Saturday, March 27, 2010

Beware of ‘the Paypal call’ and what to do today to mitigate large Paypal reserves. (Part I of II)

This is the first of a two-part series and is a first for eBay Strategies. The first post, which you are reading, is a head's up to sellers about what we've noticed at ChannelAdvisor that is happening to Paypal merchants on eBay and causing a good bit of frustration.

The second part, which you will find here is a response from the management at Paypal. The timing worked out such that I was able to let some folks at eBay know this was coming and they offered to address the concerns. I felt this added a lot of value, but didn't want to change the original post as it would be too lengthy and confusing if they were combined. Thus I have split it into a two-part series.

The Paypal Call

Like many financial institutions today, Paypal appears to be significantly tightening up on credit. This actually started about a year ago in isolated cases and appears to be accelerating in 2010. The way it works is there is some kind of a trigger that causes a seller to come onto the radar of Paypal's risk team.

I have no idea what the triggers are, but best guesses based on anecdotal evidence we have seen:

  • Any kind of bad credit report or flag on your personal/corporate credit report by bill collectors
  • Significant increase/decrease in sales in a short window
  • Increase in returns, charge-backs, Paypal claims

Whatever the reason, the call is usually directly from the Paypal risk department, but sometimes initiated by a Paypal account manager.

The call usually goes something like this: “We have identified an increase of financial risk in your business and want to gather some details about your business to assess the risk."

From here typically things go very deep and very much into the inner workings of your company and you have to produce:

  • Complete financials for the last 3-5 years
  • Details on inventory levels, cash balances
  • Detailed reasons and explanations for all returns for the last couple of years
  • Sources of inventory (this is a painful one)
  • Frequently these discussions go into the financials of the principle of the business.

As you can imagine, this is quite a burden for operating businesses of any size and can be extremely distracting for smaller businesses and feel very uncomfortable. I've had several sellers jokingly call this the Paypal colonoscopy.

Once completed, a ‘verdict’ is rendered within a week or two.

The typical verdict we’ve seen is Paypal putting a reserve on the seller’s account – usually in the 5% range, but we've seen it as high as 20%. We’ve even heard stories of Paypal ratcheting these up as sellers meet the criteria (e.g. starting at 5%, then walking up to 15% in 5% increments), which I don't don't understand, but we are hearing more of.

What’s a Paypal Reserve?

Essentially, Paypal puts a lock on X% of transactions moving through your account (regardless of channel BTW) as an ‘insurance policy’ so that should you go out of business, they have some funds to cover the inevitable charge-backs that Paypal will have to fund if left holding the bag.

Let’s say you are a $300,000/m Paypal user with $150k/m coming from on-eBay Paypal and $150k/m from Paypal on your off-eBay website. After going through the Paypal risk process, you are given a 10% reserve. 10% * $300k/m = $30k. That reserve amount will automatically be a minimum that you have to keep in your Paypal account that you effectively can’t touch.

For many sellers, having a considerable amount of cash restricted with a very short time line (weeks) can be very problematic to cash flow and in some cases devastating.

In fact, White Elephant Media, one of the largest media sellers left on eBay recently went out of business due to this exact problem. You can read their story in intimate detail here.

The Paypal reserve problem has also received some press in BusinessWeek and has been covered on the Paypal blog and eBay’s blog.

Like any financial institution, Paypal has the right to limit their risk, the goal of this post isn’t to dispute the policy, but to a) shed light on it and b) warn sellers that it is probably coming and most importantly c) give you some options to manage YOUR risk so your business isn’t pushed over a cliff if you are hit with a reserve.

What you can do today to mitigate probable Paypal reserves?

Unfortunately, we haven’t heard of any sellers being able to fight this process, so our recommendation is to go ahead and do your own ‘stress test’. Ask yourself: “What would it mean to my business if I had a 10% Paypal reserve?” If that is a business-ending scenario or otherwise problematic for you, it’s best to get in front of this now before the call, vs. scrambling after.

Here are our top recommendations to be proactive instead of reactive:

  • Establish relationships with at least two more payment processors (usually credit card / merchant processors)
    • Typically they have substantially smaller reserves than we see Paypal implementing now.
    • Two relationships will give you one extra level of protection against any surprises if you move your Paypal business to the processors and that increase in sales trips any risk flags with them.
  • Take actions to minimize your Paypal volume off-eBay
    • Consider eliminating Paypal or at least demoting it on your e-commerce site - at a minimum have a plan to scale it back very quickly if you need to.
    • In our experience, you will not have a substantial increase in abandoned carts or decrease in conversion rates.
  • Avoid Paypal credit card processing
    • Remember the Paypal reserve applies to all of your volume flowing through Paypal. As best we can tell this includes Verisign (owned by Paypal) and Paypal Website Payments Pro. In these cases you aren’t even getting the benefit of access to Paypals user base and you should definitely look at a more traditional processor.
  • Prepare a plan for what you would do if you wanted to stop taking Paypal on-eBay
    • At ChannelAdvisor, for example, we support a myriad of non-Paypal affiliate gateways such as, Optimal payments and Cybersource that are SMB/e-commerce friendly and have MUCH lower reserves than we see with Paypal. Also, behind the scenes, eBay has done a lot to make credit cards an ‘on par’ payment option with Paypal. For example, the Paypal logo is no longer plastered throughout the site and ‘accepts Paypal’ is not a factor in BestMatch/search. We've seen some folks test turning off/not launching with Paypal and not suffering from it interestingly enough. In fact, eBay's new Buyer Protection program is NOT exclusive to Paypal.
    • Run some tests to see if there is a material impact to your sales, perhaps on a smaller test ID vs. your main ID.
    • NOTE – we don’t recommend making this change until you are hit with a reserve and as an absolute last step if the reserves are significantly negatively impacting your business. But it’s important to have a plan and have everything ‘wired’ correctly should things come to this.

After taking these steps, if you are hit with a Paypal reserve, you now can play offense vs. defense AND you have lowered your risk BEFORE the call. Also, you can say on the verdict call: "I'm sorry, Mr/Ms. Paypal risk person that you have decided to hit me with a 10% reserve. Because of that, tomorrow I am going to turn off Paypal on my $X/m e-commerce site and my $x/m eBay seller ID and going with . I'll let my TSAM and my Paypal account manager know later today. Based on what I'm seeing today, this won't really bother the Paypal risk person, but if enough large sellers do this, the message will be heard loud and clear that there are other options out there and Paypal needs to remember that.

Going back to our $300k/m example business, before the Paypal reserve, if the seller had switched Paypal on their off-eBay site with a credit card processor. When they were hit with the 10% reserve, only $150k (the on-eBay portion) would be in the reserve which would be $15k vs. the ‘all Paypal’ $30k. Then, if that $15k is too much, you can get to effectively $0 (or whatever your credit card processor requires) by turning off Paypal for your eBay sales as well.

Paypal's new 'high risk bar' isn't just for existing eBay sellers - large merchants also in the cross hairs

Small and medium size sellers can take heart that in our experience, Paypal is now even either turning away many large brand name merchants or not allowing them to start with Paypal at all. This policy is now creating a very high hurdle rate to get new diamond merchants onto eBay that are eager to sell their branded, secondary marketplace goods.

What’s this mean for Paypal and eBay?

As you can imagine, there are a couple of interesting unintended consequences that are coming out of the more aggressive reserve stance Paypal is taking.


• Presumably these actions will reduce the amount of overall reserves that Paypal needs and diminish Paypals risk of being left out to dry on charge-backs from defunct customers. eBay reports this number in the 'Provision for Transaction and Loan Loss' number that includes not only Paypal write-offs, but BML, eBay MP protection programs, etc. so it's hard to tease out specifically if this new program is moving the needle, but notice that it is ticking up 10% y/y which could be the driver behind the new Paypal desire to limit risk: (Note this diagram is from eBay's Q4 results conference call)


  • You can tell from the advice above, that in our experience, the reserves are actually causing the unintended consequence of sellers taking Paypal off their off-eBay site or diminishing it substantially. Paypal generally doesn’t seem concerned by this and admits it is a way to ‘manage down’ the reserve.
  • This trend is increasing and e are seeing more and more retailers consider selling on eBay without Paypal as well. While they are impacting a small number of sellers, they are typically eBay’s largest sellers. Over time this could cause a downward trend on Paypal’s coverage of eBay GMV.
  • We’ve heard several sellers say that ‘Paypal’s risk department is the new Trust and Safety’ – a reference to the Gestapo like tactics that T+S took back in the 07/08 time-frame that killed many an eBay business by shooting first and asking questions later. So Paypal is frequently reversing places with eBay as the new ‘sales prevention’ arm of eBay that is making life harder for merchants, not easier.

None of the above negatives seem to have impacted Paypal's growth rates off-eBay or eBay penetration, so maybe the quantity of sellers impacted are small enough that it will stay under the radar. However, at the rate we are seeing this increasingly come up, I suspect within a year that may change. I think we'll see this show up in the off-eBay (merchant services) y/y growth rate as that's what most sellers are turning off immediately when they get the call. We'll keep a close eye on that going forward.

Is this 'really' just Paypal risk management?

Since most of these individual seller recommendations don’t really make sense for a company (eBay corp) that owns both the eBay marketplace and the payment system, Paypal, many sellers ask why the two companies are starting to drift apart. Why would eBay marketplaces make it easier to take credit cards and why would Paypal seemingly not really be alarmed when customers are turning off Paypal from their e-commerce sites? Why would eBay roll out a buyer protection program that isn't just Paypal?

Admittedly this doesn’t make any sense to us either. We’ve heard speculation from Wall St. that these are all steps towards a potential Paypal spin out to unlock shareholder value. Most of these rumors are probably far from reality and we’re probably just seeing two large relatively independent corporate entities, that while under one umbrella, focusing on different and divergent (ebay – GMV, Paypal – lower risk) goals.

What do you think?

Let us know your Paypal stories (have a reserve? fought a reserve? turned off Paypal?) in comments and share your insights about why eBay and Paypal seem to be drifting apart.

VIA eBay Strategies

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