Payment processing – Merchant account or PayPal?

January 18, 2009 at 5:33 pm | Posted in Software as a Service, Sofware Startup | 4 Comments
Tags: credit card, mastercard, merchant account, paypal, software, startup, visa, web 2.0

Over the past few weeks we undertook the effort to obtain a merchant account so that we could process transactions on the MioWorks.com web site.  I always heard that this was a daunting process and that most businesses would never be able to satisfy the requirements.  At first we were put off by these urban myths and looked at using PayPal for our payment solution.  We used PayPal in the past and it worked just fine, but we didn’t feel it was optimal.   Therefore we took this opportunity to look into what else was available.  As we researched the differences between having a merchant account/payment gateway and an all in solution we unraveled the mysteries and made our decision.  This post helps to explain the differences and then talks about our choice.

First let me explain how credit card processing works over the internet.  In scenario one with the all in payment solutions you can feed to them items to maintain in a shopping cart or you can send an entire shopping cart to them when the user selects to checkout.  Typically at this point of the process the user is then redirected to the payment web site and they log in or complete the transaction with the 3rd party.  At the end of the transaction the user is returned to your website and a record of the transaction comes along with them under the covers for you to process.  In scenario two, your web site has a shopping cart.  This shopping card collects the items that the user wants to buy and then formulates a total amount for the purchase.  When the user decides to make the purchase, your shopping cart application then contacts a payment gateway to request an authorization. There are many payment gateways  out there with some of the more popular being authorize.net and trustcommerce.com.  The payment gateway interacts with the banks and gains the approval for the transaction.  The payment gateway then interfaces with your merchant account to credit you with the sale and then a few days later the money is actually transmitted through your merchant account to your banking account where you can access the funds.

Sit back with a coffee and get ready to read

Since we were in research mode we wanted to fully understand the differences between the solutions.  We printed out the terms of use of the all in one services and read through them highlighting the costs and risks to the business.  Then we did the same with the documentation for one of the programs with a large banking institution.  In our case the first document was the Merchant Service Program guide weighing in at 44 pages of exciting legal jargon and rules.  The second document was 41 page pricing terms.  Just the reading time and analysis took several days (due to boredom) to complete.  In the end we uncovered some interesting differences.

With merchant accounts, rates aren’t that simple

When you use a merchant account and payment gateway the rate structure is rather complex.  I was provided a 41 page pricing terms document that requires a Phd in logic just to follow along.  From my analysis the end result is that there are two different rates that the merchant can be charged for each transaction.  There is the qualified rate and the non-qualified rate. The qualified rate is the “teaser” rate that the bank provides you to get your business.  In our case it was 2.5% of the transaction.  But the non-qualified rate can be upwards of 6-7% for a single transaction and then there are additional gateway fees on top of that.   What makes a transaction non-qualified?  Well there are two possibilities.  The first is that you don’t follow the rules for processing the transaction.  This means that for different types of transactions (Visa, MasterCard, American Express) there are a list of different rules.  Rules on when you must process your batch versus when you authorize, rules on how the transaction code is formatted, rules on how you prevent fraud.  This actually doesn’t cause us any pain, we are fine with knowing the rules and making sure we follow them.  But there is another side to non-qualified, the card type.  This is something that we as a vendor have absolutely no control over.  The type of card that your buyer uses can negatively impact your bottom line if you don’t plan ahead for it.   Those great bonus mile cards and cash back cards, they all cost the vendor more when they are used.  There are some cards that are a 7% charge no matter what.  Imagine if you are running a commodity business with slim margins and all your customers have these cards.  Your profit can go right down the drain to the bank.   This brings up our first business point.  Make sure you know the cost of processing credit cards before you set your price!

Gateway Processing Fees & other fees

In addition to a percentage of each transaction the vendor also must pay a fixed rate per transaction. This fixed rate goes to the transaction gateway.  In our case the fixed rate is $.30 per transaction which includes address verification. ($.25 for transaction and $.05 for address verification).  Lastly there are extra fees that you’ll be charged on a monthly  or yearly basis.  There are statement fees ($7.50), monthly service fees ($31), setup fees ($299), charge back fees ($31) and annual compliance fees ($40).  Make sure that you get a full list of all these fees before you agree to any deal that seems too good to be true.

Compare to PayPal or Amazon Payments

All of this complexity is eliminated when you use an “all in one” service such as PayPal or Amazon Flexible Payment Service.  The fee structure is much easier to understand (PayPal, Amazon) where you are paying roughly 2.9%+ $.30 per transaction.  They don’t have a wacky fee schedule based upon card type.  It’s one rate fits all.  In addition, there is no credit check and you can setup and start using an account in just a few days.   The entire system is automated and you never have to deal with any humans.    Another benefit of PayPal is the handling of foreign currencies.  If you plan to offer your service in several countries, PayPal makes it simple to accept those currencies and then eventually convert them back to U.S. dollars (or another currency if so desired).

Our decision: Merchant account and Gateway solution

For us it all boils down to ease of use for our customers.  When you use PayPal or Amazon Flexible Payments you give up control of the process.  You have to fit your business to the way that they process a transaction and in some cases this can dissuade your customer.  Our hope is that we can make the payment processing a very simple effort without additional logins and redirects to third party websites.  We also have the special requirement of a recurring billing system so that we can charge our customers every month, yet we don’t want to store ANY credit card information in the MioWorks.com application.  This requires a special service from our processing gateway so that we can rely on them to maintain PCI compliance and security of the credit cards.  This is not to say that PayPal of Amazon Flexible Payment Service wouldn’t do the job, it is our preference to go the route of a merchant services account and payment gateway.

The process of obtaining a merchant account

Once we made the decision to go with a merchant account we had to get it.  Obtaining the merchant account was not as difficult as the urban myth suggests.  I started out by doing research on the different banks and their “marketing” offers.  I then called a couple banks to talk more about the details and find out the real deal behind the glitz of the marketing.  When I finally selected the bank that I wanted to deal with I gave them a call.  The initial phone call was to get the process started.  After answering my questions, the agent took my application over the phone.  One item to note is that you must personally support the credit request for a merchant account.  In our case we are an LLC with multiple partners.  Each partner had to provide SSNs and agree to be bound by the terms of the credit extension for the merchant account.  If you have bad credit, or don’t have credit established yet, you can stop now and evaluate PayPal or Amazon Flexible Payment Service.   After the application was completed the agent emailed it to me and I sent it off to my partners for signatures.  Our team reviewed all the materials, made appropriate signatures and then returned the documents to the agent.  The next day we received a preliminary approval on our application pending a copy of the mock ups for the website.  The bank wanted to make sure that what we were selling was appropriate and fit the parameters they set forth.  A few days later I had the website mock ups and the legal documentation for refund policy, terms of use and privacy policy.  I sent this to the agent and everything was finalized.    The process took about a week total and some of that was delayed due to the fact that we have a brand new solution that needed documentation.

At the end of the day, the final decision is up to you and your team.  You have to weigh the complexities against the control.  And you really need to look at your process and determine if the control you are gaining by doing it yourself will simplify the process.  We have gone down the slippery slope and as the business develops I’ll be able to reference this post and compare our anticipated outcome to what really happens.  Maybe PayPal/AFPS are better solutions…..but only time will tell!

Help me decide what to write next!