T he persistent weak economic conditions haven't been easy for business owners, especially those in the small to midsize range, including many ISOs and merchant level salespeople (MLSs). Banks have tightened credit standards, so even the strongest companies have been forced to seek new funding alternatives. This article explores resources available to ISOs and MLSs looking for capital to meet their own business needs. A prior article, "Financing options proliferate in payments sphere," The Green Sheet, May 14, 2012, issue 12:05:01, focused on financing options ISOs and MLSs can offer their clients.
Questions for ISOs, MLSs evaluating lenders, purchasers
Following are key considerations for ISOs and MLSs wanting to borrow against or sell merchant portfolios:
How well do you know the lender or buyer?
Is the company financially sound?
What is the company's track record, specifically its experience lending against or purchasing merchant portfolios?
What do other folks in this market think of the lender or buyer?
Are your payout expectations in line with what others in your market are receiving for their portfolios?
Are you planning to exit the business completely, or do you just need money to grow?
Do your processor agreements make demands regarding the transfer of portfolio ownership?
Does the buyer's or lender's agreement explicitly set forth what is expected from each party?
Several years into what is often called the Great Recession, financing and other cash-flow issues continue to plague small businesses throughout the nation, according to a new report from the National Small Business Association. Among small business owners contacted for the 2012 Small Business Access to Capital Survey, 43 percent reported they have needed funds at least once in the past few years but couldn't find any willing sources.
"Not only have small-business owners been unable to find new credit over the last four years, nearly a third had their existing credit slashed, and one in 10 had their loans called in early," said NSBA President and Chief Executive Officer Todd McCracken. Forty-four percent said credit card issuers were tightening the screws, too, in terms of interest rates and fees, according to the survey.
McCracken said one result of this is that more than a quarter of respondent businesses had changed financial institutions within the past four years, many opting to join credit unions or work with small community banks. Interestingly, 13 percent reported using prepaid card programs to achieve their financing goals; 1 percent said they had turned to payday lenders.
For ISOs and MLSs, conventional lending vehicles are especially tough because banks and other traditional lenders don't understand how to value a merchant portfolio. "Typically, ISOs try to get an SBA [Small Business Administration] loan from their local bank, or take out a home equity loan against their home," said Darrin Ginsberg, CEO of Super G Funding LLC. "This is very hard to do in today's economic climate."
The same is true of venture capital firms: most won't even look at a small to midsize ISO, Ginsberg said. But some are willing, as evidenced by a growth recapitalization plan recently obtained by Merchant Warehouse, a midsize ISO based in Boston. The source is Parthenon Capital Partners, a private equity firm with $2.2 billion in capital under management. Ginsberg stated he has purchased more than 50 merchant portfolios over the past 12 years and he continues to buy portfolios. He also noted that in the past three years, 70 ISOs have received almost $10 million, combined, in loans against their residual streams from Super G. Ginsberg believes he is especially well positioned to work with ISOs and MLSs because he has been building portfolios for more than 20 years.
Typically, ISOs need money to fund marketing, hire new reps, implement new sales programs and pursue other growth opportunities. Merchant Warehouse, for instance, said it plans to use at least some of the capital infusion it received from Pantheon to help fund a new customer engagement platform. Super G's loans look a bit like a merchant cash advance product, but instead of taking a cut of each day's transaction fees, Super G takes monthly draw-downs for interest and principal before the borrowing ISO even sees residuals, which typically post two days later.
ISOs actually selling portfolios are more apt to be looking to get out of the business, Ginsberg said. They also will incur more expenses. Selling a portfolio can be 30 percent to 60 percent more expensive than borrowing against residuals; plus, a sale takes longer to execute, and proceeds are treated as taxable income, Ginsberg added.
Questions for lenders, buyers evaluating portfolios
Following are several points for lenders and buyers to consider when evaluating merchant portfolios:
How well is the portfolio performing now, and how has it fared over the past few years?
How diverse is the portfolio in terms of transaction types, merchant size, vertical markets, etc.?
What does the company's revenue stream look like? Does it rely on services fees instead of transaction growth?
What types of risks is the portfolio susceptible to?
What's the portfolio's average ticket?
Which processor is used, and what do the seller's or borrower's agreements look like both with its processor and its clients?
How does the ISO sign merchants - employee or independent contractor agents?
How many services do merchants use in addition to transaction processing?
What are the attrition rates, both in terms of transactions and merchants?
Do attrition guarantees fall within the typical 10 to 15 percent per year for a period of two to three years?
Will the ISO stick around to service the portfolio?
How long will the noncompete period after a purchase be?
Residual loans, on the other hand, are not income and can be fully funded in a matter of days. "If you're planning to stay in this business, it's better to borrow than to sell," Ginsberg said. The minimum loan size Super G offers is $25,000; the maximum is $2 million.
Typically, borrowers qualify for loans amounting to five times their monthly residual streams, Ginsberg said. That means to qualify for a $25,000 loan, an ISO or MLS needs $5,000 in monthly residuals. Repayments are deducted from residuals over periods ranging from 12 to 36 months. Simple interest rates assessed on typical loans work out to 17 to 19 percent, he added.
Super G enjoys working through upstream ISOs and recently entered into a referral agreement with Cynergy Data LLC. The lending model Super G uses is one of several options for ISOs and MLSs aiming to raise capital.
"There's no one way to negotiate or structure a deal," said Dean Caso, Partner at Velocity Funding LLC in Norwood, Mass. Caso has been purchasing merchant portfolios since 2003. He started out when he was an ISO and was unable to convince a bank to lend him money to purchase another portfolio. So he used $1.5 million of his own money to make the purchase. "And I proved to the bank that it worked," Caso said.
Caso uses homegrown software and 15 metrics to analyze the purchase of an ISO portfolio (for example, attrition rates, concentration and pricing). Offers are made in multiples of the portfolio's yearly revenues and disbursed in two payments: an upfront payment equal to between 50 and 80 percent of the valuation, and the remainder two to three years later when certain contractual benchmarks (like attrition guarantees) are fully met.
Vertical market concentration and merchant attrition rates are critical variables in Velocity's decision process. "If 10 merchants represent 60 percent of a portfolio, then I'm going to weigh that differently," Caso said. As for attrition, anything over 20 percent is cause for concern. "It may not affect overall what I pay, but it will affect what I pay upfront," he said.
Dallas-based Calpian Inc. looks at both present and past attrition when it considers purchasing merchant portfolios, tracking portfolio activity over a span of five years. "Not all years are the same," Calpian CEO Harold Montgomery said. Adopting a historical perspective also provides a better sense of overall profitability, he said. If a company looks good now, but was in a slump last year, that could be a red flag.
Initially, Calpian paid cash for portfolios. Now, as a publicly traded company, it purchases portfolios, or portions of portfolios, for a combination of cash and shares in Calpian. "Being a public company has allowed us to structure deals that deliver value over time, versus cash now," Montgomery said. "Our program is different from other residual buyout programs in the marketplace today in that our partners ... are encouraged to continue to build and operate their businesses at their own discretion."
In April 2012, Cooper & Schifrin LLC entered into its third financing arrangement with Calpian. Calpian said it paid the ISO $280,000 in cash along with 12,308 shares of Calpian stock for a chunk of the ISO's portfolio.
Cutter Financial Group LLC pays cash for partial or entire portfolios, typically in two installments. Either way, Cutter, headquartered in Franklin, Tenn., also prefers deals where sellers stay on and work at growing their portfolios.
"We do a good job servicing portfolios," said Denise Shomo, Cutter's Chief Operating Officer. "The ISO staying involved is key to keeping attrition low." Staying involved also is good for ISOs and MLSs, Shomo noted. "By working with us, and with us working with the processor, they stand a better chance of obtaining a subsequent payment," she said.
Cutter has arrangements with upstream ISOs who refer their ISOs and MLSs looking for capital. Shomo said Cutter prefers working through upstream ISOs because they're in the best position to know which ISOs and MLSs need capital. "We try really hard to build relationships with ISOs," Shomo said. "We don't want to compete with them." Indeed, if the upstream ISO wants the portfolio Cutter is negotiating to purchase, Cutter will walk away from the deal, she added.
Montgomery made a similar assessment of Calpian. "We're like Switzerland," he said, noting that Calpian has working relationships with processors large and small.
According to Ginsberg, multiples paid to purchase merchant portfolios, as opposed to borrowing against residuals, can range from 12 to 35 times monthly residuals, with larger portfolios ($500,000 a month and up) commanding the highest multiples. Multiples increase according to size because, typically, the larger the portfolio, the less risk involved, Shomo said.
Risks a buyer considers when assessing a portfolio, in addition to merchant attrition, include the potential that an upstream ISO will stop paying residuals, the likelihood that a seller will try to poach merchants as it creates a new portfolio, and economic factors such as the impact of rising fuel prices on airlines or new rules like debit interchange caps.
Not every ISO selling a portfolio is looking to exit merchant acquiring. Caso said only about 20 percent of the ISOs Velocity works with are getting out of the business. Most just need to raise additional capital and thus only want to sell a portion of their portfolios. Others are shopping around for a sense of what the market might pay for their portfolios, he said.
"We will make offers on most, but we don't necessarily purchase all of them," Caso said. That's because often the seller has a different price in mind, he added.
Montgomery said he has seen plenty of ISOs selling strong portfolios. Often they're looking for capital to start a new sales organization, he said. Shomo noted that "everybody has their own unique reasons for selling."
And every buyer or lender has its own agenda. Velocity, for example, prefers to purchase static merchant portfolios, making attrition the company's number one consideration, Caso said. He added that Velocity works to keep merchants by providing a high level of support.
Each of the executives interviewed for this story said the market for merchant portfolios is brisk. Caso mentioned he had taken "12 calls in the past three weeks" from ISOs and MLSs seeking to sell all or portions of their portfolios. Shomo said Cutter, too, is being approached by more ISOs wanting to sell all or portions of their portfolios, but it declines many offers because they aren't a good fit for the company.
So, with portfolio sales and borrowing against residuals on the rise, let's hope a lift in the economy is coming
close behind.
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