LevelUp exploits smart bundling to drop credit card interchange fees to 1.95%, saving merchants boatloads

By Michael Carney , written on April 16, 2014

From The News Desk

Its no secret that the payments market needs disrupting. Ask any merchant who’s paying upwards of three to five percent of every transaction for processing and that fact becomes painfully obvious. And consumers are growing weary of carrying around wallets full of plastic when a powerful supercomputer typically sits just a few inches away. But despite this rabid demand, even modern solutions fall short of solving these core problems.

There’s one startup payments network, however, that despite flying largely under the radar in Silicon Valley has put forth the most compelling vision for what the future of payments could look like. That company is LevelUp, a mobile payments network that allows users to pay using their smartphone at more than 14,000 nationwide merchants.

The two-and-a-half-year-old, Boston-based company has now grown to 1.5 million registered users – about 33 percent of which use the app regularly – making it the largest point-of-sale-focused mobile payment network in the US. Moreover, the average user transacts with the app five times per month. But more compelling than either of these stats, is that the company has challenged the notion that interchange fees are simply an unavoidable cost of doing business for merchants.

While merchants pay traditional processors around $0.30 plus 2.9 percent of every credit transaction (fees are lower for debit), LevelUp has always charged its merchants a flat 2.0 percent. Today the company is lowering that rate even further to 1.95 percent. While it may seem like a small move it’s symbolically significant, given the prevailing market, and will ultimately add up to real savings – $250 million if extrapolated across the national small business economy. It’s also just the beginning of more savings to come, according to founder Seth Priebatsch.

“This isn’t a promotion.” Priebatsch says. “It’s us making good on a promise we made to our merchants. This is a permanent drop in our fees. And we plan to continue dropping fees as further processing efficiencies continue to lower our costs.”

LevelUp has been fighting a crusade against interchange fees since its inception in 2011, promising merchants to never charge them more than the company itself pays for delivering these services, and committing to eventually lower interchange costs to as close to zero as possible. Until recently, the company was going one better by actually charging merchants less than its internal costs – early on when volume was small the company was paying interchange costs of more than 5.4 percent, but still charging merchants just 2 percent as promised. It’s subsidized millions of dollars in interchange fees to date. But over time, LevelUp has been able to lower these operating costs through scale and a savvy algorithm that is at the core of its unique value proposition.

Unlike traditional merchant processors, which submit every individual transaction to banks and credit card issuers almost immediately post-swipe, LevelUp delays doing so with the goal of bundling several small transactions by the same customer into a single larger transaction – processed once monthly – that can be sent up the payment stack at a lower effective cost. The lower the interchange fee the company pays, the lower the fee it can charge to its merchants.

The company uses a proprietary algorithm based on consumer behavior data collected across its network to predict when a consumer is likely to transact again soon and combine that data with the risk of holding large balances of unprocessed payments. It’s a strategy pioneered by Apple’s iTunes marketplace, which like LevelUp, sees very small average transaction sizes.

For merchants, the cost savings would be enough of a value proposition to justify adopting LevelUp. But the company sweetens the pot by assisting merchants in running targeted promotions through its platform and then delivering detailed analytics on the back end. As a result, merchants are able to generate marginal revenue, increase customer engagement, attract new customers, reengage old customers, and collect tons of data in the process, Priebatsch says.

It’s in the promotions that LevelUp makes its money. The company charges its merchants a fee of 25 percent of the discount offered in each campaign. For example, if a convenience store offers a $2 discount, then it pays LevelUp a $0.50 fee on every transaction generated through that campaign. The same with a retailer offering a 10 percent discount on a $20 purchase. With 85 percent of all merchants on the platform running campaigns, the company is generating meaningful revenue and is able to remove interchange arbitrage from its monetization strategy.

“We pass through all interchange cost savings to merchants,” Priebatsch says. “We view these fees as an unnecessary tax on the economy and have made it our mission to eliminate them altogether. We’re not far from the day where merchants will be unwilling to pay 4 percent to accept AMEX or 3 percent to accept Visa and not get any data back in return.”

It’s not just merchants who benefit. Consumers save an average of 10 percent on each transaction via the merchant promotions run on the platform. As a result, merchants who adopt LevelUp see an average of 20 to 40 percent of their total transaction volume move to LevelUp within a period of eight weeks, according to the company. That typically makes it the second largest payment processor within a given business, falling just behind Visa but ahead of Mastercard.

It’s not the credit card giants who are being cut out by LevelUp’s model. The company doesn’t change the volume of payments being processed, so these apex predators still get their standard cut. Rather, it’s the issuing and acquiring banks, as well as the legacy processors who are losing out on their swipe fees.

“It’s almost mind boggling how many hands are out looking for a piece of this pie,” Priebatsch says. “We believe its a fundamental truth that the cost of moving money has to decrease, just like it did with the cost of moving data. It’s inevitable that these intermediaries will be disrupted, which is why we’ve built our business model around adding other forms of value. There’s a reason that we’re bigger and more profitable than any mobile payments network ever.”

But for all its early success, LevelUp is still just a minnow swimming in the payments ocean that is owned by the credit card giants, who Priebatsch says are at least two orders of magnitude larger. The company’s biggest challenge over the next two years, he says, will be to prove that it can scale to this level and do so with sufficient speed to make LevelUp a viable option for every merchant and every consumer.

The 100 person company has raised $48 million in venture capital to date from Google Ventures, Balderton Capital, Continental Investors, Highland Capital, Transmedia Capital, and Deutsche­Telekom’s T­Venture. The next step in terms of capitalization will not be to raise more equity, Priebatsch says, but to raise a large revolving credit facility for use in factoring the short-term receivables generated through its payments bundling model.

Today, LevelUp is focused on small local merchants and a select few online retailers. But as payments volume improves and it shifts its capitalization from equity to debt, the company anticipates moving up the food chain to serve a broader swath of the payments marketplace.

Other payments innovators have tackled more superficial pain points like ease of implementation, point of sale interface, or end-user experience, but none have been able to assist merchants where it counts most: on their bottom line. For that reason alone, LevelUp is in a class of its own.

That the company has found a way to make money for itself while also incentivizing consumers along the way is a minor payments miracle.

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