The Story of PayPal, Bank Account Verification & Survival -- All by Reducing Friction

The Digital Leader Newsletter — Strategies and Techniques for Change Agents, Strategists, and Innovators

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Any product that needs a manual to work is broken. Elon Musk

It’s Sunday, so I’m doing what I do on most Sundays — starting to really worry about what the provocative and enticing lesson will be for this week’s The Digital Leader Newsletter. If you think my Sundays are all about relaxing and playing with our dog, Bossman, they are not! There is typically a growing pit in my stomach due to this anxiety. Publish or perish, right?

I’m about three-quarters of the way through listening to an excellent book titled “The Founders: The Story of PayPal and the Entrepreneurs Who Shaped Silicon Valley” by Jimmy Soni and the answer to my Sunday anxiety lept out to me.

Elon Musk, Peter Thiel, Max Levchin, Reid Hoffman, David Sacks — The PayPal mafia. You’d think these big brains would have had a strategic and complete plan for X.com (X.com acquired Confinity in March 2020 and the company went by X.com until June 2001 when it changed to PayPal). But for all their hard work, brilliance, products launched and traction the PayPal product was having with sellers at EBay.com, the seed of a sustainable business came from an employee trying to reduce friction. And by reducing this friction, the dominos for a “premium” PayPal service, and an actual revenue-producing business, were lined up. The X.com team then just had to topple the lead domino to start the chain reaction.

A Primer on Friction

We’ve talked about friction before. A quick refresher — what is friction?

Friction is the unfinished work we ask our customers or employees to deal with. It leads to the effort, less-than-ideal customer satisfaction, and hidden taxes in our operational costs in the form of efficiencies, quality, and manual efforts. Friction is often in the minutiae or in larger gaps customers have to take to conduct their business with us.  

Innovate by Reducing Friction

Account Verification, Fraud, and Reducing Friction

In Chapter 12 — “Buttoned Up”, the setting is laid out. X.com, founded in March 1999 by Elon Musk and three co-founders, was in a customer acquisition death-match with Confinity, founded in December 1998 by Peter Thiel, Max Levchin, and Luke Nosek. X.com was founded with the mission of being an internet-based bank offering all the consumer and business banking services and products under one offering in a pure internet business model. Confinity was founded to enable PalmPilot users to be able to easily split payments (e.g. split a restaurant bill). They both stumbled upon enabling payments by email in late 1999 and the eBay community largely found them and started to leverage these products to enable easy customer payments (most were done by check at this point).

X.com and Confinity were competing head-to-head to attract users through an unsustainable $10 referral fee. This was a classic “network effects” race with a winner-take-all mindset. The key problems were that neither had a path to significant revenue for their products, the high price of customer acquisition, and a high amount of fraud, plus others. The two companies agreed to a 50/50 merger in March 2000.

Think of the brainpower behind the combined companies. This group is often referred to as the PayPal mafia¹ with companies such as Yammer, Affinity, Yelp, YouTube, LinkedIn, Founders Fund, Tesla, SpaceX, and The Boring Company among others being born out of the PayPal alumni. For all the brainpower of this group, they had not developed a sustainable revenue model. In addition to a weak revenue plan, there was a potentially mortal weakness — almost 100% of their business was driven by eBay, which was motivated to have their own payment service, named Billpoint, succeed.

David Sacks was the SVP of Product. His teams were working on strategies and products encouraging users to link their banking accounts to their PayPal account. This was critical so that PayPal could enable payments and transfers directly from user bank accounts, avoiding the credit card platforms and a >2% transaction fee versus just a few cents for a direct-bank settlement. This drove a strategic imperative to encourage users to connect banking accounts directly to PayPal.

Thus, creating a slippery pipeline allowing users to register their bank accounts was a vital company initiative, being raised all the way to the board. Just one “small” problem — fraud. Without a mechanism for banking account verification, the fraudsters had a door to defraud X.com. A low-friction but verifiable technique was needed, or X.com had no viable path for rapidly connecting users’ PayPal accounts to checking, and the entire business was at risk. Sanjay Bhargava was a product manager on David Sacks’ team and was charged with figuring this out.

The challenge left Bhargava pondering security and identity verification within complex systems. Early in 2000, Bhargava read Secrets & Lies: Digital Security in a Networked World by computer security architect Bruce Schneier — a bestselling IT book featuring readable and lucid explanations of cryptography, hacking and, notably for Bhargava, the concept of signal and noise…

X.com needed, Bhargava realized, a cleaner, quicker signal than voided checks or inscrutably faxes to confirm bank account ownership.

Banks used such signals already: A four-digit ATM PIN confirmed debit card ownership. X.com needed something like that — a signal as simple as an ATM code.

Then, Bhargava had a thought: What if X.com generated its own onetime equivalent? Specifically, the company could manufacture four-digit passcodes by sending two random deposits of under $1 to a users bank account. If a user received "$0.35 and $0.07, for example, they coudl enter the code “3507” on the PayPal website. Entered successfully, the onetime code confirmed bank account access — and without grainy faxes or snail-mailed checks.²

This elegant solution, removing the friction of signature card verification while still verifying account ownership, was not only the critical domino to connect PayPal accounts to checking and savings accounts, but it set in play an entire set of dominos to create PayPal buttons used on any site and “premium features” for sellers, which enabled a viable revenue model for PayPal. It was a key unlocked for the PayPal business model which, up to that point, had yet to be discovered.

Musk was unreserved in his praise for random deposit: “That was a fundamental breakthrough.” David Sacks captured the ideas elegant simplicity in his launch announcement, calling it “an idea that, like Velcro, you wish you had thought of”

Paying attention to friction not only improves the customer experience and typically improves operations, but it is the skill and progress from which bigger innovations and bigger business moments are often created. It is one of the habits enabling potential championship moments.

Championship Habits

We all want the award ceremony celebrating success, receiving the “gold medal” for a glorious business built upon innovation. But the input and process are not glorious, have no guarantees and most people don’t have the discipline to consistently pursue. This is the business equivalent of going to the sweaty gym every day, looking for the inefficiency, the quality issue, the complexity, the cost, the duplication, the errors — THE FRICTION. Creating the environment in which customer and operational details are pursued, in which small teams are given the mission to identify, test, adjust and then scale improvements is the championship habit creating value from digital transformation today, and develops the potential for potential championship moments in the future.

Your Homework — Spotting Friction

How do I recognize friction? The answer to this question might make a helpful book, and this is an incomplete list of how friction is manifested, but here is where friction is found:

• Time lag & waiting between steps

• Re-entering information and duplication of steps

• Quality issues

• Any customer question or complaint

• Costs and fees without a tangible “value add”

• Setup and installation efforts

• When a user or customer has to manage the integration across silos

• Having to make a call to customer service

• Non-value added activity such as inspections

Where is there friction in your business? Want to discuss? Feel free to schedule time with me to discuss.

Onward!

John

About The Digital Leader Newsletter

This is a newsletter for change agents, strategists, and innovators. The Digital Leader Newsletter is a weekly coaching session with a focus on customer-centricity, innovation, and strategy. We deliver practical theory, examples, tools, and techniques to help you build better strategies, better plans, better solutions — but most of all to think and communicate better. You’ll be able to follow up with questions and advice.

Please share with others! Thanks

1. https://en.wikipedia.org/wiki/PayPal_Mafia

2. The Founders: The Story of PayPal and the Entrepreneurs Who Shaped Silicon Valley, by Jimmy Soni, page 205.