival ShopKeep plans to make the payments business profitable
Wall Street was abuzz Thursday with the high-profile initial public offering of mobile payments processing firm Square.
The San Francisco-based company is just the third tech startup valued at $1 billion or more to go public in 2015, following Pure Storage and Box.
The Square IPO was widely considered a harbinger of whether high-valued technology startups could still command investor interest on the stock market.
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So far, it appears as though Square has sidestepped any mines that could burst the rumored technology bubble. But the company still has a lot to prove. Primarily, that it can eventually make money by helping tiny businesses accept credit-card payments.
Square has built its business around its initial revenue stream -- payment processing fees -- and they still make up the bulk of its business today. The downside to Square's approach is simple: Payment processing fees carry low profit margins.
Another way to look at Square's business model is in contrast to one of its competitors.
Similar to Square, New York-based payments startup ShopKeep makes point-of-sale software for small businesses, with tools for managing transactions, inventory and customer information.
But unlike Square, ShopKeep earns revenue primarily through its subscription software business. According to ShopKeep CEO Norm Merritt, this model puts his company on a much faster track toward profitability than the one used by Square.
"We're the anti-Square," Merritt said.
"We have better unit economics," he continued. "We don't have a large swath of customers that cost us money like Square does. Significantly superior gross margins coupled with very low churn are proof points that our model is superior."
ShopKeep was founded in 2008 by former wine-shop owner Jason Richelson, who said he was fed up with the software available to small merchants and the cost of legacy systems. Richelson is still with the company as chief strategy officer.
ShopKeep charges businesses $49 a month, per register. Its software is made to run on an iPad, which the company sells along with other hardware used by its merchant base -- mainly restaurants, bars and specialty retail shops generating average sales of $400,000 a year.
Merritt said ShopKeep's customer acquisition payback (the time it takes until they start making money off of a customer after accounting for what it spends to acquire one) is less than a year. That means a new ShopKeep customer becomes very profitable in a relatively short amount of time.
Square, on the other hand, has struggled in its ability to make money off of some its customers, especially the tiny micro-merchants with low check averages. The way Merritt describes it, Square has an adverse selection issue in the core of its business.
"Square attracts merchants who have a very low check average and thus a typically high processing rate," Merritt said. "These low-end merchants will join Square in droves because of Square's flat 2.75 percent fee -- however, they each cost Square money as the fee is lower than Square's cost."
ShopKeep acquired a payment processor over the last year, so the company now generates revenue from transaction fees, too. But as opposed to having a flat processing fee like Square, ShopKeep uses the Interchange Plus method of pricing.
"We charge what the banks charge (Interchange) plus a small mark up," Merritt said. "For merchants whose transaction size is over $10 on average, we can beat Square's flat rate every time and we make money every time."
But because ShopKeep charges customers to use its core services, the company faces a more difficult sales pitch when acquiring a new merchant as opposed to Square. This becomes evident by the stark contrast in customer and revenue metrics for each company.
Merritt said Shopkeep has 20,000 business customers and is projecting revenue between $30 million to $40 million for 2015. Square has more than two million active merchants and did $560 million in sales in the first six months of 2015 alone.
But Merritt circles back to the size of its customers as opposed to Square. On average, a Square merchant has a gross sales value (GSV) of around $30,000 a year.
"There just is not a lot of room to sell additional, profitable features to tiny businesses like that," Merritt said.
Looking long term, both ShopKeep and Square have a lot to prove. Merritt says ShopKeep is not profitable today because it is reinvesting in its sales and marketing divisions. The same goes for Square.
Square has yet to turn a profit in its seven-year history. The company's CEO Jack Dorsey told CNBC on Thursday that Square will continue to invest in its business and accelerate its ability to scale. More recently, Square has been trying to build up higher-margin software and data offerings to complement its processing revenue.
As for ShopKeep, Merritt said 2015 revenue will end up more than double last year's total and he expects that they'll at least double revenue again in 2016. Merritt is also eyeing an IPO within the next two years.
Earlier this month, Michael DeSimone joined ShopKeep as its chief operating officer. DeSimone was most recently the CEO of e-commerce services provider Borderfree, which he took public last year and sold to Pitney-Bowes this past May. ShopKeep also recently hired new CFO John Baule, who has taken two companies public, including cloud-based e-commerce software company ChannelAdvisor.
"Ultimately, we're in a good place," Merritt said. "We have a long runway having just announced a new round of funding and are intently focused on building a strong, lasting and profitable business, as opposed to rushing anything and then underperforming."
We'll see if the same goes for Square.