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The Green Sheet Online Edition

December 28, 2020 • Issue 20:12:02

Legel ease: Buyout gotchas: watch out portfolio sellers

By Adam Atlas
Attonery at Law

ISOs work their tails off to build up a portfolio of merchants. The hope is that the ISO will be able to monetize that hard work by selling to a buyer who sees value in the merchant relationships and revenue stream.

Unfortunately, in the contemporary "MBA-ized America," to quote Elon Musk, there is a lazer-like focus on the bottom line that sometimes finds its way into ISO buyout agreements. The purpose of this article is to arm sellers with tips on the kinds of fast ones that buyers sometimes try when structuring buyout deals.

Your last residual? Oh, that's mine

Suppose you are negotiating the sale of an ISO portfolio during the month of January, with a view to closing on February 1. Most common-sense sellers would expect that January residuals, payable in February, belong to the seller—notably because the seller has continued to work for them throughout January by providing customer service and carrying a degree of risk, and so on.

These are reasonable assumptions, but sellers should read their buyout agreements carefully because they are often drafted such that the February residuals, although earned and accrued in January, are actually payable to the buyer and not to the seller. This can be a rude surprise that knocks one month's multiple off of the purchase price. If the parties agreed on a 40-times multiple, when seller stops owning the residual one month earlier than expected, the seller is effectively being paid only 39 times.

The solution here, of course, is to be certain of precisely when the cutoff will occur. This issue should be part of the first discussion buyers and sellers have. It should not be discussed the day of closing.

Pricing during earn-out drama

Portfolio sales include an earn-out. The earn-out is a portion of the purchase price that is paid to the seller as a function of the performance of the portfolio following closing. Earn outs can vary greatly from as little as 20 percent of the purchase price to as much as 60 percent of the purchase price.

In any case, during the earn-out period, which begins on closing and ends some years thereafter, the buyer usually and rightfully believes that they own the merchant relationships and have considerable rights with respect to merchant terms and pricing. Buyers, however, may have their own reasons for increasing or decreasing pricing, which could have the effect of increasing attrition or decreasing revenue on the portfolio.

Either of these adjustments could make or break the seller's ability to gain the anticipated earn-out purchase price amount. Some buyers will purposefully increase pricing to generate higher revenue off of the purchase portfolio. However, the increase could have an unforeseen and devastating effect on attrition that would deprive the seller of a substantial amount of the purchase price.

The parties must therefore carefully consider their respective rights in respect to the pricing of merchants during the earn-out period.

Attrition calculation shockers

What is attrition anyway? There is no textbook definition of attrition in payments. The most common, levelheaded definition is the percentage decline in net revenue on a static pool of merchants over the period of a year. For example, if the buyer purchases 1,000 merchants, then attrition might be calculated as a function of the change in revenue in respect to those merchants from the time of closing until a year thereafter.

There are, of course, many other ways to calculate attrition. No perfectly correct method exists. What is important is that the seller fully understands the formula for calculating attrition and be able to see the earn-out as being within reach in light of the formula.

Buyer fraudulently moving accounts

Sometimes, temptation for some buyers is simply too great. Imagine the difference between having to pay $1 million of earn-out because a purchased portfolio is performing well versus allowing a "friend" to solicit accounts in the portfolio, thereby causing it to attrit and depriving the seller of their $1 million earn-out. This level of dishonesty is not common, but sellers should still be aware that buyers have the ability to deprive them of an earn-out by moving accounts out of the purchased portfolio.

Buyers are sometimes surprised when asked to be bound by a nonsolicitation provision governing a merchant portfolio that they just purchased. It is worth including exactly that kind of a provision to purchase agreements for the obvious purpose of protecting seller rights in earn-outs.

Buyer bankruptcy

At times when massive quantities of cash are available to ISOs, it can seem unlikely that a buyer will go bankrupt. However, when money becomes harder to obtain, some buyers will find themselves overextended. An overextended purchaser of ISO portfolios may fail to pay their creditors.

When a purchaser fails to pay their creditors, and their creditors have security over the assets purchased, sellers may find themselves doubly stung. First, they may be deprived of the right to earn and earn out. Second, they may also be deprived of the legal ability to pursue the rightful owner of the portfolio from which the earn-out is to be paid.

The new, rightful owner of the portfolio may, in fact, be the secured creditor of the entity that bought the portfolio from the seller. The seller has no contractual relationship with the creditor of their buyer. Consequently, the seller may have a very hard time accessing their earn-out. A few years ago, a client of ours sustained huge losses because of a series of events like this.

New management values

The MBA-ization of the ISO business has, from my perspective, resulted in a number of transactions in which the buyer's management has had little interest in the long-earned organic and personal relationships that the seller created and nurtured with merchants and the communities in which they are located. Some buyers see the ISO portfolio through the limited pinhole of near-term profit. The consequences are often disappointing for ISOs who imbue their business careers with values that are often greater than revenue alone.

Hopefully, ISOs can sell at just the right price and reap just the right return without falling into the potholes I've just described. end of article

In publishing The Green Sheet, neither the author nor the publisher is engaged in rendering legal, accounting, or other professional services. If legal advice or other expert assistance is required, the services of a competent professional should be sought. For further information on this article, please contact Adam Atlas, Attorney at Law by email at atlas@adamatlas.com or by phone at 514-842-0886.

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