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Why the Afterpay IPO is going gangbusters

Shares in Afterpay (ASX: AFY) have rocketed 30 per cent above their initial public offer price to $1.30 this week as the latest fintech startup to hit the ASX boards receives support from investors willing to bet big on its future success.

Afterpay is at the forefront of a new trend that lets online shoppers purchase goods from popular fast-fashion stores on a ‘buy now pay later’ basis. Well-known fashion brands already signed up to the Afterpay technology include General Pants Co, CUE, Surfstitch, Zanerobe, Aquila, Princess Polly and Veronika Maine, among more than 100 other merchant retailers.

When a shopper buys an item online from one of these stores Aftepay allows them to pay for the item in regular instalments without having to pay a final amount above the original purchase price by way of interest or fees.

This is unsurprisingly popular with shopaholics and retailers as Afterpay pays the merchant the cost of the item upfront in return for a fee, while assuming the credit risk if the shopper defaults on his or her payment obligations.

In February 2016 underlying merchant sales were more than $2.8 million and Afterpay’s revenues on those sales were more than $100,000.

For the six months ending December 31 2015 the company posted a loss of $1.25 million and has raised $25 million in its IPO at $1 per share to fund product development, marketing, sales, staff and other general expenses associated with building a potential fintech phenomenon.

The scalable business model is attractive as merchants enjoy substantial uplifts in online sales and additional merchants can be signed up with little extra cost to the Afterpay business. Many of the customers also have regular online shopping habits and Afterpay can easily verify repeat customers which lessens the risks around debt defaults.

However, the key risks for Afterpay are those of fraud or customers defaulting on their payment obligations due to having insufficient funds in their accounts.

Funds are collected via direct debit and Afterpay claims it has some of the best technology in the world to evaluate customers’ credit worthiness based on their transaction and repayment history. However, substantial risks remain around the company being left with a pile of bad debts as it always pays the merchant upfront and has limited methods of recourse in the event of payment defaults.

Its core credit verification technology has been developed by substantial shareholder and recent ASX arrival Touchcorp Limited (ASX: TCH), which is a company at the cutting edge of providing secure transaction processing technology to blue-chip companies worldwide.

Touchcorp shares are up 24 per cent to $2.02 over the course of the past year and it currently holds 30.3 per cent of the issued share capital in Afterpay.

More conservative investors may prefer to pick up a small parcel of shares in the fast growing and profitable Touchcorp in order to gain some exposure to the potential of Afterpay without taking on the substantial risks.

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Motley Fool contributor Tom Richardson has no position in any stocks mentioned.

You can find Tom on Twitter @tommyr345

The Motley Fool Australia owns shares of TOUCHCORP FPO. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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