Unless you locked down a round of Venture Capital, chances are you were very cost conscious when you started your business.
A lot of entrepreneurs lean towards PayPal to accept payments in an effort to reduce their overhead. The irony is that while PayPal doesn’t have a monthly fee, its rates tend to be much higher than most traditional merchant accounts.
What’s far worse than spending too much money?
A quick Google search will show you the risks involved in using PayPal exclusively.
PayPal has an inherently different business model than traditional merchant account providers.
Failing to understand this difference has caused thousands of entrepreneurs to lose their businesses. This post will guide you through when PayPal is a good solution, how it works and the common mistakes people make with it.
The “risk” is involved when accepting credit cards:
Visa & Mastercard (and the other card brands) give consumers 6 months from the final point of delivery to dispute a charge on their card.
What that means for you, the entrepreneur:
At any point — up to 6 months after you sell a product — you may get a dispute (a “chargeback”) and the money from that sale may be automatically pulled from your bank account.
What that means to your Merchant Account Provider:
If your business no longer exists — thus your bank account can’t be drafted for the refund, the merchant account provider (including PayPal) needs to refund the customer. Their primary concern is that you will sell A LOT of product(s) and then disappear or close your doors before your sales start to get disputed… leaving them holding the bag for hundreds, thousands or millions in refunds.
How PayPal is Different
PayPal (and Stripe) are what are considered merchant account “Aggregators”. Instead of issuing a single merchant account to a single business, PayPal has ONE merchant account that they let millions of people use (it’s a bit more complicated than that — but that is the basic idea).
This model works because they are balancing the risk of all the solid, reliable and ethical business people and consumers against the entrepreneurs who will commit fraud, launder money or simply sell poor quality products and close their doors before people ask for refunds (for any given reason).
It’s what we consider a “post approval” risk management technique. Get setup quick, get shut down quick.
This allows them to accomplish several things:
First, it allows them to approve accounts in near real time. This is great because it means you as the entrepreneur can accept credit cards almost immediately. It’s great for PayPal because they can start collecting fees almost immediately. It is helpful for an entrepreneur because there is a low barrier to accepting cards.
So, what’s the problem?
They don’t know anything about you or your business. They don’t know…
- Who you are
- What your credit is like
- Your criminal background (think financial fraud)
- What kind of business you have
- What kind of product you sell
- Who fulfills the product
- How you deliver the product
- If you deliver the product.
In short — they don’t know the likelihood of you disappearing if a customer wants a refund (or millions of customers).
Because they don’t know anything about you or your company, if anything happens that they find “unusual”, their only recourse is to freeze your account entirely, or hold your money.
In addition, Visa and Mastercard monitor Aggregators very closely. Once an individual or business sells more than $100,000, Visa and Mastercard force the Aggregator to issue individual, traditional Merchant Accounts for the business.
As an entrepreneur, this should be a clear indicator to you that using an Aggregator is not intended as a long term, scalable solution to accepting payments.
Clearly, suddenly losing the ability to accept credit cards — or having your money held — is very, very bad thing…
But millions of people use PayPal… when is it good? When is it not good? Let’s shed some light on how traditional Merchant Accounts differ — then we can answer that question.
Merchant Accounts: How They Differ
While Aggregators (PayPal and Stripe for example) have a “One to Many” (One Merchant Account for Many Businesses) structure, traditional merchant accounts have a “One to One” structure. Because they’re not balancing the risk of your account against millions of others, they want details on your specific situation before they give you a Merchant Account. This is where the underwriting process comes in.
When you submit an application for a traditional Merchant Account, they will look at three things:
- Your personal history (credit)
- Your business history (if you have one)
- Your business model
All three play a role and can have an impact on your terms or ability to get approved.
The idea here is that if you are working with the Right Merchant Account provider, they will know you and your business — and understand the “risk” (or lack there of) before you ever start accepting cards. As a result, the likelihood of having your account frozen, or having funds held is much lower.
In addition, if something unusual does happen (a spike in volume, an increase if refunds or chargebacks, etc), because they understand your business they have other options to mitigate the risk than simply freezing funds or closing your account.
To be clear though — this is all contingent on picking the right Merchant Account Providers. Of the thousands of Merchant Account providers out there, only about 1% of them consider themselves “High Risk” Providers — which despite the abrasive term, are the ones who do effective underwriting.
Of that 1%, even fewer actually ARE “High Risk” Providers and aren’t simply making a run at picking up extra business.
If you end up with one of the 99%+ “Low Risk” Merchant Account Providers, they will handle your account the same way PayPal or Stripe would — approve the accounts quickly and close it quickly. It’s all a result of poor (or no) underwriting.
It’s important to note: Even with the best Merchant Account Providers, you still run the risk of them keeping your money or closing your account. Contractually, they will always have that control. The only way to protect yourself is to setup Multiple Merchant Accounts. There is a very specific way to do this — and if you don’t do it the right way it completely defeats the purpose.
We’ll get into how to screen and vet “High Risk” Providers and also how to setup Multiple Merchant Accounts shortly, but let’s define “High Risk” first so we can paint of picture of the business models that should always have good underwriting and really need to know this stuff…
What is “High Risk”?
Any time the following are part of a business model, there is a higher level of risk:
- Recurring billing/subscriptions
- Card Not Present Transactions (anything online or by phone)
- A transaction amount over $1,000
- Delivering the product in the future
- Products that are impacted by weather (travel)
- Products subjective in quality (selling information)
- Government regulated products
- Extreme guarantees of results
- Free Trials
That list is certainly not exhaustive, but it should give us a starting point.
Risk is a spectrum.
On the low risk end, you have a coffee shop. You swipe your card for a couple bucks (or 8 at Starbucks) and get your coffee immediately. How likely is the average consumer to go home, call their credit card company and dispute the charge for that cup of coffee… even if it’s terrible? Not very likely. This is a very LOW RISK transaction.
On the opposite end of the spectrum (very “high risk”) you have a company based in India that gives a free trial of a “Natural Male Enhancement” supplement and automatically bills you $99 a month after a free 14 day trial — and they guarantee it will “add two inches to your manhood” (this is a real example, I can’t make this stuff up).
Things that make this very high risk: Location (India) statistically has higher fraud, future deliverability, subjective in quality, extreme claims, free trial, recurring billing, etc.
All of these things increase the likelihood of a consumer disputing the charge.
Now we’ve built a solid foundation and can use the same language. You also now understand just how dramatically different PayPal and Stripe are from traditional Merchant Accounts, so let’s tackle the question at hand…
When to Use PayPal or Stripe vs Traditional Merchant Accounts
Regardless of the situation, the likelihood of having a PayPal or Stripe account shut down is much higher than a Traditional Merchant Account (because they don’t underwrite). If your world is going to collapse if your account is closed — you should rethink solely relying on PayPal.
With that in mind, here are a few scenarios where PayPal makes a lot of sense.
Use Cases for PayPal and Stripe
Still Proving Concept
If you have a startup that you’re still trying to prove as viable business — PayPal is a super fast, easy way to get setup.
You will likely pay a slightly higher percentage and transaction fee, but the flexibility of not having a monthly fee can be worth it. Without true proof of concept, the business might not be around next month, or you may “pivot” (alter your business model). In those situations, it may be best not to have a contract, which all merchant accounts have.
Low Sales
Similar to being in the “proof of concept” stage (and often overlapping), when your sales are under 10,000 a month, there is less incentive to spend the time and energy fully protecting yourself with a traditional merchant account. There is also less incentive for an Aggregator to flag your account; If you have a 100k or Million dollar spike, there is significant liability. If you have a thousand dollar spike, it’s simply less relevant to an Aggregator.
Supplementing
There is actually a use case for mid-sized and large scale businesses to use PayPal. It’s when they’re making an effort to capture a portion of the people that abandon their shopping cart — or perhaps won’t buy unless they can use their PayPal account. Of course, I’d encourage to split test this yourself and see if it’s relevant for your market.
In fact, even in the retail sector, in 2013 Home Depot added PayPal as an option for consumers to pay with. This supplemented the Traditional Merchant Account they use to accept cards.
Personally, I treat my PayPal account as “fun money” because I often get PayPal payments from miscellaneous things I sell on Craigslist or eBay, or for a random affiliate commission.
It doesn’t feel like real money, so I leave it in my account and use it for things I wouldn’t necessarily spend money on otherwise.
When NOT to use PayPal or Stripe
Your Sales Volume Exceeds 10k/mo
First and foremost, we know that Visa and Mastercard mandate independent Merchant Accounts once you’ve sold $100,000 so it stands to reason that if you currently do or will shortly have sales greater than that, it’s time for a real merchant account.
But beyond Visa/Mastercard’s mandates, you have a proven concept for your business with that sales figure. To place all the risk with one provider is not a good idea…much less a provider who doesn’t thoroughly understand your business. The downside of losing the ability to accept credit cards is simply too high.
Your Business Lies Anywhere on the “High Risk” Spectrum
I laid out some examples of what Merchant Account Providers consider “High Risk” above. To recap, if you have any refunds or chargebacks at all, or are simply in an industry where that’s common, you’re considered “High Risk”. As such, PayPal is not a good option. The higher risk the business, the more likelihood of a chargeback…
And how does PayPal manage their risk? They freeze funds, suspend accounts and close them altogether. No bueno.
Which is Right For You?
So in a nutshell, PayPal and Stripe are great entry level options to accept cards as they comes with some flexibility built in, but they don’t provide much protection. When your business is very small or you want to add a payment option, PayPal and Stripe are a solid go to.
Once you have money coming in consistently though (or with any volume — more than 10k/mo), you want to have Traditional Merchant Accounts setup.
So how do you protect yourself with the right Merchant Account?
The short answer to that:
1) Setup multiple Merchant Accounts — each with their own member bank (the important part)
2) Setup a gateway that automatically routes your sales across those Merchant Accounts
It is absolutely critical that you don’t put all of your eggs in one basket if you’re selling more than 10k/month.
Even the best Merchant Account Providers can shut down your accounts on a whim. There are actually MANY reasons a provider could shut down your account that have nothing to do with your Individual Business.
Scary, right?
Having the right gateway is the foundation of accepting payments this way. Without the right gateway, it’s nearly impossible to setup Multiple Merchant Accounts.
There you have it! You should be on your way to choosing a solid, reliable way for getting paid in your business.
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