If you’re still not convinced of the power of the PF model, prepare to be so. Square, perhaps the leading payment facilitator, with 2 million active customers, has finally made its financials public via its S-1 filing, and its losses are staggering.

How could this company have attracted private valuations in excess of US$6 billion? Simple: by being a great company with a great plan in an emerging market. Despite being on target to accumulate half a billion in losses in a four-year period, it is a robust business, with solid management on the brink of profitability. Its losses do not result from negative business factors, but rather because management is so excited by its opportunities that it is taking a Amazon-esque approach, forgoing short-term profits to invest in its many future opportunities. One should view the magnitude of the losses not as a negative, but rather as indicative of the magnitude of the opportunity.


Heartland Payment Systems (HPY), is a highly respected, well managed, publicly traded merchant acquirer with an enterprise value of about U.S. $3 billion. Heartland was founded in 1997, which makes it a much more mature company than Square, which was founded 11 years later. However, Square’s revenues are already approaching Heartland’s. At its current compound annual growth rate (CAGR), we can expect it to surpass Heartland in 2016.


So how is it that Square is pulling in nearly half a billion in revenue and not making a profit? Does that management team have a clue as to how to manage its expenses? Square’s management is actually doing a powerful job managing expenses. Total expenses went from U.S. $149 million in 2012 to U.S. $375 million in 2014, and are on track for U.S. $508 million in 2015, a CAGR of 50 percent annually. Since revenue grew at a 90 percent rate over the same period, this represents significant cost discipline. In fact, as a percentage of revenues, expenses have fallen at a 20+ percent rate annually.


By simply continuing to do what it has done over the last three years, Square can cut an additional 20 percent off of the 2015 number of 110 percent, bringing the expense ratio to 88 percent in 2016 and achieving profitability next year.

But Square is already doing more to cut expenses than it has in the last three years. It has already announced that in 2016 it will be terminating its relationship with its largest customer, Starbucks, because the relationship has not been profitable. Square’s net loss associated with the Starbuck’s account will be about 19 percent of revenue, so that should even further accelerate realization of profitability.

Not only that, but Square could easily have achieved profitability already, but chose not to for very good reasons. In each of the years from 2012-2015, Square spent more on product development and sales and marketing than it incurred in total losses, meaning that losses were not losses resulting from normal operations, but rather a conscious decision to invest in future growth at a level that is above and beyond its current revenue.


This is normal for a startup, although not necessarily normal for a company with hundreds of millions of dollars in revenue. Square, however, disclosed in its S-1 that its average payback on customer acquisition costs (sales and marketing expenses) is between 4 and 5 quarters. It also reported that, over time, customers grow their business with Square to the point that “retention of transaction revenue net of transaction costs for our cohorts has, on average, exceeded 110 percent year over year.”

So while the sales and marketing expenses are a drag on the current year’s earnings, these investments are clearly paying back in the subsequent year and will continue to do so for years to come. Given the opportunity to invest in something that pays back at this rate, investors have backed up the armored truck and said “Take it! Take it all!” and Square has quite rightly obliged. There is no good reason to cut these sales and marketing expenses because the return on investment is just too good.

At the same time, Square argues that it is a differentiated offering, in that it is a merchant service provider that offers a cloud-based service where all of its active customers interact with Square every day. This is in sharp contrast to traditional merchant acquirers that provide payment services via a payment terminal. The regular and ongoing on-line customer interactions provide Square with continuous sales and servicing opportunities and Square is therefore investing heavily in new product development in order to take advantage of those opportunities.

Success has been limited thus far. Square reported that 95 percent of revenue still results from payments and POS services. However, the opportunity to further expand the profitability of its customer acquisition investments by offering incremental services is just too great to pass up. Thus far, Square has value-added offerings that include payments, point-of-sale hardware, invoicing, gift cards, analytics, employee management, payroll, customer appointment scheduling, small business lending, online selling, customer engagement, and food delivery. It also offers an app marketplace through which third party developers can deliver solutions to Square customers, with any resulting fees being split between Square and the developers.

Square rightly intends to continue to make these investments in order to further expand the returns realized on its sales and marketing efforts. It’s also important to note that, should these investments not bear fruit, they can easily be eliminated from the operating plan. These expenses should therefore be considered controllable, long-term investments funded by highly rational investors seeking to further enhance their current returns.

In other words, Square is absolutely killing it. Its growth is astounding, its expense management is solid, and its losses are a function of having massive opportunities and the capital inflows needed to pursue them. Who can deny the power of payment facilitators when they are facilitating numbers like these?