n this installment of "Street Smarts," I have the privilege of introducing my second guest columnist: Ken Musante, President of Humboldt Merchant Services.

During his years at Humboldt Bank, Musante managed a niche merchant portfolio as it grew from infancy to its present size of $5 billion with over 100,000 merchants. To achieve such enormous growth in a 10-year span, he effectively cultivated both large ISO sponsorship relationships and a bank-owned and -branded merchant portfolio.

In 2003, privately owned First National Bank acquired Humboldt Bank's bank-owned merchant portfolio, along with key staff members, for $32 million. Musante managed the business during the transition, and he serves as President of the newly created entity, Humboldt Merchant Services.

Today, Humboldt Merchant Services has 15,000 merchants that process in excess of $1 billion annually in Visa and MasterCard volume.

Supported by his years of experience and expertise, Musante discusses in this column a very important issue that every MLS should bring to the forefront of his or her business plan: the portfolio sale. Here are Musante's thoughts (my opinion follows) on this timely subject:

At one time or another, even rapidly appreciating properties must be sold. Whether it is due to an unexpected need for cash, the death of the deed holder, or circumstances dictated by the market, so too must every MLS understand the optimal time for a residual or portfolio sale.

Similar to a rental property, a merchant portfolio is an asset. It can appreciate through speculation and can throw off regular cash flow based on performance of the asset. It also requires upkeep, maintenance and oversight. If neglected, it will loose value faster than that of a regularly cared for asset.

You should consider a number of factors when determining if and when to sell a residual. I won't get too much into portfolio valuations or contractual limitations; M&A experts can more effectively discuss those topics.

Moreover, I will not discuss how to eject from a poor relationship; Ed has addressed the value of knowing one's partner in plenty of prior articles. I do, however, want to discuss issues more personal to an MLS's overall financial planning. Consider the following items:

• Market. The best time to sell is when someone wants to buy. Never turn down an offer without consideration.
• Diversification. Are all your eggs (assets) in one basket? If so, consider diversification.
• Length of time to retirement. No one wants to reach his or her financial goals only to find the bar has been raised. As MLSs approach retirement, they should sell pieces of their portfolio. Retirement experts recommend moving financial assets gradually from equities to fixed income as one approaches retirement. MLSs should take a similar approach.
• Taxes. When it comes to taxes, consider whether you can defer a sale to a year when you have offsetting losses or to a year that produces lower income.
• Cash needs. Just because you need cash doesn't mean you need to sell a portfolio. Any income-producing asset can be used as collateral for a loan, and your portfolio is no different. After you have decided when to sell your portfolio, address the next question: To whom should you sell?

Unlike a rental house, buyers for MLS portfolios are often scarce.

Buyers include other MLSs, ISOs, processors and financial investors. Typically, your ISO or processor can offer the largest multiple because they will not need to convert your portfolio, and they know the history and attrition ratio.

Any on-going supplies, warranty service or customer service will need to be considered because you will not want to continue performing these services after you have sold the residual.

Further, know your contract ahead of time. Does your contract have a "first right of refusal" clause? Does it allow transferring of accounts? Does it allow assigning of the residual?

Contracts with pre-determined sell rates are a bad idea. You would not buy a stock if the upside were limited, so why would you want that limitation placed on your portfolio?

In preparation for this story, I posted the following questions on GS Online's MLS Forum; I also posed the questions to several knowledgeable industry folks:

• What are the rates/multiples being offered to MLSs for residual buyouts?
• Have you ever sold a portfolio? What were the factors in the portfolio's valuation?
• If you have sold a portfolio, are you pleased with the outcome, and why?

Jason Felts, Advanced Merchant Services, Inc. responded with the following MLS Forum post:

"I think for any MLS, a good buy out is a great option to consider when needing cash. Three and a half years ago, I found my 'dream' house: 5,000 square feet on the water and tons of porches; it's the perfect party house.

"The only problem was the $500,000 price tag. We needed a large amount of money down, so we did sell a portfolio. Here are my answers to your questions:

"1) We didn't really consider ourselves an MLS because even back then we had over 12 agents working with us. We did our buyout based on 'house accounts' only (we have a tele-sales department). Having said that, I feel the buyout amount we received was better than average. Average back then was 16 - 24x. We sold at 28x.

"2) When we sold, the primary situation was the fact that it was 95% retail. We also had some attrition responsibilities in the sale. The other thing is we are not just a new-business/slam-dunk-equipment-leases type of shop. Ours was, and is, primarily a good mix of new and existing retail business.

"3) Yes, it was a good move for us at the time. We were able to move into the house that now appraises at over $800,000. We did okay!

"From what I can tell, [valuations] have gone down some. Many times it's hard to even get what appears to be good buyout on a residual stream from what the MLS agents have told me. I'm hearing 12 - 16x currently as an average."

I received another response from industry consultant, Marc Beauchamp. He sold two portfolios, although he sold them many years ago when multiples were higher (as all merchants were retail). The sale amount was based on a multiple of the most recent three-month's processing.

In both cases, an offer from the processor initiated the sales; they were not planned. The first portfolio was for 35x monthly residuals and the second was for 24x monthly residuals. The sales allowed Beauchamp to grow his business, and he needed the cash at the time to do so.

Long time industry veteran Brian Anderson has also sold portfolios. In one case in particular, he sold a portfolio because the processor changed, not because he necessarily wanted to sell the portfolio. Despite a fair return, he would have preferred to continue receiving the residual.

In Anderson's opinion, reasons to sell are to 1) retire, 2) fund future growth and 3) diversify risk. He reiterated the importance of understanding your contract and recognizing if it allows for perpetual payments.

Reviewing what companies pay upfront on a per deal basis is another way to understand the multiples paid for an MLS portfolio. Some companies will pay 12x (monthly) upfront if previous processing is provided and follow-up residuals of 3x, 6x or 9x are provided six months later. This seems equal to the going rate of 15x to 21x monthly residuals.

In closing, MLSs should respect the enormity and complexity of their asset. Once you have worked hard to build something, ensure that it provides for maximum payout by understanding the sale process and the motivations for sellers and buyers. Plan for your sale to maximize your return.

Ed, I want to thank you and The Green Sheet for providing this forum and discourse. I appreciate you taking the time to assimilate industry perspectives into your articles.

Should any of your readers wish to contact me for feedback or additional information, they may do so at 707-269-3200 or at kmusante@hbms.com .

Ken Musante President, Humboldt Merchant Services

I'd like to thank Ken for putting together a terrific analysis of the components every MLS should examine when considering a merchant portfolio or residual income buy back or sale. If you want to correctly think through your entire business plan, you need to include thoughts and plans for selling your rights to residual income.

Following is my opinion on some of the points Musante mentioned above:

The Best Time to Sell

I'm not a big fan of selling residual income. Personally, I've never sold an account. However, I've bought many portfolios ranging from $500 to more than $400,000 per month. From these deals I learned that I no longer say, "You should never sell your residual income." Instead, I make a few exceptions.

One of these exceptions is "flat lining." Let's say you build a residual income of $15,000 per month with 500 merchants. And you're adding 10 - 15 new deals a month, but also losing the same amount every month. That $15,000 is not really increasing; rather, it's flat lining.

If you're unable to sign 40 - 50 deals a month, try to sell the existing portfolio for a good multiple. Then start the re-building effort. This way, you can sign 200 merchants a year, and in two and a half years, you'll have another $15,000 a month in residual income to sell. This is a much better scenario than only treading water because you're flat lining.

Tax Treatment

Consult an accountant regarding the tax treatment on residual income sales. If you sell accounts that you activated more than a year ago, I believe you might qualify for long-term capital gains treatment. Currently, the federal income tax is only 15% (compared with 33 - 37% federal income tax on ordinary income).

This makes it an excellent time to sell! The bottom line is not how much someone pays you or the multiple you were paid. It's how much money you have, after taxes, compared with the residual income stream and paying ordinary income tax rates.

To Whom Should You Sell?

I think the first organization you need to consider is your ISO provider: the company paying your residual income. Other financial organizations will not give you the best multiples. Additionally, you can negotiate the best deal with your provider.

I suggest that you structure a deal that pays you money upfront and some more money in six months, based on attrition and doing more business with your provider.

If you want the best deal, structure the best deal for the company to whom you're selling. Think about what the company wants: It wants to buy your residual stream; it wants attrition to remain at or below 1 - 2% per month; and it wants your business moving forward. The company does not want you to take its money and then do business elsewhere.

Feel free to send your comments on this article and any other topics to streetsmarts@totalmerchantservices.com . As always, thank you for your continued support.

My next column will be a much-deserved tribute to Paul Green, an industry icon who received a lifetime achievement award at the Midwest Acquirers' Association (MWAA) conference in July 2004.

"Drive thy business or it will drive thee." - Benjamin Franklin

See you next time where the rubber meets the road.

Ed Freedman is founder and President/CEO of Total Merchant Services, one of the fastest growing credit card merchant account acquirers in the nation. Freedman is the driving force behind all business development activity as well as the execution of Total Merchant Services' marketing plan, including recruiting and training independent sales offices and establishing strategic alliance partnerships with leading vendors, so that Total Merchant Services can provide its customers with the highest quality and most reliable services available.

To learn more about Total Merchant Services, visit the Web site at www.totalmerchantservices.com. To learn more about partnering with Total Merchant Services, visit www.upfrontandresiduals.com or contact Freedman directly at ed@totalmerchantservices.com.