Wall Street is getting excited about a small corner of Jack Dorsey's empire

Carmen Rodriguez was in a bind. She was facing a job loss and trying to figure out what to do next.

Then it struck her. She would often rope her sister and cousin into helping her bake for the holidays. Why not launch a bakery?

Rodriguez and her sister launched Brooklyn Cupcake, a Williamsburg-based cupcake shop, creating Puerto Rican- and Italian-inspired cupcakes. The news spread quickly, she said, and the support came pouring in.

The fledgling business took off, and soon the sisters were approached by the Food Network, Whole Foods of Brooklyn, and Circle Line Sightseeing Cruises to stock their cupcakes. They were asked to host their cupcakes as part of the Brooklyn food cultural experience and were appointed the official cupcake of Brooklyn by the Prospect Park food court.

"We needed to build out a kitchen and we needed it fast," said Rodriguez.

They needed $20,000 to keep up with demand. They applied for a loan at a bank and were rejected. "We were only about two years in operation and still considered a startup. Receiving funding was next to impossible."

They were already customers of Square, having decided to use the Square reader and point-of-sale (POS) system for their nascent business after seeing an ad for the company. The sisters didn't know about Square Capital, the lending arm of Square, until they were unexpectedly offered a loan. They were shocked.

"I was able to use the proceeds to secure the commercial kitchen space, build it out, and lease new equipment, which helped us to generate about $100,000 more in revenue that year," she said.

They have since used Square Capital loans four times to expand their business.

"Each time it gets easier and easier," Rodriguez said. "Just push the button and the funds are there, usually the next day. Square Capital was a game-changer for me and my family."

Behind the game-changer

Square was founded by Twitter CEO Jack Dorsey. Along with Twitter, Square saw a tumultuous start to the year. Square's net loss reached $96.7 million in the first quarter, nearly double the level at that time last year, because of a more than 70% increase in operating expenses. (The company settled a $50 million lawsuit by someone who claimed to be the creator of Square's credit-card reader.)

But in Square Capital, a small but fast-growing part of the 1,449-employee company, Dorsey has a business with a ton of potential.

"Square Capital is probably the most profitable value-added service that Square provides," Tien Tsin Huang, a managing director in research at JPMorgan, told Business Insider.

In the second quarter of 2016, Square Capital extended almost 34,000 working-capital loans to small businesses, totaling $189 million, an increase of 123% year over year.

The loans are funded by the company's own balance sheet as well as third-party institutional investors, with five new investors added in the second quarter.

Square Capital remains the largest revenue contributor to software and data revenue at Square, according to an August research note by Morgan Stanley. Software and data revenue came to $30 million, or about 17.5% of total revenue, in the second quarter.

The business opportunity is huge - 99.7% of businesses in the US are small businesses, and 48% of US employees are small-business employees, according to the US small-business administration.

"It's such a big market and it's so underserved," Jackie Reses, Square Capital's CEO, told Business Insider. "That presents tremendous opportunity for Square and for Square Capital as we continue to expand, meeting the unmet demand small businesses have for access to funds they need to grow."

The flywheel of Square

Square Capital has a slightly different motivation to a bank. Whereas the primary business of a bank is issuing loans, Square is focused on generating additional revenues from the payments business. The idea behind Square Capital is that it provides funding to help small businesses expand, allowing them to generate more revenue. This in turn helps Square's main business, which makes money by charging a 2.75% fee on every swiped credit-card transaction.

Everything Square Capital does, according to Reses, "is to keep the flywheel of Square going as well. Everything we do will be connected to Square's purpose in some way."

Square Capital offers loans only to small-business owners who use Square's devices. The company gets unique insight into the real-time transaction data of its customers, which helps inform underwriting and risk models.

Square Capital then selects small-business owners who are eligible for a personal loan based on their activity with Square, and it approaches them with an offer.

The owners select which loan offer they want, and the funds are usually deposited by the next business day. The loan is repaid as a fixed percentage of daily card sales. That means that when business is good the business owner repays more; when business is slow they pay back less.

So far, default rates are about 4%, according to the company. "Square's scale and product ecosystem is the secret sauce of Square, not just Square Capital," Reses said.

According to JP Morgan's Huang, the strength of Square's customer-acquisition tool, with their core payments business, cannot be overestimated. "It allows them to get to know their customers, be proactive, and in turn sell value-added services like Square Capital. I think Square is the first nonbank to offer it up at scale using their own risk management."

Square recently launched products that provide sellers with more options to accept payments, including scheduled invoices, recurring invoices, and keeping a card on file.

The timing is great for the payments business

In August, Square announced a partnership with Upserve, a startup that processes card payments and provides business-management tools to small restaurants.

"The approach we took there was to go outside of Square, such that we could take our lending product and provide it seamlessly to another company's customers to give them a great experience," Reses said.

Square Cap receives anonymized transaction data from Upserve that allows it to apply its models for underwriting and risk just as it would if those businesses operated on Square. "We think that going outside of Square will be an interesting strategic long-term opportunity," she said.

The partnership has given Square a leg up in the restaurant business, where it hasn't traditionally done well, according to Neil Doshi, a managing director of research at Mizuho Securities USA.

"Upserve will fill that gap," he said. "The demand for their product is increasing, and they are looking to expand their existing customer space."

Reses hinted at an expansion of its product portfolio in the future. There are many pain points for small businesses, she said, that Square could serve. A coffee shop may want to open a second location and need a longer-term loan instead of a short-term one. A business may need money to invest in equipment in advance of having the cash flow.

"You can work through the ecosystem of what a business needs to continue and sustain growth and build out a fairly significant product portfolio, " Reses said.

There is potential for Square to expand beyond focusing on payments and to look to how they use the underlying customer data. "It's really about where our data and insights can drive a differentiated product," Reses added.

Doshi is bullish on the company. "Our view is that a lot of companies are getting more interested in the SMB [small- and medium-sized business] market, and Square has pretty high take rates," he said.

Like Reses, he sees potential in expanding the startups' offerings.

"We view the payments business almost as a lead generation into selling higher-margin software and services, and that includes Square Capital," he said. "They could look at [small-business customers'] transaction data and provide them with more insight into scheduling, payroll, and market implications."

Because Square has a wealth of transaction data on a given small-business customer, it can analyze certain days or weeks that are busier for them than others, and help companies focus their marketing efforts, he said. They can also provide small businesses that may not be as business-savvy or software-savvy with the data and tools to run their business more efficiently and in a simpler way.

"There are a lot of interesting implications," Doshi said. "A lot of interesting use cases and a lot of opportunity."

Doshi predicts that Square Capital could soon move more upstream into larger businesses, perhaps working with companies that could provide more transaction data. For example, it could team up with larger firms like AmEx, Visa, or MasterCard.

James Faucette, in Morgan Stanley's equity-research team, also sees an opportunity for the company to cross-sell software and data-analytics solutions to customers. Still, he said the "visibility is too limited" right now.

"Long-term profitability of the business is yet to be proven, but we see a path driven by scale," he said.

JPMorgan's Huang is also bullish on the company. "The timing is great for the payments business," he said. US retailers are increasingly converting to more secure EMV chip credit readers from traditional swiping, and Square's hardware is already chip-ready. "They are able to go to market with a lot of speed," he said.

Square isn't going to have it all its own way, though.

"A lot of the bigger players are moving downstream and this could be a problem for them," Doshi said. "Payments companies like Chase and PayPal want to move downstream to provide smaller loans to businesses."

JPMorgan's Huang sees a similar potential threat. "It's not a new market," he said. "We will see banks trying to pursue this market more aggressively."

But while the threat exists, it can present an opportunity. Doshi predicts that as the market grows, one of the larger players may even acquire Square for its technology.

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