By Adam Hark
Much of the merchant portfolio and ISO valuation focus is centered on the numbers ‒ revenue and charge volume attrition, revenue concentration, standard industrial classification and merchant category code distribution, and Europay, MasterCard and Visa chip technology conversion percentage. Often overlooked, much to the detriment of sellers, are the contractual terms of the agreements that both merchant level salespeople (MLSs) have with their ISOs and ISOs have with their processors.
Certain terms of these contracts can relegate any promising acquisition to the "dust bin" permanently. Unfortunately for many would-be sellers, these contractual terms and their implications are neither fully understood, nor even noticed, in the basic due diligence until sellers are deep into the transaction process, having already invested a substantial amount of resources, in both time and money.
Arguably, with regard to agent or ISO processing agreements, it's the responsibility of the lawyers representing the ISOs and MLSs to ensure there isn't any language that can be detrimental to a future sale of the merchant processing assets, whether or not any such sale is being contemplated at the time.
And, yes, lawyers would ideally identify these contractual issues before a seller entered into the deal process. However, there's also an argument to be made that it is in the best interest of every owner-operator in the acquiring industry to understand the terms of their agreements before those agreements are consummated, thus avoiding the contractual hazards and pitfalls that can derail any attempt to sell their merchant processing assets in the future.
As an experienced, professional intermediary, I am a proponent of this way of looking at things, and as such, I know that certain words can kill any chance a merchant acquirer has of monetizing his or her merchant processing property by way of a sale. Let me share with you what I call the three most important elements of an agreement that every MLS and ISO owner-operator should pay close attention to when negotiating contracts: contract term, first right of refusal and exclusivity. Contract language pertaining to these elements, if written unfavorably, can kill a potential deal.
The contract term is the section of a contract that specifies the date a contract is to begin and how long it will remain in effect, including whether it will renew. It should be noted that the contract term will typically affect an ISO owner-operator's agreement with a processor more so than an agent's agreement with his or her ISO.
It should always be assumed in any bankcard mergers and acquisitions transaction that the sale is going to be structured, meaning that a substantial amount of the transaction proceeds will be paid at closing, but there will be a hold back of monies that will be distributed to the seller over time. The amounts of the hold backs are most often tied to some mutually agreed upon attrition threshold in the case of a portfolio sale, or growth, in the case of an ISO sale.
When a seller looks at the contract term for an ISO or portfolio sale, the seller should always make sure to not become locked in to a multiyear agreement with the processor. The rationale is that most acquirers of ISOs and portfolios will seek to move the merchants in portfolios being acquired to their own contracts at some point, presumably because they have better pricing, and they can get credit for the "clicks" (number of transactions), which will allow the acquiring ISOs to achieve a higher pricing tier with their processors and be granted a better buy-rate.
When dealing with ISOs that have conditional portability, where the ownership of the merchant contracts themselves can be sold to the acquiring ISOs, the contract term is even more critical. In many cases, the condition of the portability is that they become portable upon the expiration or termination of the selling ISO's agreement. This means that the selling ISO doesn't have portability until the contract is up; if the ISO is stuck in a very long contract term, the ISO doesn't have true portability at all, which will kill a deal.
The right of first refusal (FROR) refers to the contractual right that gives an ISO or processor the option to purchase a portfolio or residual before the owner can sell it to a third party. FROR applies equally to both MLSs and ISOs and their respective processing agreements. In the bankcard industry, one would be hard pressed to find any MLSs or ISOs who don't have FROR language in their processing agreements, so it's not a case of whether or not there is a FROR, but rather, what the conditions of the FROR are.
Typically, the FROR of an ISO (in an agent's case), and a processor (in an ISO's case) provides for some conditions to be satisfied in order that the FROR be waived so that the portfolio (in an ISO's case) or residual (in an MLS's case) may be sold to a third party. These conditions usually involve a combination of the following: providing the ISO or processor a bona fide offer from a buyer that the ISO needs to match or beat, and a time frame within which the ISO needs to make that decision.
The FROR can kill a deal when one or both of the following happens: the party entitled to the FROR is granted too long of a time to match, beat or waive the FROR, and/or the party entitled to the FROR has what I call an "absolute" right to FROR, meaning the ISO or processor, depending on the case, doesn't have to match or beat a bona fide offer from a buyer, but rather can refuse to grant the seller a waiver of the FROR based on a whim, and not on certain criteria having been met. In both these instances, the FROR language can kill a transaction.
Exclusivity refers to a seller's contractual obligation to write new business solely for a certain ISO or processor. Of the three most prominent aspects of a processing agreement that can kill a deal, exclusivity is by far the most deadly. As I mentioned before, it should be assumed that in 99 percent of merchant processing ISO, portfolio or residual sales that the deals are structured; a certain amount of the consideration paid to the seller is conveyed at closing (usually between 70 to 85 percent of the aggregate purchase price offered), and the rest is paid over time based on certain performance benchmarks that can be tied to attrition maintenance, growth, or both.
Sometimes these performance-based future payments are referred to as earn-outs. Whether the earn-out is based on attrition or growth or both, the ability of a seller to achieve the earn-out is largely a function of a seller's ability to write new business to either offset any losses from lost accounts (attrition), or increase the existing merchant base (growth).
In both cases the buyer usually requires that the new business be written on the buyer's processing agreement. Therefore, if a seller has agreed to write exclusively for the current ISO or processor, the seller will be precluded from writing new business on the buyer's processing agreement, and that will kill a potential deal.
Most owner-operators in the bankcard industry have a build-and-sell mentality; build up a portfolio of merchants and residual and sell it in order to re-invest the transactional proceeds to build a larger portfolio and residual. It therefore behooves all owner-operators to diligently scrutinize the processing agreements they enter into, whether they are MLS or ISO agreements.
As an ISO or MLS, before you enter into any processing agreement, seek counsel from a payments consultant or payments attorney. And regarding the contractual terms, especially the three elements discussed in this article, make sure to negotiate terms that are reasonable and fair. Don't rush into signing any agreement, and always know that for all contractual business terms there's a quid-pro-quo. Ask yourself what you're receiving in exchange for the terms you agree to, not just in the present, but also in the future, because you will decide to sell someday, and you don't want to be prevented from doing so by a contract provision that had previously operated under the radar.
Adam Hark is co-founder of MerchantPortfolios.com, a dba of Preston Todd Advisors Inc. With over a decade of experience in the payments industry, Adam specializes in mergers and acquisitions, growth and exit strategies, and asset and enterprise valuation for payment processing and payment technology companies. He can be reached at email@example.com or 617-340-8779.
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