Acquiring: What You Should Know Before You Sign

By Holli Targan and Joel Alam

Dealmaking is hot in the acquiring business just now, in many cases drawing buyers from outside the industry. But acquiring transactions isn’t like making widgets. Here’s a summary of key deal points both buyers and sellers should know.

Mergers and acquisitions in the payments industry are hot. The advent of mobile payments and attendant radical change in the business are driving owners to conclude that there is no better time to take some money off of the table.

As we all know, the payments industry is unique in many ways. This translates into M&A deal points that are completely different from acquisition considerations in other industries. At the same time, deal activity is drawing fresh faces into the industry who are not likely to be cognizant of these crucial differences.

This article will provide insight into distinctive and key deal points you should consider as you contemplate buying or selling a merchant portfolio or payment company.

At the macro level, M&A deals take the form of an asset sale, a stock sale, a portfolio sale, or an equity investment. On the buy side, purchasers will be either a strategic buyer or a financial buyer. Strategic buyers are knowledgeable about the business and are interested in growing their existing portfolio or acquiring a unique vertical or technology.

Financial buyers generally are backed by a private-equity fund, and take a much harder look at the financial performance and associated numbers of a potential target.    

In either case, the value a buyer will ascribe to a seller’s business will depend on a number of considerations, including whether the seller: (1) can show solid year-over-year revenue growth; (2) has its own sales channel; (3) has historically low attrition; (4) has a strong management team; (5) has proprietary technology that supports its platform; and (6) can easily transfer “ownership” of its merchant portfolio.

There are certain aspects of an M&A transaction in the payments business that do not exist in purchase or sale transactions in other industries. A few of these are discussed below, including the nature of the assets being bought or sold, processor rights of first refusal, apportioning liabilities for chargebacks and reserves, earnouts and clawbacks, personal guarantees, and non-competes.

Nature of assets. Whether the transaction is structured as an asset transaction, in which assets are being sold, or an equity transaction, in which the buyer is buying the equity (stock or membership interests) of the seller, it is critical to understand the nature of the assets that will be acquired by the buyer.

Certain property is easy to identify (such as technology and fixed assets), but “ownership” of the main asset of most payment companies, the merchant portfolio, is not always easy to figure out. Clauses in a multitude of contracts impact the issue of who owns the merchant portfolio.

Therefore, a careful analysis of all of the following must be conducted: merchant agreements, the payment-network sponsor contract, the processor agreement, sales-representative contracts, and even sales-employee arrangements.

Rights of first refusal and first offer. Many payment-network sponsor and processor agreements permit those parties to have a first look at a residual stream, portfolio, or company that is being sold. These “rights of first refusal” require the seller to disclose the terms of a proposed transaction to the processor, and then enable the processor to buy the assets or company by matching a third party’s proposed terms.

Sometimes a less formal right of first bid is included in the agreement, which requires the seller to inform the processor that it is interested in selling, and then permit the processor to have the first shot at bidding on the portfolio.

Either clause has the potential of devaluing the assets. Due diligence on the portfolio will reveal this right of the processor to snatch the asset away. Anyone paying a hefty sum to buy a portfolio or company asset will not want such a lien on their purchased property.

At the very least, these clauses can slow down the progress of the deal, because a waiver of the right of first refusal must be obtained before the deal can proceed. When contemplating a transaction, this is one of the first issues to tackle, as it may take some time to obtain a waiver.

Apportioning liability after the sale—chargebacks and reserves. Any purchase agreement must address which party has liability for chargebacks incurred on merchant batches entered into interchange prior to the closing date of the sale. Related to this is how any ISO/processor or merchant reserve funds will be handled after the sale. The purchase agreement should specifically set forth which party takes liability for these critical obligations.

Earnouts and clawbacks. An earn­out makes a portion of the final purchase price contingent upon the actual post-sale performance of the acquired business. Clawbacks give a buyer the right to retrieve a part of the purchase price if the target company fails to meet agreed-upon milestones after the acquisition.

If the buyer and seller are not able to reach agreement on the purchase price, they can use an earnout or a clawback to bridge the gap on their understanding of the value of the target business. These mechanisms reward sellers if sellers’ projections are accurate (in the earnout, they get paid more and in the clawback they get to keep all of the purchase price), and protect the buyer from overpaying if the seller’s projections are overly optimistic.

These two mechanisms are really just the flip side of each other. As such, the considerations for dealing with them are the same. Some of those considerations are:

– Operating control issues: Who is in charge of the business during the earnout/clawback period? Buyers always want to maintain flexibility in running the business. Sellers want to have the best opportunity to control the achievement of the milestones.

One issue, for example, concerns who controls the underwriting criteria. If the criteria tighten post-closing, that will affect achievement of the milestones. Another is who controls the decision on what merchant categories to eliminate post-closing.

One way to address these issues is to include a covenant that says the buyer will operate the business “consistent with past practice” and reserve some authority to make major decisions during the earnout/clawback period. Another is an agreement to operate the business in accordance with a pre-approved business plan. Deviations from that plan will be taken into account when calculating the milestones.

– Measuring performance: How do you measure performance if the target is integrated into the buyer’s other businesses? What happens if the target is used as a platform for a rollup? The seller should carve out changes that are the result of future acquisitions (including expenses incurred in connection with the acquisitions).

– Dispute resolution: There are always disputes on earnouts/clawbacks. It is critical to have an agreed-upon dispute-resolution mechanism, such as agreeing up front on an independent third party that will consider the parties’ disputed items.

– Other issues to be considered: Allocation of overhead, affiliate transaction pricing, R&D costs and expenses, effects of extraordinary or non-recurring items, and acquisition-financing costs and management fees.

Personal guarantees. Business owners typically personally guarantee leases or processor contracts. When the owners sell the business, the lessors and processors are often not willing to release the personal guaranty and the buyer is not always willing to provide a replacement personal guaranty. So the guarantors are left with a personal guarantee of an obligation now controlled by the buyer.

The goal should be to release the personal guarantees or replace them with corporate guarantees. Sellers should be cognizant of this problem upfront when executing guarantees with processors and landlords. 

Non-competition and non-solicitation clauses. It is typical for buyers to require that sellers enter into a non-compete and non-solicitation agreement as a condition to the acquisition. The problem is that most owners do not want to stop working in the industry after the sale.

It used to be that non-solicitation of sold merchants was enough. However, buyers are now expecting a more typical non-compete that precludes the owner from working in the payments industry for a length of time. That period can be as short as one year to as many as five years. We have been successful in negotiating a carve-out of the non-compete for specific types of merchants or services that allow the seller to continue in the industry during the non-compete period.

Experience in M&A deals outside the payments industry does not translate into experience in M&A transactions in the payments industry. The above represent some of the unique characteristics of M&A transactions that must be considered and addressed by buyers and sellers.

Selling a company is one of the most important transactions a business owner will undertake. Buying an acquiring business is one of the most expensive transactions a purchaser will make. Invest the time and resources to make sure you have a solid purchase/sale agreement documenting the deal.

Holli Targan and Joel Alam are attorneys and partners at Jaffe, Raitt, Heuer & Weiss, P.C., Southfield, Mich., who concentrate on electronic payments and merger-and-acquisition issues. Reach both authors at htargan@jaffelaw.com.