A Split Decision on Processing Contracts

  Like most small-business owners, managers of independent sales organizations need capital to expand their enterprises. But for many small ISOs, cash flow is being crimped by stiff competition, which is eroding margins on
  processing services and terminal sales. Fierce competition also is creating double-digit portfolio attrition rates as merchants will break contracts at the drop of a hat to cut their discount fee.
  Given the ultra-competitive conditions ISOs are facing, it's a wonder more aren't throwing in the towel and selling their portfolios. "To enter the business today you need a lot of working capital," says Marty Blank, president of Coral Springs, Fla.-based Automated Merchant Services. "And there are a lot of low-rate players who enter the business that undercut the competition to build a portfolio and then sell it."
  ISOs, however, do not have to resort to selling a portion of their portfolio or even drastically cutting their operating costs to improve cash flow. One solution gaining momentum is the split contract, which makes it possible for
  a small ISO to lease processing capacity from a larger ISO.
  The advantage of split contracts is that small ISOs can obtain the infrastructure they need to run their business without having to expend the capital to build it themselves. Instead, the small ISO pays a portion of its revenues earned on the processing fees from their merchant contracts.
  Typically, the split on revenues is 60-40, with the smaller percentage going to the ISO providing the additional processing capacity. Some contracts are reportedly being signed with a 50-50 split, which is less advantageous for
  the ISO paying out the revenue split. The split is usually paid on earnings above the base interchange rate charged the merchant, plus a predetermined amount. For example, interchange plus 15 cents.
  The payoff from a split contract for the leaser is lower overhead and improved cash flow to invest in its own business, such as signing new merchants. Many of the ISOs offering split contracts are so-called super ISOs, which sit
  between the traditional small ISO and the processor.
  In addition to having the economies of scale small ISOs need, super ISOs also can provide underwriting, risk management and BIN (bank identification number) sponsorship so that transactions can be submitted into the
  Visa/MasterCard networks. Hence, split contracts are especially attractive to new ISOs because they can provide substantial savings in start-up costs.
  "Split contracts are a low-cost capital investment for small ISOs and a way for them to gain the economies of scale needed to cut operating costs by pooling their resources with a larger player," says Ali Raza, a vice president at
  Atlanta-based consulting firm Speer & Associates. "It is a trend we are seeing more of."
  Numbers are difficult to ascertain, but some experts believe that most super ISOs and processors offer split contracts, since they want to open as many sales channels to the merchant community as possible.
  The benefit for the super ISO is it can recoup the cost of building infrastructure quicker. Basalt, Colo.-based Total Merchant Services, for example, spent $3 million to expand its processing capacity with the goal of becoming a super ISO. There are about a handful of super ISOs in
  existence, including Total Merchant Services and Nashville, Tenn.-based iPayment Inc.
  A Catch-22
  "Split contracts or shared earning agreements are a way for larger ISOs and banks to attract sales agents, and these arrangements are said to be becoming predominant in some segments of the market," says C. Marc Abbey, a partner with
  Linthicum, Md.-based First Annapolis Consulting, without giving details. "They are also an indicator of the price competition at the wholesale level among ISOs."
  Super ISOs counter that splits are becoming a part of doing business, because most small ISOs cannot afford to invest heavily in their businesses right out of the gate. "You need the infrastructure to grow profits, but the
  margins are getting beaten down so you don't necessarily have the revenues to expand your infrastructure," says Ed Freedman, president and CEO of Total Merchant Services. "It's a Catch-22 for many players. Working with a super ISO
  is a way for small players to build their portfolios and remain profitable."
  While there is little question that split contracts enable small ISOs to compete effectively for business, one potential downside is that they may cede partial ownership of their merchant accounts to the super ISO. That can prove
  problematic when the smaller ISO wants to strike out on its own.
  "You have to be careful of how the contract is written," cautions one ISO executive who requested anonymity. "If you give up control of the contract you can't earn residual revenues downstream or sell the contract as part of a larger
  portfolio. It has been known to happen in these deals."
  Although super ISOs offering split contracts are reluctant to talk specifically about the details of how their contracts are structured, industry experts advise ISOs entering a split contract to negotiate ownership of the
  merchant accounts from the outset. One option is for the smaller ISO to share account ownership with the super ISO for the length of the contract, but regain complete ownership when the contract expires. Contracts vary in
  length, but typically range from 12 to 24 months. "It's just prudent business to spell out everything up front," says Abbey.
  Problem Agents
  Another downside to split contracts is they can attract unsavory sales agents who may sully the reputation of the super ISO. Indeed, many merchant-level sales representatives come into the payment business with little training and don't always make much of an effort to obtain it once they hang out their shingle.
  "Split contracts are a recruiting tool and with the fragmentation in this business, the potential is there for attracting problem agents," says Speer's Raza.
  Some ISOs looking to expand their volume will offer split contracts as a way to recruit or attract smaller ISOs with existing portfolios as limited partners that can also act as feet-on-the street sales agents. That fact has not
  been lost on super ISOs, which will screen sales agents and keep tabs on their agents' business practices to avoid risking damage to their reputation.
  Despite the risks involved with split contracts, they are becoming more common in the industry. Small ISOs can use them to enter the business and grow, and super ISOs can use them to increase revenues and gain additional economies of scale. "Split contracts help both parties compete more effectively," says AMS' Blank.
  For cash-strapped ISOs looking to grow in an ultra-competitive market, that's not such a bad deal.