If most people have never heard of PayPal, it's because they aren't tempted by online auctioneer eBay and its featured items, such as the "Grand Funk Railroad Collector Series Sealed CD" I spied there the other day. Yet eBay denizens know PayPal well: It's their favorite way to exchange money online. After at least one in four eBay auctions, buyers settle up by clicking on a link to PayPal, which takes a small fee from the seller. Beyond eBay, PayPal also appeals to small online merchants. Revenues last year soared to $105 million, from $14 million in 2000. PayPal netted a loss of $108 million. Yet, while full-year cash-flow results still are not in, through Sept. 30 operating cash flow swung to $34 million from a prior-year burn of $12 million--not, in other words, the sort of bubblicious Internet IPO that plagued us in 1999.
Before placing your bid, however, know that PayPal faces two sizable threats: competition and regulation. Execs at PayPal, which so far has been bankrolled by leading venture capitalists (table), declined to talk ahead of the deal. But their securities filing identifies two chief rivals: Citigroup (C
), which runs a money exchange known as c2it, and eBay (EBAY
) itself, with its own eBay Online Payments. Both have been slower than PayPal to win market share, yet each boasts formidable advantages. eBay can use its control of the online auction block to steer bidders toward its service--or ban PayPal altogether--while c2it is promoted prominently by America Online (AOL
) and Microsoft's MSN (MSFT
). Both enjoy the financial muscle of big banks, including Wells Fargo, which owns part of eBay's service. Their bank affiliations ease the way for eBay Online Payments and c2it to set up their money-transfer services.
PayPal's lack of ties to a bank, by contrast, could prove to be a problem. Its lengthy, eye-glazing user agreement says explicitly that it is not a bank, but to regulators in four states, PayPal looks suspiciously like an unlicensed banking operation. They are questioning PayPal's practice of opening accounts from which its users can leave cash, have it swept into a PayPal money-market fund, or withdraw it via ATM and debit cards. They could conclude that PayPal's operation is illegal.
That's no slim chance. In fact, three days after I raised the issue with the states--California, New York, Idaho, and Louisiana--PayPal amended its filing with the Securities & Exchange Commission. Its depiction of the regulatory risk now is more sober. For example, PayPal's earlier filing noted, "New York regulators are waiting for a determination by the State of California before taking any action, but we believe they will defer to the conclusion of the California authorities." Its reference to New York now says only that regulators "have expressed their view that the ability of our customers to leave amounts on account for future transfer represents impermissible banking."
In California, too, regulators are still trying to resolve PayPal's questionable status. Counterparts in Idaho and Louisiana told me that their cases also remain very much open. "We do frown on anyone retaining funds for a customer," said Gary Newport, general counsel in Louisiana's Office of Financial Institutions. "Until we have resolved [our concerns], PayPal has been instructed that they may not do business in" Louisiana. PayPal hopes the Federal Deposit Insurance Corp. will issue an advisory opinion that PayPal accounts don't tread too close to banking. The FDIC told me it is still studying the question.
The regulatory clouds over PayPal's future--and stock--could blow away. But given how much experience with regulators PayPal's two leading rivals, Citi and Wells Fargo (WFC
), have built up, I'd rather bid on a Grand Funk CD. By Robert Barker