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Battling the Government, the Mafia, and the Rest of Planet Earth

Posted on: Tuesday, 11 October 2005, 03:01 CDT

By Anderson, William L

Battling the Government, the Mafia, and the Rest of Planet Earth THE PAYPAL WARS by Eric M. Jackson 344 pages; Los Angeles, Calif.: World Ahead Publishing, 2004

ONCE UPON A TIME, there existed the Land of the New Economy. It was a place where old rules did not apply and where the suffix ".com" was the sign that vast wealth could be created by the simple issuance of common stock. The requirements of earnings (or even "potential" earnings)-not to mention the presence of a real product- were seen as so Old Economy that they had no place in this New Land.

As we know in hindsight, those very clever "New Economy" commercials from the 2000 Super Bowl were not the heralding of a new era in business, but rather the last utterances of some business firms that soon would disappear forever. We did not realize it at the time, but the myth that a bunch of 20-somethings on motorized scooters could circumvent the laws of supply and demand was about to explode.

Yet, just because the New Economy crashed and burned with the plummeting of the NASDAQ, we should not forget that this heady era was not a complete dry hole. For many of us, the Internet, which was just breaking into our lives a decade ago, is now a commonplace part of our lives. Webvan, e-Toys, and Pets.com may have disappeared into cyberspace and bankruptcy court, but more than a few readers of this review will purchase or sell something on eBay this week. And many of the people who will engage the World Wide Web for trade most likely will use their trusty PayPal accounts to consummate the purchase.

If you are one of those people, you might want to offer some thanks to Eric M. Jackson, author of The PayPal Wars. No, Jackson did not invent PayPal, the convenient, easily accessible online payment system, but he was the person who first explored the idea of eBay buyers and sellers using PayPal as the vehicle for payment. As it would turn out, PayPal would be the ideal mechanism to allow a vast number of users to consummate their exchanges.

Before going further, let me say that The PayPal Wars is not just a book about how a startup company managed to survive in the modern hightech business atmosphere. There is more-much more-to the story. The PayPal Wars should resonate with the readers of Regulation because the role of regulation is an important theme of this book- but not in the conventional sense of how regulation may work or not work. Instead, we find that the story of PayPal is one in which entrepreneurs attempted to create a financial product that was relatively unregulated-but, not surprisingly, the regulatory empire struck back.

A BUSINESS IS BORN The PayPal story is one of stages. In the beginning, there was the fledgling company that began with a vision. The second stage was continued existence in the face of competition from other companies, a merger gone wrong, and an assault by organized crime. The third stage was the almost-miraculous initial public offering, but it was here that the dreary realities of the regulatory state came to the fore. Finally, at least for Jackson and the company's founders, there was the semi-happy ending in which people rode off into the sunset with large wads of cash in hand.

PayPal was started by two entrepreneurs, Peter Thiel, a hedge fund manager from California, and Max Levchin, a Ukrainian-born engineer who specialized in security. They had a most interesting idea: Having seen the sad results of the Asian currency collapses of the late 1990s, Thiel and Levchin saw an opportunity to create a system in which people could protect their own monetary holdings by quickly exchanging their own currency for another via computer transactions.

The beauty of the system, as Thiel saw it, was that this new product would give average people an opportunity to move their money- an ability that, at that time, was available only to those wealthy enough to afford offshore accounts. PayPal was to be an "egalitarian tool," something that would be available to people of average means. Furthermore, because PayPal would permit its users to have options that previously were not available to many of them, it would have a secondary effect of keeping governments from forcing people to keep their money in banks after a round of inflation or other irresponsible governance.

Before Jackson came aboard in December 1999, the young Stanford graduate had been an analyst with the accounting firm formerly known as Arthur Andersen, which he describes as an Old Economy entity. When Thiel, a friend from their Stanford days, offered Jackson the prospect of stock options-a common form of compensation in the days when Silicon Valley was the nation's hot spot for economic growth- Jackson decided to enter the world of the New Economy. The description of his first days with PayPal is something out of the Silicon Valley stereotype of the "unstructured" (or, as they say in the Old Economy, "disorganized") workplace:

I introduced myself to the receptionist, who had no idea that I was expected. She quickly circled the office only to conclude that Peter was not in the building. Her call to his cell phone went straight into voice-mail, prompting her to ask if I could come back later. I began to feel uneasy-I had just burned my Andersen bridges for an unspecified position without so much as an offer letter because Peter said I needed to start immediately, and now he was nowhere to be found.

Jackson's misadventures continued for awhile until he found Thiel, but it took a while longer before he had any sense of the duties he would perform for the fledgling firm. His makeshift desk was set up in the company's ping-pong room (another New Economy feature) and he took on the title of director of marketing. His real value to the company, however, became manifest while he was surfing the Internet one night.

Logging onto the site of the auction giant eBay, Jackson quickly realized that PayPal would be a perfect mechanism to permit large numbers of buyers and sellers to consummate their transactions quickly. Jackson recognized that small sellers who could not afford to use a credit card service would have to wait until the check or money order from the buyer arrived a week or so later in the mail-a very low-tech approach to what supposedly was a high-tech transaction. Because of the ease of obtaining a PayPal account, almost anyone with a modem and credit card could use the service. Thus, while the foray into eBay might have seemed as though the company was veering from its original mission, in the end it would be the company's bread-and-butter for growth.

PROFIT OR PERISH Of course, a good idea-and a mechanism for pursuing that idea-inspires entry into the market, and it was not long before PayPal had competition from other services, including Yahoo!, Bank One, and eBay itself. Jackson, Thiel, and company had to deal with the dicey problems of competition, not to mention the fact that PayPal was not turning a profit but was very good at burning through its available cash. In other words, the company needed to produce or go out of business.

To deal with its burn rate (and to attract new investors), the company engaged in a number of innovations. First, it managed to entice fee-paying customers-a major feat, given that the original PayPal accounts were free (with the company making money on the floats). Second, it developed a paying mechanism to permit customers to use their bank accounts instead of credit cards, which enabled PayPal to lower its credit card transaction fees. Third, the company was forced to deal with foreign organized crime rings, which were funding their PayPal accounts with stolen credit card numbers. While the criminals, led by a shadowy figure who called himself Igor, seemed to have an upper hand, Levchin's talents in creating security devices ultimately saved the company from having the crooks drive it into bankruptcy. In the meantime, Igor unwittingly helped PayPal develop an automated fraud-detection tool that Levchin appropriately named "Igor." (As the story goes, the real Igor met an untimely death at a San Francisco nightclub a year later.)

GOING PUBLIC In short, the company began to turn a profit, which ultimately made it a candidate for IPO. PayPal signed up more than 5 million users in its first year, and another 7 million the next. Usage grew steadily and billions of dollars ($5 billion in the first two years) flowed through the system. By late 2001, not only was PayPal profitable, but it had done so despite the crash that sent so many other Web-based companies into cybergraves, not to mention the September 11 attacks and their aftermath.

And that is when PayPal began battling its most formidable opponents: regulatory agencies, state governments, class-action lawyers, and the ever-present Eliot Spitzer. None of those battles resulted from regulatory violations committed by the PayPal executives, but instead were the result of various people's decisions to use the mechanism of the state to extort money from a successful company.

On the eve of PayPal's IPO, for example, Louisiana's Office of Financial Institutions suddenly decided the firm needed a money transmitter's license in order to operate in that state. The decision was more than a little surprising given that \transmitter's licenses are intended to regulate banks and PayPal is not a bank. But that did not stop the regulators, as well as some representatives of the American Bankers Association, from trying to impose "consumer protection" measures against an entity that some banks feared could somehow, someday pose some competition to financial institutions.

PayPal was ultimately able to deal with Louisiana, but then it came up against the Securities and Exchange Commission. The SEC threatened to kill the entire IPO because a market research firm published an independent study that found PayPal to be the most popular online method of payment. According to the SEC, this was a violation of the agency's "quiet period" that comes before the approval of an IPO. Understand that the study was independent and PayPal had nothing to do with the research firm's actions, but nevertheless a bureaucrat at the SEC had to rattle his cage.

Even after the company was able to go through with the IPO (PayPal began to trade on NASDAQ on February 15, 2002), the parade of parasites did not stop. Next came class-action lawsuits by lawyers who claimed that the fraud detection mechanisms used by PayPal to hamper the efforts of the Russian mafia unduly hampered some people who clearly were not Mafiosi. Then there were the issues dealing with enforcement of the Patriot Act and other legislation passed in the wake of 9/11.

Last but not least was New York's Attorney General Eliot Spitzer, who was incensed that some individuals used PayPal to pay for their online gambling activities. Even though the practice was legal (or, at least, there was no federal law against such commerce), Spitzer demanded what was, in effect, an extortion payment in exchange for his deciding not to litigate the company into a post-Enron state. Understanding their unhappy position, the executives at PayPal sent a check to the New York AG's office.

There clearly are financial advantages for firms to be publicly traded, but it did not take the PayPal brass very long to understand that the regulatory and legal pitfalls facing such companies were more than they would be able to handle. Thus, they sold the firm to eBay.

THE MORAL There are a number of lessons in the PayPal story. First and most important, entrepreneurial genius still lives in the United States and there is no shortfall of individuals who are eager to create new products in the pursuit of profit. Second, there is no deficit of problems that any new firm will face. Some of those difficulties come with the territory, as well should be the case. Furthermore, there are people like Igor who look for ways to steal the property of others, and while one can lament such a state of the world, the firms that survive are those that find ways to combat the theft and serve their customers at the same time.

But perhaps the biggest-and most unfortunate-lesson of The PayPal Wars is that entrepreneurship in America is increasingly threatened by what can only be called a class of parasites. At least one can outwit an Igor or create a better and more responsive product than a competitor. However, to deal with regulators, attorneys, and other government officials bent on legally extorting money, none of the aforementioned skills are helpful. The Eliot Spitzers of the world are not interested in someone building and selling a better mousetrap; they are only interested in how they can gain control over the mousetrap maker's money.

One hopes that readers of The PayPal Wars come to the conclusion that entrepreneurial geniuses are alive and well in this country and that we should be encouraging them to put their many talents to work creating products for the rest of us. Unfortunately, the present state of U.S. law and regulation is incompatible with such genius. It is to our own loss and sorrow that this state of affairs continues to dominate our lives and benefits only the parasites among us.

William L. Andersen is assistant professor of economics at Frostburg State University. He may be contacted by e-mail at banderson@frostburg.edu.

Copyright Cato Institute Fall 2005

Source: Regulation

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