What Facebook’s IPO Filing Reveals about Its Payments Business

Facebook’s S1, which was filed on February 1st in preparation for its IPO, shows that this almost 8-year old company will likely become a global powerhouse in payments.

Payments is the second largest revenue generator for the company. It accounted for around 15 percent of Facebook’s $3.7 billion of revenue in 2011. Payments revenue has grown from $5 million in 2010Q1 to $188 billion in 2011Q4. And, between the last quarter of 2010 and the last quarter of 2011 Facebook’s payments revenue grew by a whopping 247 percent.

That said, don’t try to draw an analogy between Facebook and PayPal, the only other successful Internet-based payment company. Or even to Visa, which is the largest payments card business in the world. That’s because Facebook is a very different sort of payments company. Here’s why.

An Overview of Facebook

To understand the nature of Facebook’s payments business, let’s first take a short detour into its business model.

The core asset of Facebook is the social graph. Let us unpack what that really is.

People open accounts on Facebook and obtain an alias that allows them to be identified. About 60 percent of the Internet users in the United States have done so and in some countries such as Chile more than 80 percent have. Facebook is trying to get all 2 billion Internet users to open accounts and has gone long way in a short time in accomplishing that objective. Meanwhile a rapidly portion of the world’s population has an Internet connection increasingly as through mobile phones, making it easier for more people to establish an account with Facebook and use it.

Once people have an account on Facebook, they form friendships (or enhance the ones they already have). There are roughly 800 billion bilateral connections on Facebook with each Facebook account holder having about 130 friends each.

The result of this is that Facebook essentially has the largest phone book in the world (a directory of all the people that have signed up for Facebook and can be communicated with). But it also has a register of who is communicating with whom (info on who is calling whom). And of course it has detailed information that people provide for their profiles plus the content they post on their pages or receive from their friends and other source (and details on much of what you say to your friends).

Facebook decided not to keep this data-rich communication empire to itself. Instead it created a software platform. That means that it created APIs that enabled developers to hook into that powerful social graph and create applications that leverage the information contained in it. Much of Facebook’s S1 is about this software platform and how it and others are using it.

Some of the most successful applications on Facebook have involved games. Zynga, which is the game king for now, developed popular “social games” such as Farmville for Facebook. Zynga and the other social game developers have made most of their money from selling virtual goods to their users. If you want to compete on Zynga’s Mafia Wars you might really want a (virtual) tank and you’ll have to buy that tank from Zynga. It doesn’t cost much but with millions of users it helped drive Zynga’s revenues. It also drove its own IPO last December. Zynga’s market cap as of February 7, 2012 is $9.3 billion.

So far, Facebook has made most of its money from advertising. It charges for various sorts of ads that appear on Facebook user’s pages and on the pages of applications such as Zynga’s Farmville that run on Facebook that Facebook users are interacting with.

But its payments revenue is skyrocketing.

Facebook Money

May 2009 marked the time when Facebook introduced its own currency – Facebook Credits – which works on Facebook much like the dollar, euro, or yuan does Lots of other players have tried to create virtual currencies but have not gotten traction. Facebook is different.

Unlike everyone else who has tried, Facebook is in many ways its own country. It has a “population” of about a billion people making it the third largest country in the world after China and India. Its people live together in a community and interact with each other as well as the many businesses and other organizations on Facebook. It also has the power of a government. It can mandate that transactions take place in its currency. That’s because it controls the platform and can prevent pretty much anything it wants to in its borders. Just ask Zynga.

When Facebook Credits was first introduced it was just another tender type that could be used for transactions on Facebook. It was a convenient payment method for small purchases and many businesses and people opted to use it.

In early 2010 Facebook announced that it was going to require the use of Facebook credits for social games. Most importantly it said it would impose a 30 percent “exchange rate”: that is, if someone wanted to convert their pile of Facebook credits into dollars Facebook would take a 30 percent slice off the top. It was as if the European Union had figured out a way to impose a 30 percent tax on the exchange rate on the euro.

Facebook turned to Zynga for a slice of its game revenue. Zynga complained, and of course hired lawyers, but quickly relented. Zynga threatened to leave Facebook but that was sort of like McDonald’s threatening to leave the European Union—pretty tough when that’s where there are a lot of customers and you’ve already built your restaurants to serve.

To get an idea of just how significant payments is likely to be for Facebook it is important to recognize how nascent this $500+ million revenue business is. After only two years it accounts for 15 percent of Facebook revenue. And most of that revenue comes from one very successful social game company. More social game companies will join Facebook and Zynga’s game business will likely expand.

Most importantly Facebook has every reason to extend its currency to other transactions on Facebook. As it says in its S1, “Payments integration is currently required in apps on Facebook that are categorized as games, and we may seek to extend the use of Payments to other types of apps in the future.” How important that is depends on how social commerce evolves on Facebook. Given that most businesses have opened up Facebook pages and can access a large fraction of world’s population on Facebook it is likely that Facebook will become an enormous e-commerce platform. This prediction rests on the fundamental premise that Facebook is like a highly wired country with almost a billion people. What business wouldn’t try to sell there? (More on this in a forthcoming piece on social commerce.) In that case Facebook will take a slice—probably not 30 percent since margins are lower on much e-commerce activity—of those payments too.

Owning a currency is pretty cool. In fact, for millennia governments have made a lot of money from having a currency. Those revenues are called “seinorage” and they come from depreciating the currency by printing more of it. (Back in the golden days governments just reduced the mount of precious metal in the coins.) It is one of the best taxes going because so long as the government doesn’t get carried away (that is, causing high inflation) hardly anyone notices it and when they do they just blame businesses for raising prices.

Facebook can do that but it has an even better deal going. Money is so liquid that it would be very difficult for any country to impose a tax on exchange. Facebook can do this though because it controls essentially all of the communications systems and other infrastructure in its “country.” You can’t take Facebook Credits out of Facebook easily without them knowing about it and so they can insist on the exchange rate tax.

There is of course nothing wrong with Facebook’s approach. The company is providing businesses and people with an incredible asset for engaging in commerce. Facebook wants to get paid for that and, in fact, needs to be paid in order to continue to improve this asset. Facebook Credits is a clever mechanism for ensuring that the social network it has created can be monetized.

Facebook Credits in More Detail

Here are some excerpts from the Facebook S1 that describe its payments platform.

“Facebook provides an online payments infrastructure that enables developers to receive payments from users through an efficient and secure system. Developers can focus on creating engaging apps and content rather than spending time and resources to build payment processing and fraud management capabilities. Our users can store their payment credentials with Facebook in a trusted and safe environment, facilitating easy and fast purchases across the Facebook Platform rather than having to re-authenticate and re-enter payment information for each developer. We designed our Payments infrastructure to streamline the buying process between our users and developers. Our Payments system enables users to purchase virtual or digital goods from developers and third-party websites by using debit and credit cards, PayPal, mobile phone payments, gift cards or other methods. We have also extended our Payments infrastructure to support mobile web apps on certain mobile platforms. Developers have used the Facebook Platform to build a variety of user experiences, including apps on Facebook, desktop apps, mobile apps, and Platform-integrated websites, each of which can take advantage of the capabilities of the Facebook Platform.”

“When users purchase virtual and digital goods from our Platform developers using our Payments infrastructure, we receive fees that represent a portion of the transaction value. Currently, substantially all of the Payments transactions between our users and Platform developers are for virtual goods used in social games, for example virtual tractors in the social game FarmVille. Payments integration is currently required in apps on Facebook that are categorized as games, and we may seek to extend the use of Payments to other types of apps in the future. Our future revenue from Payments will depend on many factors, including our success in enabling Platform developers to build experiences that engage users and create user demand for their products, and the fee arrangements we are able to negotiate in the future.”

The Future of Payments at Facebook

You can do a lot with a global currency!

To begin with Facebook Credits is different from the payment card networks. Companies like Visa and PayPal are in the business of facilitating non-cash payments at the physical point of sale and online. They make their money from fees for authorizing and settling transactions between parties. But they obviously do not actually own the underlying currencies that are behind these transactions.

Facebook does. It can make money from selling its currency to people and businesses that want to transact on Facebook (think about going to China and having to get some yuans) and exchanging its currency for other currencies when people want to use its currency off of Facebook (think about leaving China and exchanging your yuans for dollars). It can also make money from seignorage.

With a global currency Facebook can operate a global system for transmitting money between people and businesses. That is different from what Visa, PayPal, or Western Union can do because Facebook can do these transfers from account to account on its own platform and without the hassle of dealing in several hundred different currencies with fluctuating exchange rates. It is like a bank that has a billion accounts and can shift money between any of those accounts.

Of course, just like the euro is only useful in the Eurozone, Facebook’s currency is only useful on Facebook and today only for social games. If commerce takes off on Facebook though, and people spend a lot of time on Facebook, Facebook’s currency is more like the euro for people that are living most of the year in the Eurozone countries. Except Facebook will likely have a bigger population.

Does this mean that payment companies should care as little about Facebook credits as they care about the dollar, euro, or yuan—just another currency to deal with? Hardly. That will be the subject of the next article in this series.

David S. Evans is an economist and a business advisor to payment companies around the world. His recent work has focused on helping companies create, ignite and profit from payments innovation. He is the originator of the Innovation Ignition Framework® , a tool provides a systematic way for companies to evaluate and implement innovative ideas and achieve critical mass. 
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