As financial services startups debate whether it is better to ask regulators for permission or beg for their forgiveness after signing up customers, PayPal's history might offer some lessons.
Once a startup itself, PayPal, now a unit of eBay (EBAY), argued for years with officials over whether it was, or wasn't, an illegal banking operation. Now, PayPal has licenses wherever it needs state approval.
In 2002, Louisiana regulators nearly banned PayPal from operating in the state, sending the company a warning that it might be operating there illegally.
"I think it's a great example," remembers Eric Jackson, who was PayPal's first marketing director and wrote about his experiences in a 2004 memoir, The PayPal Wars, "because it points out how regulators say, 'If we don't know what you are, you must be dangerous, and later on we'll figure out what we'll call you.'"
The Louisiana Banking Department quickly reconsidered after meeting with PayPal's lawyers and other state officials. According to Jackson, it probably helped that hundreds of angry PayPal users phoned the state to complain.
"It has a funny ending, but it's not a funny story," says Jackson, who is now the CEO of CapLinked, an online platform for managing financings and M&A deals. "Because people were using PayPal to sell online — and it was making life easier for consumers — and [regulators'] first reaction was: 'We think you might be a bank, but we don't have any approval for you, so we're just going to ban you.' "
In its home state of California, PayPal is among those that have lobbied to amend a notoriously onerous money transmitter licensing law. The company met with Assemblyman Roger Dickinson, D-Sacramento, who has sponsored a bill that would make the Department of Business Oversight's licensing decisions more transparent and lower capital requirements.
"We perceive ourselves, in many ways, as having the same dog in the fight" as startups, says John Muller, PayPal's general counsel, who has been with the company since before the initial public offering. "We want to do new things, and even in some cases acquire new companies."
Part of the reason PayPal went public in 2002 was to satisfy capital requirements for state-licensed money transmitters, explains Muller.
In its infancy, PayPal structured the capital it received from investors as preferred rather than common stock. Even though the money was in the bank, it looked like debt on the books.
The IPO "caused the venture capital investment to convert to common stock," Muller says. "Just by the way the paper was shuffling, in a sense, all of a sudden we went from several million negative net worth to several million positive net worth, so we could easily meet the minimum capital requirements."
He's quick to say, however, that regulators are straightforward in their dealings with PayPal — and well intentioned.
And he's less worried about state regulations than about the cost of federal requirements, "in particular having to create an anti-money-laundering program," Muller says. "For any international transactions or even domestic transactions — not to totally downplay the states, the state process is burdensome, especially when you take into account 48 different states — but to me what winds up being the biggest cost is the cost of federal requirements and anti-money-laundering programs in particular."
An average-size company can wind up spending at least several million dollars a year on anti-money-laundering compliance just monitoring and updating the program, Muller says, and PayPal's program costs the company far more.