A tiny part of Square's business could make it a Wall Street darling

Square finished a bumpy ride to the public markets on Thursday, losing half of its value in its IPO pricing and then popping 45% on is first day of trading.

As the IPO buzz and excitement settles, questions about the digital payments company’s business prospects are taking center stage.

Square’s revenue growth is slowing, while losses widen, and some wonder whether its core payment processing business is getting commoditized with shrinking margins.

But there’s a tiny part of Square that may hold the key to taking the company beyond its core business: Square Capital.

Square Capital is its cash advance unit that has processed more than $US300 million since its launch in May 2014.

It’s a tiny portion of Square’s overall business — looped under “software and data products,” which accounts for less than 4% of Square’s total sales — but it is believed to be growing significantly faster, with richer-margins than the rest of Square.

And as Square moves forward as a public company, Square Capital will play a bigger role convincing investors of its future upside.

Gillette’s razor blade model

While the nifty credit card swipers that plug into smartphones and tablets are often touted as a evidence of Square’s innovation, the company’s future success may rely on the more old-fashioned business of making loans.

“Square can monetise [Capital] very efficiently. It allows them to build up a high margin revenue stream to complement the traditional lines of business,” Battery Ventures general partner Roger Lee told Business Insider (Battery Ventures is not a Square investor).

Square Capital follows a traditional merchant cash advance (MCA) model that lets pre-qualified Square merchants borrow money and pay back gradually. Borrowers return a small, fixed percentage of its daily sales, meaning the more you sell, the more you return, and vice versa on a slow day.

Square makes money by charging a small percentage of premium, usually around 10% of the total, on top of the advances. It also charges a service fee when the advance comes through a third party lender. In any case, it’s a highly efficient, low cost business model (“Software and data products” had an over 60% gross margin vs. 36% gross margin for its core payments business).

It’s also growing fast — the broader Software and Data Products group generated $US35.6 million in revenue in the first 9 months of this year, a 6X jump from the same period of last year, while doling out $US1 million a day to its merchants. The product is proving to be sticky too: nearly 90% of the merchants are choosing a repeat advance, according to Square’s prospectus.

Battery Ventures’ Lee said the model could potentially evolve into something much more significant that somewhat resembles Gillette’s classic razor blade model — in which the commoditized razor grabs market share, while the higher margin razor blades rake in the real profits.

“Think of the credit card reader as the razor, and the loan as the razor blade,” Lee added. “The reader is basically an enabler of a much more interesting lending business. It will drive their long term profitability and equity value.”

Square seems aware of this, too. Just recently, it poached top Yahoo exec Jackie Reses as the new head of Square Capital. In its IPO prospectus, Square points out the advance service as a potential future growth driver.

“Although Square Capital currently does not contribute a significant amount of revenue to our business relative to our payments and POS services, our software and data product revenue, including revenue derived from Square Capital, has grown quickly, and we expect these products will contribute a larger portion of our total revenue over time,” it writes.

Huge market opportunity

Square’s primary market is the small business owners. And Square Capital solves a problem every small business owner struggles with: cash flow.

Banks have traditionally overlooked small business loans because of its low margin and high default risk nature.

But a number of online lending and cash advance services in recent years have made it cheaper to acquire and process loans/advances, while using better technology and data analysis to lower default risks.

Square Capital, for example, only extends the advances to its existing users, whose financial data is already shared with Square. That allows it to have a full understanding of the merchant’s sales history and future projections, and safely determine the cash advance terms accordingly.

This is a market that’s been hit particularly hard after the recession, and never fully recovered, leaving a big gaping hole for services like Square Capital to come in. The value of loan originations to US small businesses has been nearly cut in half since 2007, while banks are still slow the embrace this market.

“The 2008 financial crisis left hundreds of thousands of small businesses with pent-up demand for working capital to grow their businesses. Only 2.4 million traditional loans were originated to businesses with $US1 million or less in revenue in 2013, down 54% from 2007,” BI Intelligence writes in a report.

Still a long way to go

As Square admits in its S-1 filing, Square Capital is still in its early stages. In some ways, it’s also a limited product because it’s only available to the small business owners that use Square, and you can’t take out multiple advances before paying back your initial one.

“Square’s merchants are smaller,” IVP’s general partner Eric Liaw said, estimating the average Square Capital advance to be less than $US30,000. Online lending marketplaces, like OnDeck, in which Liaw’s invested in, typically make 6-figure loans, resulting in much higher fees for the company processing it.

Square will certainly want to expand its lending to a broader swath of businesses, but that will require licenses with stricter conditions and more regulatory compliance, all of which mean increased costs.

“As our business continues to develop and expand, we may become subject to additional rules and regulations. For example, if our Square Capital program shifts from an MCA model to a loan model, state and federal rules concerning lending could become applicable,” Square wrote in its S-1.

Still, Square Capital seems to be in a good place with much more room to grow, especially if Square can continue to expand its merchant base.

“The product itself will have unique advantages in the market, and it’s a big market,” Lee said. “If they focus on it, and execute it, it can be a big success for them.”

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