Klarna: Solving the Most Fundamental Challenges of eCommerce

Earlier this week, a mate told me about a Swedish payments company that is funded by Sequoia Capital, the venture firm that invested in Google, Paypal and more recently Square.  To learn more about the Klarna, I thought I’d do a post on them.

First, some background.  Klarna was established by three students at the Stockholm School of Economics in 2005, when they took part in the school’s incubator programme and received EUR 60K of angel investment.  The background for their business idea can be summarised with two simple facts:

·      70% of online shoppers would prefer to pay by invoice

·      29% of those who don’t shop online do so because of security

The entrepreneurs behind Klarna therefore decided to develop a convenient, secure and flexible solution to enable online payments by invoice.  The customer simply selects Klarna Invoice as payment method at check-out, enter its national ID number and Klarna will underwrite the payment.  The merchant sends the order, along with an invoice, to the customer, who settles the invoice with Klarna within 14 days. 

By implementing Klarna Invoice, and better catering to customers who are uncomfortable with using credit cards for online purchases, merchants increase sales by an average 25%.  Klarna charges the merchant a set-up fee of EUR 330, an annual membership fee of EUR 330 and a transaction fee of 2.95% plus EUR 1.7.  This is clearly not cheap, but with few competitors offering a similar service, most merchants will probably see the value of Klarna.

In addition to their basic Invoice solution, Klarna has launched two other products; Klarna Account and Mobile.  Klarna Account is an instalment service that allows customers to break up their repayments over several months.  All purchases that are made through Klarna are consolidated to a single account, which provides additional simplicity.  This service has half million users, who on average make 5 times more purchases than other online customers.  

Klarna Mobile is the most the most recent Klarna product and is currently only available in Sweden.  With this solution the customer enters his mobile phone number at check-out and receives a PIN-code by SMS, which is used to verify the purchase.  The customer is automatically set up with Klarna Account, which provides one monthly account that aggregates all purchases and enables the customer to split the payment in instalments.  Although this service initially targets online payments, there is clearly potential to expand it to brick-and-mortar purchases.

The numbers certainly demonstrate that Klarna has hit on a very attractive opportunity and show why Sequoia chose to invest.  Five years after being set up, Klarna is now present in 6 northern European markets, Sweden, Finland, Norway, Denmark, Germany and the Netherlands, and is accepted at more than 8,000 merchants.  4 million customers have made a purchase through Klarna to the value of more than EUR 500 million.

The beauty of this model is that Klarna is not dependent on building a network, as customers can use the service without already being registered users.  Although customers may be more inclined to use the service as it becomes more familiar and they begin to consolidate their services with Klarna Account, at its core, the service is as relevant to the first merchant as it is to the millionth.  

Still, there are a number of challenges ahead.  The credit card networks are continuously improving their security features, slowly alleviating customers’ concerns with security.  Furthermore, every week a new player seems to enter the online payments space with new, more convenient and secure technology.  These trends may eventually put pressure Klarna to reduce their merchant fees.

Moreover, Klarna’s Mobile solution does not seem like a viable competitor in the bricks-and-mortar space.  Customers are more comfortable with using credit cards for physical transactions, cancelling out Klarna’s proposition to brick-and-mortar merchants.  With this in mind, physical merchants are unlikely to accept the relatively high implementation, membership and transaction fees that come with Klarna’s service.  Finally, the scale of sales and implementation resources that would be required for Klarna to expand their service among physical merchants would probably see them overreaching.

Despite these challenges, by developing a secure and convenient method for customers to shop online, Klarna has solved two of the fundamental challenges associated with ecommerce.  With little competition in this space in Europe, Klarna will likely to continue growing for many years to come, certainly justifying Sequoia’s EUR7M investment.

Square and the Mobile Acceptance Devices

Square has become a bit of a media darling recently and received much press attention when they yesterday announced that they have closed their Series B funding round for $27.5 million led by Sequoia Capital, which values the company to $200 million.  Square is headed by Jack Dorsey, the co-founder of Twitter, and is benefitting from this association in the media.  However, it has also developed an exciting, new product that merits attention on its own.

Unlike most mobile payments companies, Square is not challenging the cards industry, but taking a more pragmatic approach that is likely to give greater payoff in the short term.  It works from the observation that everyone already have plastic cards and that this model works quite well for now. 

However, not all merchants are able to easily get card terminals and merchant agreements. Square has therefore developed a device that turns any mobile device into a card terminal and developed an approach that enables anyone to get set up to accept cards in minutes.  The technical innovation is a small, square card-reader that plugs into the phonejack of any mobile device and processes Visa, Mastercard, Amex and Discover cards. 

The device is cheap to produce and Square distribute them for free to merchants that sign up for their service.  This has proven very popular, with between 30,000 and 50,000 merchants signing up per month since launch in October 2010.  It is especially smaller merchants for whom it was previously not cost efficient or convenient to accept cards that sign up for Square.

It is primarily this market positioning that differentiate Square from other providers that have launched similar products over the last year, such as  Verifone, Intuit and HomeATM.  None of these have seen the same level of success, either due to more stringent merchant agreements, or possibly because they have been outshone by Jack Dorsey’s star power.

However, a number of market participants have warned against lacking security features on Square.  Essentially, Square relies on the mobile device to encrypt the magstripe data, whereas more secure devices perform this encryption at the magnetic head.  With Square’s approach there is a risk that the mobile device is hacked and that the credit card data is intercepted before it has been encrypted, and therefore exposing the cardholder to fraud.  

Moreover, Square and other mobile acceptance devices do not really tackle the bigger issues where cardholders and merchants hope to benefit from mobile payments.  They may bring some convenience for smaller, mobile merchants, and may justify its media hype and valuation on this basis alone.  However, it does not reduce merchant fees or improve security and is therefore unlikely to make a bigger dent in the card industry.

Rewards: do they work, and for whom?

Sumit Agarwal, Sujit Chakravorti, and Anna Lunn of the Federal Reserve Bank of Chicago published a paper that explores how reward programmes affect consumer behaviour (. 

They find that consumers that receive an average of $25 of rewards over one year.  During the first quarter, these customers increase their spending and debt by $68 and $115 per month respectively.  During the following 3 quarters, average spending and debt rise by $76 and $197 per month. 

Importantly, customers increase their debt by more than their spending, presumably as switch their repayment to other cards in an effort to consolidate their debt to the rewards card.  This is backed up by evidence that overall spending and debt accumulation remain constant or increase slightly, suggesting that cardholders substitute spending and debt from other credit cards.

The authors conclude that only a small incentive is necessary for customers to significantly change their behaviour and therefore an effective tool for banks to attract new customers.  Furthermore they suggest that this is proof of time inconsistency and bounded rationality on the part of the customer.  In other words, consumers do not initially intend to use the credit line, and therefore ignore the interest rate, but change their mind when the bill comes, leading to higher than intended debt levels.

In my mind, this conclusion is incorrect on many levels.  The authors have already shown that consumers’ overall spend and debt-levels stay constant or increase slightly (possibly due to substitution of cash transactions).  As they receive a $25 incentive to switch to a different card, their increased spend and debt on that product therefore seems entirely rational. 

More interestingly; are the authors correct in stating that cash back offers are effective in attracting new customers?  The challenge with cash back offers is that banks benefit only from the incremental spend and debt that customers put on their products, while banks needs to reward total spend, including the spend that they already captured. 

In our case, banks capture $888 of incremental spend during the first year.  If we generously assume that banks have an average margin of 1% on this spend, the incremental spend is worth less than $9.  Against an investment of $25, banks must generate $16 from other revenues in order for the rewards offer break even.  With an average increase in debt of $177 during the 12 months following the cash back reward being introduced; banks require a net spread after credit losses of at least 9% to break even in the first year. 

Banks may be happy to treat the first year as an investment and look to generate profits from the programme during following years.  However, as their customers have already revealed their fickle nature when switching their spend, it appears risky for banks to treat this as a multi-year investment.

Our analysis is of course based on high level assumptions and patchy data, but should cast doubt over the claim that reward programmes are effective (and profitable) marketing strategies for banks.  It is my belief that the rewards space is now so crowded (particularly in more sophisticated markets) that in order for programmes to be effective they must be genuinely differentiated.  These are likely to be offers of products or services, carefully targeted to the specific customer and based on hard-to-replicate technological platforms.

M-Pesa: Financial Inclusion through Mobile Payments (Part 2)

As a follow-up to my previous entry on M-Pesa, today’s post will focus on the market conditions that facilitated its success, Safaricom’s impressive execution approach as well as future opportunities.

Although Safaricom’s roll-out of M-Pesa was exemplary, it is important to recognise the market conditions that enabled its success:

·      Strong demand for domestic remittances: being a developing country, Kenya’s working population is increasingly drawn to urban centres.  This migration pattern leads to split families, where the migrant workers remit parts of their salaries to family members in rural areas

·      Poor quality of existing alternatives: Kenya’s banking network consists of less than 1,000 branches, too few to serve a market of Kenya’s size.  Migrant workers therefore resorted to insecure, slow and costly alternatives, such as the postal service and unlicensed money carriers

·      A supportive banking regulator: the Central Bank of Kenya recognised the need for a secure, convenient and cost efficient payment system and adopted a flexible regulatory approach.  The CBK required all deposits to be held by a regulated commercial bank, restricted M-Pesa from earning interests on deposits or lending money to its users and set a limit on transaction sizes.  Beyond this, M-Pesa was free to operate outside the banking law

·      Safaricom’s dominant market position: beyond Safaricom’s ability to finance the scheme, its dominant market position was important for three key reasons:

o   Greater customer base to cross sell the product

o   More agents (retail stores) to handle cash-in/cash-out services

o   Better brand recognition and trust to handle sensitive business

Having laid out the market conditions in Kenya, let’s look at how Safaricom designed the M-Pesa product offering and marketing approach.  Safaricom knew that people may be intimidated by new technology and designed M-Pesa to overcome any barriers to adoption.  Mas and Radcliffe identify seven key pillars to their approach:

·      Easy to understand, straightforward message: Safaricom recognised that M-Pesa would seem daunting to many potential users, and chose to focus their marketing on one basic message for which they new there would be a demand; ‘Send Money Home’

·      Simple user interface: in line with the marketing message, Safaricom opted for a basic, step-by-step user interface that would be intuitive to anyone

·      No set-up costs: to encourage users to sign up and try the service, Safaricom charges no fees to register for the service, deposit money or maintain the account.  All fees are usage based and therefore directly related to activities users value 

·      Payments available to anyone: to further encourage adoption; receiving money through M-Pesa is not restricted to registered users or even customers of Safaricom.  Non-customers simply receive a PIN-code by SMS, with which they can withdraw cash at any M-Pesa agent.  Safaricom recognised that receiving money would be a fantastic first interaction with M-Pesa for non-customers and use this to win new customers

·      High trust agent network: as it was left to retail stores that sell Safaricom airtime to handle all cash-in/cash-out transactions, it was essential that customers perceive them as trustworthy.  To build trust in the network, Safaricom took a three-step approach:

o   As a well-known and trusted mobile network, Safaricom linked M-Pesa and its agents closely with its own brand.  Agents were required to point their stores in ‘Safaricom Green’ to underline this visual identity

o   Safaricom rolled out a training programme for front-line employees and inspect each store on a monthly basis

o   Agents record transactions in a ledger and give a paper receipt to the custom, who also receives a confirmation from Safaricom by SMS 

·      Transparent, easy-to-understand pricing: Safaricom adopted a usage-based, flat-fee pricing structure that any customer would easily understand

·      Banks offer liquidity of last resort: as customers rely on individual agents being liquid to receive cash, Safaricom has signed up local banks to offer liquidity of last resort

Having understood the market conditions and customer needs in Kenya and designed a product and communications approach accordingly, Safaricom recognised that they would also need to execute M-Pesa flawlessly.  There were two main components to their execution plan:

·      Launch with national scale: Safaricom had identified remittances as the key feature of M-Pesa and knew that they would need to launch at a national scale in order to achieve relevance.  Having completed a small pilot with 500 customers, they therefore launched across all 69 districts of Kenya, involving 750 retail agents.  This was clearly a risky approach and inevitably led to a umber of teething problems, but these were quickly straightened out and M-Pesa had become a national brand within a few months

·      Staged brand positioning and advertising: in line with the marketing message of ‘Send Money Home’, M-Pesa was initially targeted at young, upmarket, urban workers.  This positioned M-Pesa as an aspirational, sophisticated product and enabled a quick roll-out to other segments.  The advertising campaign was also initially centralised, with TV and radio ads, backed up with roadshows.  Later, this was substituted with a more local approach, where billboards and agents promoted M-Pesa in their communities.

The greatest logistical challenge of launching at a national scale was to build the agent network.  Let’s look at the key challenges and how Safaricom went about solving this:

·      Two-tier agent management structure: Safaricom recognised that a national network of retail agents would require thousands of stores and implemented a structure that would enable them to manage at this scale.  They therefore developed a two-tier system, in which certain agents were assigned Head Office (HO) status and would manage its own network of agents.  This would enable Safaricom to maintain a level of control over the network without spreading itself too thin

·      Managing the customer experience: to complement the two-tier network structure, Safaricom realised that it would be important to retain central control of the customer experienced.  While agent HOs manage the day-to-day activities, Safaricom therefore hired a third-party agency to deliver training to agents and regularly visit them to ensure brand consistency

·      Incentivising agents: M-Pesa relies on local agents being sufficiently liquid to perform the basic cash-in/cash-out service that underlies remittances.  Safaricom therefore chose to incentivise agents based on the number of cash-in/cash-out transactions they perform, which indirectly rewards agents for managing their liquidity

·      Ensuring agent liquidity: to enable agents to maintain liquidity, Safaricom made available three separate channels for local agents to trade cash for e-credits.  Agents are able to make this trade directly with the Head Office, with the Head Office but through a bank or directly with banks.  Each of these channels have their benefits and drawbacks and each play a critical role in providing liquidity

Having gotten a better understanding of the market conditions, product design and implementation strategy that lay behind M-Pesa’s success, let’s look at future opportunities. 

Upon launch, Safaricom opted for a flat-fee pricing structure.  This had the advantage of being easy-to-understand and transparent, but discourages smaller transactions, as the fee becomes relatively high.  In order to encourage smaller transactions, become more ingrained in its customers’ daily lives and open up for poorer customers that view M-Pesa as prohibitively expensive, Safaricom should consider variable fees for transactions under a certain threshold.

Furthermore, Safaricom has only begun to partner with non-bank businesses and should explore opportunities to enable customers to receive salaries and government payments to their accounts and pay bills to utilities and other service providers.  Broadening the range of available transactions would reduce the need for cash-in/cash-out services and take M-Pesa to another level.

Finally, Safaricom does not have a banking license and is not allowed to offer interest on deposits and is consequently unable to offer savings products.  Although M-Pesa is a fantastic means to encourage financial inclusion, its customers also need access to savings and credit products in order to improve their financial opportunities further.  Working with the Central Bank, Safaricom should therefore explore opportunities to integrate closer with local banks, enabling them to offer customers access to a broader range of banking products.

In conclusion, we have seen that M-Pesa has been both a fantastic business opportunity to Safaricom and a tool for social transformation.  Its success is credit to a product that was well designed to meet the market specificities and customer needs in Kenya, as well as flawless execution of a considered implementation strategy.  Although, M-Pesa has already been a fantastic success, there are still opportunities to attract lower income segments, cover a broader range of transaction needs and widen the choice of banking services.  Without doubt, it will be exciting to follow the M-Pesa story going forward as well as similar initiatives around the world.

M-Pesa: Financial Inclusion through Mobile Payments (Part 1)

I have previously written about my enthusiasm for mobile payment and remittance schemes, particularly for their transformational potential in emerging markets.  It therefore seemed appropriate to dedicate a couple of posts to Safaricom’s M-Pesa, perhaps the most famous and successful mobile payment scheme launched in a developing country. 

In today’s entry I’ll give an overview of M-Pesa’s business model, describe its progress to date and explore the lessons for financial inclusion and development.  market conditions that facilitated the development of a mobile payment scheme.  My next entry will focus on the market conditions that facilitated M-Pesa’s success and Safaricom’s impressive execution and likely future developments.

For those who are not familiar with M-Pesa, it is an electronic payment and store of value system accessible through mobile phones.  The idea was developed by Vodafone in London and launched through its Kenyan subsidiary in 2007.  Customers sign up to the service through Safaricom’s extensive network of mobile credit agents.  The user provides basic personal information and identification and is assigned a payment account that is linked to an application that sits on their SIM card.  If the user’s SIM card is not already enabled, the agent will provide an upgraded SIM card at no cost.

The fee model is entire usage-based, so customers can sign up and deposit funds for free.  The user is then charged a flat fee for available services; P2P transfers, bill payment, withdrawals and balance enquiries.  As Safaricom is not a licensed bank, all funds are deposited with a commercial bank and customers are not offered interest on money that is stored in their account.  Instead, all interest that is generated from deposits are donated to a non-profit organisation.

By mid-2010, M-Pesa had achieved tremendous success in the Kenyan market (source: http://www.pymnts.com/mobile-payments-go-viral-m-pesa-in-kenya/):

·      9 million customer base, equal to 40% of the adult population

·      17,000 agents for cash-in/cash-out services, of which nearly half are located outside urban centres

·      $320 million monthly P2P transfers, equal to roughly 10% of GDP

·      $650 million monthly cash deposits and withdrawals

A 2008 study revealed that early adopters of M-Pesa are more likely to be relatively affluent, have access to other bank services and be educated, literate and tech savvy.  Yet usage is basic, with more than half of users primarily sending and receiving funds, and very few storing meaningful value.  Still, 98 percent of users report being happy with the service and 84 percent claim that losing M-PESA would have a large, negative effect.

In a 2010 World Bank publication, Igancio Mas and Dan Radcliffe identify three important lessons from the M-Pesa experience for encouraging financial inclusion:

1.     The potential of mobile and prepaid technologies to facilitate financial inclusion in developing countries.  These technologies combines the ubiquity of mobile phones with low-risk nature of prepaid financial services to make basic banking services available to everyone

2.     Usage-based fee models, as opposed to float-based models, are critical in reaching poor customers.  These are customers that are not profitable in a traditional float-based model, I which banks make money from collecting and re-investing deposits.  However, mobile operators in developing countries have developed a usage-based, prepaid model for mobile airtime.  This model is fully aligned with the small-value, transactions-based payments model that is needed to serve poorer customers that are not profitable for traditional banks

3.    The importance of developing a low-cost transactional platform that enables customers to complete a broad range of financial services.  With access to M-Pesa, customers are able to complete all financial transactions that are necessary to fully participate in society

Combined, these three lessons suggest that financial inclusion through a low-cost, usage-based payment platform may be an important development strategy on par with more traditional credit- and savings-led approaches.  In fact, providing access to a basic payment may be a more appropriate first step, on which credit- and savings-strategies can build.

FaceCash: a Fresh Approach to Payments

In previous entries, I have written about new players in the payment space that threaten to disintermediate the established players.  FaceCash was developed by Aaron Greenspan, one of the several former Harvard students who sued Mark Zuckerberg over ownership of the idea for Facebook.  It provides a really interesting example of new entrants that use mobile phones to innovate in the payment space.

Its technology links a barcode on your mobile phone directly to your bank account.  Merchants scan the barcode using a regular barcode scanner, which prompts your ID picture on their computer terminal, and enables them to verify the transaction.  On the backend, FaceCash instructs your bank to transfer the funds by ACH, which enables it to bypass the credit card networks entirely.

By bypassing the traditional credit card infrastructure, FaceCash is able to charge considerably lower merchant fees than its competitors.  FaceCash charges a flat 1.5% for all transactions, which could easily save merchants as much as 50% in credit card fees. 

On the flipside, many merchants will need to upgrade their POS to accept FaceCash – FaceCash provide scanners for $30 and computer terminals for $150.  Although, merchants can make this back from lower transaction fees, they are unlikely to install new POS infrastructure unless they see real customer demand.  It is this ‘chicken and egg’ challenge that face all new payment schemes and could derail FaceCash even before it gets off the ground.

While working with merchants to improve their acceptance, the real challenge for FaceCash will be to generate customer demand.  However, when they initially launched in April 2010, the customer value proposition was unconvincing.  While, FaceCash does not add much in terms of convenience, it should be more secure than other payment solutions, as users must both have access to their FaceCash account and match the photo ID.  However, these benefits, combined with the service being a pure debit solution, with no access to credit, are unlikely to be enough to win over customers.

It is therefore encouraging to see that FaceCash has launched a digital coupon system through which merchants can communicate offers to potential customers.  FaceCash charges the merchant on a a cost-per-action basis only if the customer uses the offer through FaceCash.  At 30 - 50% of the transaction value, this is relatively expensive marketing tool for the merchant though.

Although such offers make FaceCash a better proposition to customers, a proprietary system is unlikely to offer sufficient scale to overcome the ‘chicken and egg’ dilemma.  Instead, it would be interesting to see FaceCash strike up partnerships with already established deal sites, such as Groupon, Google or even Foursquare.

Regardless of whether FaceCash manages to achieve scale, it is a great example of new entrants to the payment space that aim to shake up the existing payment system.

Prepaid Payroll Cards

In my previous blog entry, I wrote about the exciting opportunities within the prepaid space and used four MasterCard partnerships to demonstrate what appear to be the biggest opportunities. 

Among those areas are prepaid payroll cards, particularly to un- or underbanked employees.  These employees are restricted to alternative financial services, which are much more expensive than traditional services.

The primary benefits to employees are:

• Cost Savings: reduce transaction costs associated with handling cash or check.  Additionally, migrant workers will also get access to cheaper remittance options
• Faster Access to their Pay: eliminates possible admin or mail delays
• Safety: no need to carry large quantities of cash
• Protection: the major networks all protect cardholders against unauthorized purchases
• Pay Anyone: access to an online bill pay service enables cardholders to pay bills to anyone

For companies prepaid payroll cards provide:

• Cost Savings: electronic payroll delivery eliminates the expense of issuing, delivering and reconciling cash or paper checks
• Optimize Payment Process: avoids production, handling and distribution of checks; eliminates the time constraints and fees associated with lost and stolen checks
• Security: electronic delivery of funds eliminates risks of physically distributing cash or checks
• Environmental: eliminates paper checks

There already is a sea of new entrants to the cards space that are looking to benefit from this opportunity.  However, it is probably the established commercial banks and card issuers that are best placed to capitalise, particularly in the larger segments. 

Citibank demonstrates this through their recent partnership with Voltas, a global engineering group, to provide prepaid payroll cards in the United Arab Emirates.  However, in general, commercial card players do not consider this part of their core business and do not appear to have fully woken up to this opportunity.

Non-bank card providers are clearly at the disadvantage of not having a customer base to tap.  Yet, they appear to be more aggressively pursuing the opportunity and could grow through distribution partnerships.  They are searching out  B2B players in industries with high usage of migrant workers and striking up distribution partnerships before the commercial banks get a grip on the market.