Current mergers and acquisitions (M&A) activity in the payment processing and broader fintech sectors is robust. Private equity sponsors and other financial investors are often attracted to payment processing companies with recurring cash flow streams and relatively low overhead. Strategic buyers in this industry are usually interested in acquiring new customer relationships and complementary product solutions.
Given the level of M&A interest in payment processing businesses from both financial and strategic players, business owners may be tempted to “strike while the iron is hot” and rush to put their companies on the market. While an extended company sale process can be a negative distraction to the business, most business owners understand that execution and completion of a successful project requires extensive preparation. In the case of the sale of a business, that preparation certainly includes items like ensuring that reliable financial statements are available, understanding the range of valuations for companies in the same or similar niche, and assembling a team of experienced financial, legal, and tax advisors.
One area that sometimes receives less focus in the context of preparing a company for sale or investment is a review and analysis of the company’s existing legal documents and framework. Often, parties will simply wait to receive a legal due diligence request list from a potential buyer or investor and then populate a “data room” with responses and react to any issues or questions that arise. An alternative suggested approach is for the company and its advisors to take a proactive role with legal due diligence. This proactive approach may result in resolving legal issues before they are raised as problems or concerns by a potential buyer or investor. At a minimum, the company and its advisors should be better-versed on the relevant issues and able to craft a proposed solution (as opposed to being caught by surprise). In addition to streamlining the due diligence process, an advance review of a company’s legal documentation is advisable in order to assist advisors in developing a proper transaction structure and in executing a successful transaction.
Typical areas for getting your “legal house in order” in advance of a company sale or investment transaction are described below. While some of these considerations are generally applicable to all businesses, they are particularly relevant to most payment processing companies.
A proper understanding of the company’s current ownership structure is critical in the context of a potential sale or investment transaction. Clear documentation relating to the relative rights and obligations of the various equityholders is essential. The terms of the company’s “distribution waterfall” and the presence (or absence) of drag-along provisions and similar terms can have a material impact on whether a certain transaction is attractive to the various stakeholders or if it is even feasible. Similarly, because many payment processing companies offer equity incentives to their employees, it is important that the equity incentive awards are appropriately documented and that the terms of the underlying plan (including applicable vesting provisions) are clear and understood from the outset.
The structure of a sale or investment transaction will often be dependent on the company’s tax status (i.e., C-corporation, S-corporation or partnership). Accordingly, it is important that the parties’ assumptions about the company’s tax status are confirmed as early as practicable. In particular, S-corporation status requires compliance with highly technical tax rules. Some inadvertent violations of these S-corporation rules can be cured if there is ample time.
The acquisition of top management and employee talent is often one of the key reasons that a potential purchaser or investor pursues a payment processing company. As a result, employee relations and related documentation will be a primary focus of any due diligence investigation.
Some payment processing companies are able to generate significant revenue with relatively lean employee staffing requirements. However, the failure of a business to comply with the myriad of applicable employment laws can still result in material risk and exposure. Particularly since a small-to-midsize payment processing business may not have strictly defined roles for all employees, companies should consider conducting a self-assessment with respect to the exempt versus non-exempt classification under the Fair Labor Standards Act. Similarly, a fast-growing payment processing business may have elected to utilize independent contractors for the performance of certain services or functions. However, these types of determinations are now under greater scrutiny, and a misclassification can result in liability for failure to withhold income and employment taxes, as well as a claim by the service provider (even if the service provider initially agreed with – or even requested – the independent contractor classification).
A potential buyer or investor will be keenly interested in whether the company’s employees are bound by appropriate agreements that protect the company’s confidential and proprietary information and its relationships with customers, employees, and key business partners. The company’s counsel should review these business protection agreements to confirm both that they adequately address the company’s needs and that they are enforceable under applicable state law. If material deficiencies or omissions are identified, the company should strongly consider putting appropriate agreements in place with key employees at the outset of any sale or investment process.
Legal Proceedings and Investigations
Any company considering a sale or investment transaction should gather summary information for all pending, threatened, or recently settled litigation, arbitration, and regulatory proceedings. To the extent outstanding claims can be settled or resolved in an expedient and commercially reasonable manner, the company should consider doing so; otherwise, material outstanding litigation can be a distraction during due diligence (and potentially adversely affect valuation). If quick resolution is not a feasible option, then the company and its advisors should develop a plan to share the relevant information with the potential buyer or investor while preserving the attorney-client privilege and similar protections.
Material Business Contracts
Contracts with customers, vendors, and key partners constitute the “DNA” of the typical payment processing business. It is critical that the company and its advisors have a firm grasp of the material terms and conditions of these contracts as early as possible in a potential sale or investment process. This is particularly important due to the interrelated nature of many of these contracts, as well as the fact that it is not uncommon in the payment processing industry for a company’s key vendor or partner to also be an actual or potential competitor. These factors will almost certainly be highlighted and stress-tested in a due diligence investigation in connection with a potential sale or investment transaction.
In addition to the key business and economic issues (such as initial and renewal terms, and pricing), attention should be paid to the following contractual provisions in connection with any preliminary evaluation of a payment processing business:
- Anti-assignment/change of control provisions – The exact wording of these provisions may require the consent or waiver of the other party to the contract in connection with a potential sale or investment transaction.
- Exclusivity provisions – These provisions may dictate whether one party is the exclusive provider or marketer of specified services or solutions.
- Non-solicitation or non-circumvention provisions – These provisions may restrict one party from soliciting or contacting certain customers, employees, and other third parties under certain conditions for a specific period of time.
- “Most-favored nation” provisions – These provisions may require a provider or other party to give a customer or other partner the best terms it makes available to any other customer or similar partner.
The foregoing summaries are very high-level in nature, so each particular contract provision needs to be carefully analyzed in the light of the specific facts and circumstances. A contract that was executed at an early stage of a payment processing company’s life cycle may have unintended consequences if assumed by a larger and more diversified player in the industry.
Intellectual Property Matters
Together with contractual relationships and management talent, intellectual property rights typically represent one of the key “assets” that a potential purchaser or investor is buying in a payment processing business. The first step in this regard for a company considering a sale or investment transaction is to summarize the company’s intellectual property portfolio (patents, trademarks, designs, copyrights, trade secrets, databases, software, or other types of intellectual property) and be clear about what items are owned versus licensed. For customized licensed software, careful review of the applicable license agreements is recommended in a manner similar to the “Material Business Contracts” section above.
If proprietary software is material to the current or proposed conduct of the company’s business, then the company and its advisors should consider preemptively conducting the level of due diligence that a typical investor or buyer would: namely, identifying all individuals involved in the development of the software and verifying that appropriate assignment language in favor of the company is in place. If there are any “gaps” in this chain of title exercise, it is typically advisable to try to remedy the issue at an early stage of a sale or investment process. Lastly, the company and its advisors should identify and understand the extent to which “open source” software is utilized by the company in connection with its intellectual property development efforts. Under certain circumstances, using open source software without the proper safeguards could require unexpected disclosure of proprietary source code and exposure to other undesirable risks.
Licenses and Permits
Payment processing organizations are subject to a myriad of complex (and ever-evolving) regulations at the federal, state, and association levels. The company’s exact regulatory framework and required licenses and permits will depend on the particulars of the company’s business model. Qualified regulatory counsel should be consulted relatively early in any potential sale or investment transaction process in order to assess the level of regulatory advice that the company has received to date and to plan for the expected inquires from a potential purchaser or investor.
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As is probably apparent from the above, an investment of time and resources will be required in order for a payment processing company to be fully prepared for a potential sale or investment transaction. Many companies avoid taking a proactive approach with respect to legal due diligence in order to save expenses. However, this decision will often prove to be “penny wise and pound foolish.” When these types of issues arise during the legal due diligence conducted by the advisors of a potential buyer or investor, there is usually a delay in the timing of the transaction, ultimately having an adverse impact on the company’s valuation or the assumption of increased exposure (through indemnification or otherwise) by the seller owners of the business. Conversely, with some preliminary homework at the beginning of a sale or investment process, many of the legal issues of this nature can be dealt with ahead of time or at least be the subject of a thoughtful approach and plan. Any payment processing company that is contemplating a sale or investment transaction should consider being proactive with respect to the legal due diligence process and working with its counsel to review and analyze the areas described above that are material to its business.