Square has been a remarkably successful start-up. Since its IPO in 2015, the stock has risen 418% compared to the equivalent S&P gain of 38%. Even arch-competitor PayPal is up only 195% in that period. By May 2019, Square’s price-adjusted sales ratio reached 13, an extraordinarily rich valuation for an as yet unprofitable business.

How has it done this? Square processes payments for small and medium enterprises (SME). Square calls its customers “sellers” and surrounds its payment “rails” with a set of software to carry out typical seller functions like point-of-sale (POS) transactions, inventory, customer management, payroll, short-term loans, and more. In short, this is an all-encompassing merchant acquiring capability so simple that 80% of Square customers “self-onboard,” as Square puts it. And, the firm’s strategy is to keep adding functionality to lock customers in.

Twenty-five years ago, merchant acquiring was not considered a particularly attractive business. At that time, most retailers collected scads of paper, either cash or check. It had to be trucked daily to some local depository, which usually served as the merchant’s main bank. Cash registers or POS systems were found in stores of every size. Although card payment volumes were large and growing even then, the merchant acquiring function remained an addendum to the bank. Merchants that accepted significant volumes of card-not-present (CNP) payments were large players, like airlines, that required specialized treatment. There was intense competition between the major merchant acquirers, which consistently pushed margins down. In short, the business was a very different business than it is today.

Four major trends have changed all this.

First, the internet, Wi-Fi, and smartphones have allowed every seller, no matter how small, to be online and connected. Twenty-five years ago, “online” meant access to an old-fashioned dumb terminal, which not everyone had. Those SMEs who accepted payment cards, and there were some, had to call in for an authorization or take huge risk. And then use a three-part imprinter. But most small businesses didn’t take cards at all.

Second is the continued growth of card transactions in general. It took several decades but noncash payments rose from maybe 50% of all transactions to today’s world where merchants don’t want cash at all and legislators in various states are busy passing laws that a merchant must take cash.

Third, an SME’s back office was generally unautomated at that time and if it was, it might be just homegrown spreadsheets. Even aside from payments, other SME functions are entering a third stage of simplified interactive and online automation that is amenable to packaged software.

Fourth, card payments themselves have grown far more complex. Hundreds of interchange rates now depend on card type, merchant type, charge amount, technology used, geography, merchant rating, and so on. The growth of CNP payments instigated huge antifraud measures and concerns. Regulations are triple what they once were. Fraud and risk controls have quadrupled. Handling credit and debit accounts correctly has moved from nice to have to mandatory.

Square has taken advantage of all these trends. Technically, it is not a merchant acquirer at all but looks that way to its customers. It’s a “payments aggregator” that stands in as the merchant of record. Square sends 70% of its volume through Paymentech, constituting about 4–5% of the latter’s volume. It does take risk – transaction charge-offs were $17.4 million in the last quarter. In essence, Square and its competitors represent a new class of company inserting itself in the flow of data that constitutes a transfer of value to the “seller” from the “sellee.” That flow is no longer from merchant to merchant acquirer to merchant bank to the associations. Now it is from merchant to payments aggregator to merchant acquirer etc.

This makes sense. Square has focused clearly on the smallest of sellers by beginning with a dongle and a system so simple that an individual with a smartphone and very low volume (such as a tradesman) could start taking card payments relatively safely. Then it began working its way upscale into stores or service businesses with an emphasis on start-ups and trendy niche urban stores. Today, it claims over 2 million sellers but also advertises about 24,000 actual stores, the largest of which, it says, has 40 locations.

Previously, small sellers would have been approached by a commissioned salesperson working for an ISO trying to fit them into the technology and procedures of a much larger acquirer. This would been a push product, a high cost sales (and service) channel. But Square’s approach is pull, with high cost in the beginning for development but low cost on the increment, and once up to scale, likely more profitable than the ISO way.

When we look at its financials, we can see that Square could be GAAP profitable if it stopped reinvesting and adding. Two thirds of the company’s revenue comes from transactions that have a fairly nice “take rate” of over 1%, boosted by charging the same for debit and credit transactions. In fact, the firm’s markup over interchange is 55–60%, which is extremely high. Larger merchants will naturally prefer interchange-plus pricing, which costs them much less, and Square will encounter more resistance to its pricing as it attempts to attract larger sellers. (The abortive 2012 deal with Starbucks may never be repeated but is illustrative. Square lost big time on razor-thin pricing over interchange.)

Square’s total payment volume (TPV) was $22.5 billion in Q1 2019. Excluding its 4% international volume, this is roughly 1.5% of the total U.S. acquiring market. There had been worry about how high Square can go in attracting larger merchants and thus whether or not it is a major threat to the large established acquirers. (Of course, large players are retaliating; e.g., First Data’s Clover.) But this concern may be exaggerated. For example, Square claims that its percentage of coming from large sellers is growing. To Square, “large” is over $125,000 annual sales. While that is a legitimate market, such businesses would likely be called “small” at Worldpay.

I think Square has already shown that its strategy is to rely mainly on the low end of the market. If it can get larger sellers, great, but that is not where its current emphasis is.

First, its acquisition and investment focus is on expanding its software “ecosystem” for SMEs. Purchasing Weebly, a website builder, helps, but that is less likely to affect larger merchants which already have extensive websites. Purchasing Caviar, a food delivery start-up, has everything to do with a hot new market and nothing to do with penetrating the larger merchant acquiring business. Buying and selling Bitcoin might appeal to innovative Cash App users but won’t do anything for a high-volume merchant. The investment in, and proposed partnership with, Eventbrite is targeted at that firm’s impending marketplace, which is just another way to reach small sellers.

A second focus is Square’s high interest in financial services, which may be helping the firm but is probably not scalable. Square has offered Square customers, the sellers, loans averaging $6,000–7,000, 12 months’ installment with 4% losses that are easily sold off. That’s fine, but the Q1 2019 loan volume of $500 million is in the community bank range and hardly any threat to Chase. Instant settlement for 1% instead of 1- to 2-day settlement is equivalent to a payday loan at well over 100% APR. Square claimed $4 billion in such volume in Q2 2018, or $40 million – about 10% of adjusted revenue. The company claims it can control the losses since they not only see the revenue, they control the revenue. But this type of naïve bootstrap start-up gouging of the seller won’t go upmarket very much.

Debit card access to a seller’s funds makes sense for an individual proprietor but does little for an incorporated company with employees. The “instant” installment loan for a seller customer at the point of sale is a credit card substitution product analogous to what Lending Club has tried to do, so far unsuccessfully.

Square’s fastest growing revenue component is from Cash App, in the person-to-person (P2P) payment business, competing against Venmo. The company claims this has been successful and even exceeds the current downloads of Venmo. There may be an overlap with Square’s sellers but even if not, it will have little resonance trying to go upscale into larger merchants.

In summary, Square is likely here to stay. Last quarter its adjusted EBITDA was $61 million, 72% above the same quarter a year ago. Certainly its business idea of a wraparound ecosystem of software and payments for SMEs is here to stay. Whether it will ever appeal to enough larger merchants to threaten established acquirers is doubtful. Some of today’s lofty valuation is based on unrealistic expectations of climbing the seller-size pyramid. And the market may have begun to notice this. Square’s stock has drifted downward by about one-third since its peak in October 2018 although it is still richly valued.