SOs agree: Margins are decreasing, while the cost of boarding new merchants is on the rise. These trends, left unchecked, appear to be on a collision course. As a result, many ISOs are limiting their expenses and scrutinizing merchant operations to ensure that the light at the end of the tunnel is not an oncoming train.

According to Sam Caine, President of Card Payment Services Inc., average account acquisition costs have increased steadily over the past few years. And the culprits are higher marketing and HR costs, untenable pricing structures and longer sales cycles.

"For us the average break-even point is about six to eight months of processing, based upon our fully loaded acquisition cost," he said. "But the biggest challenges come from the revenue side, not necessarily the costs side of the equation.

"Margins are being compressed by the illusion created by loss-leader type pricing structures and more and more reps offering rates slightly above costs."

Caine said this pricing is not sustainable for those planning to provide the requisite merchant services. "So indirectly, keeping the back-end servicing costs down is a significant issue if we want to compete with the perceptions created by low-ball rates," he added.

Additionally, he said, "If it takes 20% more time to close the average sale than it did five years ago - and I believe it does - the average rep will be able to handle only 80% of the prospects they were able to handle [before]. Therefore a rep closes less business, which increases the acquisition costs associated with HR."

Acquisition costs ballooning

Jared Isaacman, Chief Executive Officer of United Bank Card Inc., agreed the cost of acquiring merchants has gone up considerably in the last few years.

"In the past, the only real hard [merchant boarding] expenses a super ISO or processor had to absorb were operational- and marketing-related," he said. "Our costs were typically covered on the equipment, shipping and other hard costs like PIN-pad encryptions.

"In today's environment a super ISO/processor also has to absorb the equipment costs if a free terminal program is offered, as well as all the bonuses typically offered to the MLS [merchant level salesperson] community. But from an MLS perspective, the cost to acquire a merchant, I believe, has gone down.

"Free terminals, increased signing bonuses, conversion bonuses, production bonuses - the list goes on - have no doubt increased the profitability of many MLSs and, in fact, lowered the acquisition cost per merchant."

Matt Freedman, Chief Operating Officer of Total Merchant Services, said his company's upfront costs have been rising steeply. "Our upfront costs two years ago, before free equipment, were probably $100. Now it's about $800.

"That's a pretty dramatic change in a short period of time. But I think it will level off at this rate. I don't see it going up very much higher."

Freedman broke down his $800 per merchant estimate as follows:

• Terminal equipment: $400 to $500
• Upfront bonus: $150 to $200, on average
• Master agent/recruiter bonus: $200 to $300. This bonus is restricted to fewer than 100 sales reps qualified under the Advanced Merchant Services LLC brand.

Freedman estimated that recouping the cost of acquisition can be done within the first 23 months after boarding. This assumes net revenue after payment of commissions is $35 per merchant.

Many factors influencing costs

But Freedman's estimates don't include other fixed costs of doing business - things like overhead, payroll, marketing and technical support.

"It costs a small fortune to staff a sales support department that makes it possible for a MLS to board and activate an account," said Henry Helgeson, President of Merchant Warehouse. "We look at two things when we come up with our cost per acquisition.

"First is the variable costs that go into each deal. Those costs mainly include agent bonuses or sales rep commissions, marketing support, and any free equipment that goes out the door."

While those costs can add up, Helgeson said the increased costs associated with acquiring business have to do with the overhead that comes with boarding accounts.

"Large ISOs can spend millions of dollars a month supporting their agents and boarding accounts," he said. "These costs have to be factored into the cost of boarding an account. Very often these costs exceed the bonuses and the free equipment costs that an agent sees."

Some ISOs say $800 - or more - in upfront costs to board a new merchant is simply too high to sustain. For example, Caine said over-leveraging can be a house of cards if the growth rate doesn't continue to climb.

"Attrition causes natural barriers to net growth, so an over-leveraged ISO has to become more aggressive to maintain the required growth - either by lowering rates or increasing sales incentives, or both. I've seen this many times, and once it starts it generally leads to failure," he said.

According to Helgeson, ISOs seem willing to postpone their break-even point longer than ever. "It seems like only recently we had all measured our break-even point in months," he said. "Now it appears that some large ISOs are willing to wait years to recoup the variable costs they put out on a single account.

"Some ISOs are clearly setting up their exit strategies and spending more money than others in hopes of building a business that is meant to be sold rather than one that is built to be sustainable on a long-term basis."

Valuations to weigh

Freedman said those who don't understand the logic behind an $800 investment in a merchant account are failing to recognize the differences in valuations between small and large companies.

"Most ISOs fall into the 3,000 to 15,000 merchant category," Freedman said. "And that's a tough place to be.

"They may be acquiring 200 new merchants a month and losing 200 merchants through attrition, and they feel like they're treading water. If they want to sell, they're selling assets, basically, and they'd be valued at two to three times their annual revenues.

"But if they could build a much larger company and were to go public or be valued at a 50,000-plus merchant size, they'd probably be looking at a 10 to 15 times [annual revenue] valuation. That's a big difference."

Freedman compared his $800 in upfront costs for merchant boarding to acquisition costs. "I can go out and buy a portfolio of 5,000 accounts, or I can buy my accounts one at a time for $800 each. We do both. And I don't really see the difference.

"Paying $800 in upfront fees puts the acquisition at about 24 times monthly revenues, which is right in the ballpark ... for an acquisition. And it's a cash flow positive for us from day one."

Freedman acknowledged that this sets a precedent many smaller ISOs can't meet.

"It really doesn't make sense to invest that kind of money if you don't have the cash flow or access to capital beyond asset lending," he said. "It gives us the opportunity to use our size to differentiate ourselves in ways that smaller companies just can't do.

"Of course it's a good idea if you have access to the money to do it. But if you don't have the desire or the means to build a large company, it would be pointless.

"I don't know how smaller ISOs can compete with these kinds of offers. We are in acquisition mode, so we keep an eye on ISOs who are interested in selling. And I'm seeing more and more in the 5,000 to 15,000 merchant level looking to sell."

Efficiency to the rescue

Steve Norell, President of U.S. Merchant Services, said his average cost to sign a new merchant is rising and now runs between $300 and $600, primarily due to closure fees, free equipment and payroll. That has pushed the average break-even point to nearly $600. "Avoid attrition at all costs," he warned.

Attrition is the greatest challenge for Isaacman as well. "An investment to gain a merchant account is fine just as long as you can keep the merchant long enough to create a return on the investment," he said.

"That is why UBC is always looking for new ways to improve and enhance our service levels to increase merchant retention."

Helgeson said the only way to preserve profits is "to focus time and energy on making your operations group more efficient" to keep internal costs down.

"By improving internal systems, constantly retraining agent support reps and offering incentives to stay with the company longer, we can drive the cost of acquiring accounts and pass those savings on to the MLS in the form of sales incentives and better buy rates," he said.

Freedman said high upfront costs are not as risky as they sound. "The terminal costs, for example, are recoverable," he said. "Our equipment is locked down.

"A merchant can't simply change processors and keep the equipment. They agree to return our equipment to us within 10 days of closing their account, or they pay a cash equivalent.

"We also get $150 of their $300 termination fee, and the bonus is paid back if a merchant closes their account within six months of activation - within 12 months for a conversion bonus. So, all in all, we probably lose a couple hundred dollars per merchant attrition, but it's not the whole $800."

Isaacman agreed that with careful management, equipment costs are mostly recoverable. "A free terminal on a low-volume account no doubt has the longest return on our investment," he said.

"However, we do operate a refurbishing operation. And we continue to recycle those terminals from small merchants that go out of business or cancel their service for one reason or another.

"With annual fees being billed within the first 60 days, we can ensure a high collection rate and actually reduce the ROI [time] significantly if that same terminal is deployed more than once in a year."

Isaacman noted that UBC has already recovered its free-terminal investment. "With over 30,000 free terminals deployed since November 2004, and approximately 7% of those units having been returned, refurbished and deployed again, we are already working in the black on the program," he said.

Portfolios under scrutiny

The higher costs associated with signing a new merchant - and the potential losses - have made portfolio management trickier. Many ISOs are looking harder at the merchants themselves.

"Accounts sold over the telephone are more problematic because of ... margin compressions," Caine said. "The rep has less opportunity to build the rapport required to counter misleading and less than honest price quotes.

"Further, new businesses are bombarded with postcards offering free equipment, unrealistically low rates, cruises and trips, so we find it is generally not worthwhile to pursue these prospects.

"Since most have no track record and will generally be lower volume, it is virtually impossible to recoup the acquisition costs."

Norell said larger merchants are the most problematic because they want price concessions that further erode margins.

Freedman, too, avoids huge merchants. "We can make more with smaller merchants who don't demand as much in price concessions and who are happy just to get good, free equipment," he said.

Helgeson cautioned that some accounts produce a lower ROI, and ISOs have to be careful not to pay too much for them upfront.

"In particular, wireless and new Internet businesses seem to be the largest culprits that can cut into an ISO's ROI," he said. "If other ISOs try to compete with these business models where the break-even point is years out, we could find ourselves in a race to the bottom."

Helgeson added it's "even scarier" that some ISOs are leveraging their portfolios and their MLSs' portfolios to finance higher acquisition costs.

"Should they find themselves in financial trouble, the MLSs may unknowingly be right alongside them," he said. "Only time will tell how this will all shake out."

That said, perhaps a thought from long-ago humorist and writer Mark Twain would be in order: "It's not the size of the dog in the fight; it's the size of the fight in the dog."