GS Logo
The Green Sheet, Inc

Please Login

Banner Ad
View Archives

View PDF of this issue


Table of Contents

Lead Story

Growth by acquisition

News

Industry Update

Visa says Durbin impact 'manageable'

TCF appeal denied

$100 million for Square means change for low-end payments

Cyber security update

Features

An interview with Paul Martaus

Ken Musante
Eureka Payments LLC

Research Rundown

Meet The Expert: Adam Atlas

The accidental advertisement

Selling Prepaid

Prepaid in brief

Law center faults UC card programs

A primer on prepaid's basics

Views

The unbanked: Banks are ceding billions in potential revenues

Patti Murphy
ProScribes Inc.

Mobile payments follow many new paths

Brandes Elitch
CrossCheck Inc.

Education

Street SmartsSM:
Networking groups and referral marketing - Part II

Bill Pirtle
MPCT Publishing Co.

The adaptability of POS terminals

Dale S. Laszig
Castles Technology Co. Ltd.

HIPAA compliance fundamentals for ISOs

Mark Brady and Ross Federgreen
CSRSI, The Payment Advisors

Michaels breach reveals gray areas

Nicholas Cucci
Network Merchants Inc.

Company Profile

Creative Vision Studio LLC

Network Merchants Inc.

New Products

A processor-agnostic payment gateway

PayCommerce gateway platform
PayCommerce Inc.

Inspiration

Breaking up is hard to do

Departments

10 Years ago in
The Green Sheet

Forum

Resource Guide

Datebook

Skyscraper Ad

The Green Sheet Online Edition

July 25, 2011  •  Issue 11:07:02

previous next

Growth by acquisition

Baked into the DNA of payments industry businesses is the desire to grow. Growth by acquisition is considered the quickest way to achieve greater size and scale. In the sphere of merchant services, ISOs buy other ISOs, acquire the merchant portfolios of other ISOs, or sell their own merchant portfolios in order to fund initiatives that, you guessed it, spur growth.

The basis of any growth initiative is financing. Montreal-based payments attorney Adam Atlas said a comparatively small ISO seeks financing between $100,000 and $1 million. But securing that money can be challenging, even in good economic times.

Atlas said banks have been traditionally apprehensive about lending to businesses in the payments industry because they don't understand the ISO business model of merchant portfolios and residual earnings. Atlas drew an analogy to dairy farming.

"If you were a farmer buying a herd of dairy cattle, you own the cow and the cow makes milk," he said. "You feed the cows, you treat them right, you'll get your milk. Well, is buying a merchant portfolio like buying a herd of cattle? Not really, because you don't get a cow. You don't get a right in the cow. All you get is a promise, let's say [from] this other farmer, that they'll pay you a percentage of the milk produced.

"So, not to use a scary word in finance today, but you have a derivative right on what is being sold rather than a direct right in the thing itself."

Harold Montgomery, Chief Executive Officer of Dallas-based merchant processor Calpian Inc., said banks will lend to ISOs with merchant stables of over 50,000. "But when you are down below 50,000, the banking world has been very skittish about that world and very reluctant to play," he noted.

When a bank lends money to an ISO the transaction is considered to be a cash-flow loan. "And understanding the nature of the cash loan and understanding the nature of the asset is very difficult," Montgomery said. "It's very difficult [for ISOs] to access capital, and it's doubly so in today's world where the capital markets are in such a state of stress and confusion."

Acquisition as business model

One solution to the financing dilemma is to find investors or private equity firms to bank ISOs' growth strategies. Another way is to sell portfolios, and Calpian is buying.

Montgomery characterized Calpian as being in the business of serial acquisitions. "We don't have an indigenous merchant sales force," he said. "We depend on ISOs out there in the field who want to sell blocks of merchants for various reasons to us on a periodic basis to develop our customer base."

Being a publicly traded company, Calpian can structure deals so that portfolio-selling ISOs receive Calpian stock in addition to funds from portfolio sales. It is a strategy that is beneficial to smaller ISOs in particular because they receive ongoing value as Calpian shareholders in a market that "loves payments," according to Montgomery.

"There's a big difference between what you get for a small portfolio and what you get for a large portfolio," he said. "There's a big difference between what the private market will pay for a portfolio and how the public market views large processing companies. The idea behind Calpian is to connect the smaller ISO with the highest possible valuation for his portfolio over time and the most favorable tax treatment as well."

From a tax perspective, portfolio sales that are partly compensated for with Calpian stock are considered capital gains. "If you sell a portfolio outright, it's typically treated as ordinary income," Montgomery said. "If, on the other hand, you sell the portfolio in exchange for a formula that conveys value over time, and has performance characteristics in it that are typically referred to as an earn out, then you can treat that as a capital gains."

If Calpian bought a portfolio for $1 million that did not compensate the seller with Calpian stock, that transaction would be taxed at 35 percent, Montgomery explained; but if that same deal were structured to include Calpian stock, the ISO would be taxed at the capital gains rate of 20 percent - a 15 percent reduction in the seller's tax burden for that transaction.

Basics of the dance

In "The Fine Art of Friendly Acquisition," a special report in the November - December 2000 edition of the Harvard Business Review, authors Robert J. Aiello and Michael D. Watkins broke down the acquisition process into steps. It begins with screening potential deals, then initiating communication with targeted companies either formally through auctions or through less formal talks with senior executives.

Then comes the due diligence stage where buyers conduct detailed investigations into the selling companies, followed by the negotiation of final terms, which the authors considered the most sensitive and potentially volatile stage. The last phase is a kind of nebulous period between the time the agreement is signed and the deal's final closure.

The authors stated that a surprising number of deals fall apart in the final stage because of unforeseen events such as natural disasters or adverse changes in the selling company's competitive position. But the authors also highlighted the hazards of the earlier due diligence stage, where deeper dives by buyers into sellers' businesses uncover financial and human shortcomings.

"Hidden problems of this type are about more than money - they also raise important concerns about the competence, even honesty, of the target's management team," the authors wrote.

Atlas goes a step further. "The most important risk in an acquisition, with all things being equal, is in the dishonesty of the seller," he said. In the buying and selling of portfolios, that dishonesty manifests itself when the seller resolicits merchants from the portfolio sold to another ISO.

Atlas offered the scenario of an ISO receiving a call from a former merchant discontented with its current processor. The merchant begs the ISO to become its processor again. Even though the ISO signed a deal not to solicit that merchant, it's tempting to renege if the merchant produced substantial residuals for that ISO. "Generally speaking, it's forbidden to move a merchant like that," Atlas said. "But the temptation is sometimes too big for some people to resist."

Devilish are the details

According to Atlas, most acquisitions fall apart for the simple reason that buyers and sellers cannot agree on price. Those disagreements arise over the valuation of the portfolio or company being sold. "It's not that the seller wants more and the buyer wants to pay less -that's not the issue," he said. "It's that the buyer calculates a price based upon this formula, and the seller is calculating a price based on another formula. And those are irreconcilable."

Complications arise in how valuations are arrived at due to the individual assets under question. For example, when ISO A buys ISO B's merchant portfolio, ISO A is often not just buying the merchant contracts in that portfolio.

"A lot of these purchases involve not just the purchase of the merchant residuals, but also the agents that helped create those portfolios - therefore, the future deal flow of those agents, which is in so many ways more valuable than the merchant base itself," Atlas said.

It is his advice that early in the courtship, well before parties walk the aisle to the deal altar, they iron out high-level points of disagreement. "Perhaps the most important thing that I think needs to be discussed before any information is really exchanged is the seller needs to know, on an objective basis, how does the buyer propose to calculate their purchase price?" Atlas said.

"Are you wanting to buy at 25 times my monthly residual?" he added. "And, if so, what is my monthly residual? Does it include only my credit card and debit card processing? Does it also include PCI fees and IRS fees and annual fees and early termination fees and ACH processing, gift card and whatnot? Will you take an average of the most recent three months, or will you look over 12 months? Will you take into consideration the residuals for the month during which we're closing the deal?"

If these questions are not addressed at the outset, a seller might end up "very surprised" by what he or she receives for selling a given portfolio, Atlas warned.

The right combination

Thus, a seasoned, experienced hand is necessary to navigate the complex business of acquisitions. The Harvard Business Review article quoted Joe Nolan, a partner at GTCR Golder Rauner, as saying that the leveraged buyout firm backs "people who know how to both operate and acquire companies, which is a rare combination."

One such individual that fits that description is Kenneth M. Goins Jr., Chief Executive Officer of Prepaid Solutions Inc. (PPS). In late 2009, Goins and his colleague Eric Ohlhausen worked with Atlanta-based private equity firm Navigation Capital Partners in the acquisition of PPS from Chicago area-based West Suburban Bank.

Upon acquiring PPS, Goins and Ohlhausen assumed the positions of CEO and Chief Financial Officer, respectively, at the prepaid card program management firm.

Goins said he had experience in over 50 acquisitions for different companies when he approached West Suburban Bank about the opportunity to buy PPS. Goins said the investment thesis detailed, "A: we'd like to find a company in the payments space; B: it's about this size; it has a certain amount of scale to it; C: has unique product verticals; and D: has a good record for compliance and management stability."

As luck would have it, the bank wanted to exit the prepaid card business when Goins et al approached the bank with its offer. Goins wanted the deal consummated within 90 days, by Thanksgiving of 2009, although it stretched into early December.

"You don't want it to drag out," he said. "You try to keep it between 60 and 90 days. You have to have enough time to do deep due diligence. There's financial due diligence. There's operational due diligence. You need to make sure and check the contracts and patented intellectual property. So you go through and do the walk through the house beforehand."

The negotiation stage for PPS went smoothly, with both sides agreeing on price. The first business day under PPS' new leadership, Goins called an employee town hall meeting to explain the direction the new regime expected to take the company. Those meetings continue. "It takes really thorough, solid communications, reaching out, getting to know people, setting expectations and delivering on what you promise," Goins noted.

Culture match or clash

Ken Musante, President of Eureka Payments LLC, found himself smack in the middle of an acquisition when Humboldt Merchant Services, the ISO which he once helmed, was purchased by Canadian processor Moneris Solutions Inc. in November 2008.

The saga chronicled in "The HMS odyssey," (The Green Sheet, Feb. 23, 2009, issue 09:02:02) and in Musante's final Street SmartsSM column, "Finding opportunity in an altered business environment," (The Green Sheet, March 28, 2011, issue 11:03:02), involved the economic meltdown of 2008, the intervention of the Federal Deposit Insurance Corp. into the day-to-day operations of HMS and the soft landing of the Eureka, Calif.-based ISO when it was purchased by Moneris.

The experience taught Musante the importance corporate culture plays when one business buys another. "Although there could be financial reasons to do something that looks very compelling, I think there has to be a lot of consideration given to culture," he said. "Even if there's not a culture match, it doesn't mean that you should not succeed or move forward with the acquisition, but to recognize that culture plays a tremendous impact on the ultimate success or relative success of the acquisition."

In the ISO world, another constituency that may be overlooked is merchants themselves. It becomes problematic when a base of low-price merchants must suddenly deal with a processor that raises prices and offers services merchants neither expected nor wanted, Musante said. The opposite can also be true, with merchants used to a level of customer service feeling undercut by their new processor's lack of support.

If acquisitions seem complex and potentially risky, they are, and the expertise of financial and legal professionals is therefore required. But it is worth noting that the toleration of complexity and risk is a natural part of life in merchant services. Growth is never easy. Nothing worthwhile ever is.

Notice to readers: These are archived articles. Contact names or information may be out of date. We regret any inconvenience.

previous next

Spotlight Innovators:

North American Bancard | Harbortouch | USAePay | IRISCRM.COM | Humboldt Merchant Services