By Adam Atlas
Attorney at Law
For certain businesses, big money is cheaper to come by than ever. As a result, some of that money is finding its way into the payments niche. The purpose of this article is to share a few thoughts on this development, which is exciting but risky for all concerned.
Private equity investment cash - some of it borrowed at historically low interest rates - doesn't have the same gravitas as the money earned by feet-on-the-street sales organizations that grew their residuals one merchant at a time. These differing perspectives actually make for a good marriage.
Investors from the mergers and acquisitions world - having lost principal in markets like real estate and dot-coms - are stunned to find a business model that earns money in a reasonably predictable way. ISOs, on the other hand, have for years been turned away by traditional banks for financing and are delighted to meet investors willing to compete to lend to them or purchase their portfolios.
Investors from outside our industry often think in terms of multiples of annual earnings. A starting benchmark for investing in traditional businesses is the premise that a business is worth about twice its annual revenue. Then, investors may increase or decrease the multiple as a function of the specific characteristics of the business.
For instance, the business may show great promise of growth or have rights to a coveted patent. Or investors may get carried away by a simple idea, as in the case of Groupon Inc.
The challenge for investment firms from outside the industry is to understand the ISO perspective and translate that into something meaningful for their investors.
ISOs and merchant level salespeople (MLSs) evaluate their portfolios as a function of monthly multiples. In very broad strokes, the range is about 10 to 50 times monthly residuals. In Wall Street parlance, that translates to about one to four times annual earnings.
ISOs have the challenge of receiving residuals from more than one source, such as one or two acquiring relationships, check processing, gift card residuals, and automated clearing house processing and leasing. ISOs see all of these sources of income as parts of one basket.
ISOs then have the challenge of explaining to investors new to the industry why these various sources of income can be grouped together or how to sever them if an investor is looking to buy only some of them.
A key provision in a purchase or investment deal is the definition of residuals. This asset can determine other important trigger points in the deal, such as earn-outs of the purchase price, entitlement to future buyouts, duration of exclusivity, and pricing on new deals.
Having advised on a number of investments for lenders, borrowers, buyers and sellers, I have concluded that taking the time to properly define residuals is of enormous benefit to all concerned.
For example, are they calculated before or after agent payouts? Are residuals calculated with or without Payment Card Industry Data Security Standard compliance fees, IRS fees, and annual and minimum fees, etc.?
Some deals work as a function of not only actual residuals but also the rate of growth of new residuals, merchant count or merchant processing volume. The individual set of variables changes from deal to deal, as different ISOs have different qualities.
For example, some ISOs get new merchants only through call centers and rely on monthly minimums as a major source of residuals. Other ISOs sell only face to face and rely on lease revenue as a major residual source.
In our industry, big-money investors often bring their own law firms into transactions - firms with expertise in many fields, except merchant acquiring. This is advantageous to ISOs because law firms from outside our industry are not usually equipped to adequately protect their clients from the rough and tumble world of ISOs, MLSs and some of the pirates in our marketplace.
Yet bringing nonindustry lawyers into transactions is bothersome to ISOs because it tends to make the deals paper-heavy and much slower to close. We have advised on agent buyouts that range from two-page buyout agreements to deals exceeding one hundred pages of documentation.
The length of the agreement is not usually an indicator of its quality. However, it is usually an indicator of the transaction's legal fees.
Keep in mind that most ISO agreements contain confidentiality clauses. If an ISO discloses to a potential investor the pricing applicable under the ISO agreement without the consent of the ISO's processor, the sales organization may be in breach of its agreement.
ISOs are sometimes reluctant to speak to their processors about possible investments or acquisitions because either could be perceived as a sign of weakness. ISOs should take comfort that, if they are meeting their commitments, their processors should not meddle in the financing.
Another factor to remember is the processor's right of first refusal for residual sales often granted in ISO agreements. While processors rarely exercise that right, it is important to grant the right to the processor in order to avoid surprises or, more importantly, breaches.
ISOs have their own reasons to sell or seek financing. Some need cash to expand their businesses or pay off personal debts. Readers should know, however, that a good number of agents and ISOs decide never to sell. Even compared to a sale at a high multiple, an ISO that provides good service to its merchants will earn more money over the long run if it does not sell.
Think of it this way: investors would never buy a portfolio unless they believed it would earn more over time than the purchase price. When a buyer dangles offer numbers in the hundreds of thousands or millions of dollars, a typical ISO will find it difficult to refuse. ISOs should, however, consider the option of not selling.
In publishing The Green Sheet, neither the author nor the publisher is engaged in rendering legal, accounting or other professional services. If you require legal advice or other expert assistance, seek the services of a competent professional. For further information on this article, email Adam Atlas, Attorney at Law, at atlas@adamatlas.com or call him at 514-842-0886.
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