What is a high risk merchant account?
The high risk component comes from the following concept- in the event the merchant suffers charge backs that they are unable to pay the MSP or bank must cover the cost. A typical MSP make less than 1% of mark up on merchant processing, and for that, they assume the liability of 100% of the merchant’s sales month in and month out. Now, if the merchant is a fast food restaurant- let’s say Taco Bell, well, with a low average ticket size and a recognizable brand the likelihood of charge backs is extremely small. As one moves up the pricing chain, charge back possibilities become even greater. For example, an auto repair facility that replaces a transmission, but does not do an adequate job of it is possibly subject to a dispute from a consumer. Let’s say the amount is $2,500 paid on a credit card. Well, if you were that consumer, and you paid $2,500 for a service and product that did not meet your expectations, of course you would feel you have the right to dispute the transaction and not pay, or at least get the problem resolved at no additional cost.
Credit cards are payment “vehicles” and are not actually a party to the transaction between the consumer and the merchant. A consumer has the right to pay cash, check, financing, or a credit card- of course depending upon the options provided by the merchant. When a credit card is used, the card itself is just a means of transferring what will ultimately be CASH- between the consumer and the merchant. Basically, the merchant accepts the card for a fee but receives cash in their bank account. The consumer uses the card to settle the amount- but ultimately has to pay (in real money) the credit card company.
In some cases consumers are allowed to carry a balance on the credit card- this constitutes the credit portion. In the case of a debit card the money immediately comes out of the consumer’s bank account, and in the case of a travel and entertainment card such as American Express, the consumer is obligated to repay the amount in the short term- maybe 30 to 60 days.
When the consumer disputes a transaction, for example the $2,500 transmission, the credit card issuer (the bank that issued the card to the consumer) typically takes the money back immediately from the acquirer (merchant services underwriting financial institution), and, in turn the acquirer takes the money back from the MSP (if one is involved) and, the MSP must get the money back from the merchant.
MSPs typically redeem charge back amounts from the merchants processing funds or, if not enough is available, then directly from the merchant’s checking account. The entirety of this process is automated. In the event the merchant does not have enough money in either processing funds (earlier card transactions due to be deposited) or in their checking account, the MSP must initiate a manual collection procedure (calls, letters, etc.).
Now let’s expand on this example. Suppose that transmission shop installed several faulty transmissions- say ten. And let’s say the shop is fairly new and doesn’t make much money. The money previously paid to the shop for the work done is already spent. Now a local news agency gets the story that this auto repair/transmission shop has been doing faulty work and there are numerous complaints. So, as a matter of course the shop gets no new business and is forced to close. Under this scenario, the MSP or bank would be stuck with the difficult task of trying to collect $25,000 in charge backs.
With the business entity no longer in existence, the only recourse the MSP or bank has is to collect the money directly from the owner or personal guarantor- if there was one. Assuming the business owner is the guarantor and he’s now out of business and has no income and he invested his entire net worth in the business- well of course he can’t repay the $25,000. The MSP or bank is now stuck with the loss. They can sue the business owner, but unless the business owner has assets to cover the loss, the suit will be a bust. Even if the MSP or bank obtains a judgment, in many cases the merchant can file bankruptcy and alleviate the debt.
The Rules of the Game
So now that you see how this works, you now see the rules of the game in merchant services. Right or wrong, whether you agree or not, these are the rules. The bottom line is that the merchant is responsible for their own business and charge backs or refunds. When the merchant can’t pay, the MSP or bank that processed the merchant’s card transactions takes the loss.
For the reasons stated above, there are several ways in which merchant accounts are underwritten.
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Underwriting the Merchant Account Risk
The primary rule in underwriting merchant accounts is as follows:
Determine whether or not the merchant being considered creates a risk to the company or bank of possible loss due to unpaid charge backs. During the underwriting process companies like mine will look at the following:
The Merchant’s Business and Personal Credit: If the merchant sells six dollar tacos from a food truck on the roadside, credit is not much of an issue because we’re not concerned too much about charge backs. However, if the credit is significantly horrible, we may be a slight bit concerned that the merchant can’t even pay his bill at the end of the month. In most cases, many MSPs are willing to take the risk, whereas most banks will treat that merchant like a borrower, and deny them the account. This is why MSPs exist today- the willingness to take more risk than the banks.
Now suppose the merchant sells a $5,000 consulting package- delivered over a few months. Well, of course, this is a significantly larger transaction and subject to much scrutiny. Other factors are then reviewed, but as regards credit- if the merchant shows a high credit score with good to excellent credit, perhaps a mortgage showing he or she is a home owner- well they have something to protect. As regards credit, they may get an OK in that category- because in all likelihood they don’t want to get their credit fouled up over a $5,000 charge back. Of course, their good credit is not the only thing we review in order to make a final decision.
By extrapolation you can see that any small ticket retail or restaurant owner with good credit is almost an automatic approval.
Financial Stability of the Company: The strength of the company is determined by a few factors including length of time in business, profit or loss, assets versus liabilities, and whether or not the company’s financials are audited. Audited financials prove, in most cases, the actual strength of the company’s financials, whereas unaudited- although they may be accurate, are not proven or verified.
For example, if the same $5,000 consulting package was sold by two different businesses- one of them a start up with no credit history and little assets, versus another with a fifteen year track record and $8 million net worth or retained earnings- and still profitable- well the established and valued entity in this example stands a far greater chance of merchant account approval.
Some companies don’t have much in terms of assets but perhaps have a long operating history and are profitable- and again would be more qualified than a start up with no history.
Financial Stability of the Guarantor: If the business has strong financial stability, in other words- profitable, established history, strong positive balance sheet, then, in some cases, a personal guarantor may not even be a requirement. This is definitely the exception and not the rule. In most cases the MSP or bank will want the entrepreneur to assume the risk of their business.
When the business is new, fairly new or does not have a significant balance sheet and profitability, or if the business model is very high risk, MSPs and banks will require a personal guarantee. If the merchant services volume or the average transaction size are large (perhaps more than $50,000 per month and/or more than $1,000 per transaction), in these cases the MSP or bank will want to verify the net worth of the guarantor. If the guarantor has a reasonable net worth that substantiates his or her ability to repay debts in the event the company has unpaid charge back, the guarantor may be given a positive rating on this criteria.
Personal financials are usually provided in the form of a personal financial summary, tax returns, and other means of showing assets (bank statements, 401K statements, equity in property, etc.).
If the business has week financials and likewise the guarantor, unless the business model is so risky that it is prohibitive, the MSP or bank may consider approving the account with an established reserve account- which will be discussed more later.
Is the Business or Merchant on the Terminated Merchant File(TMF)?: This is a file shared by all the major credit card companies (Visa, MC, Amex, Discover), and has complete data on all companies and business principals that have had a merchant account terminated by any bank or MSP for specific causes. The file is accessible to all MSPs and banks in the industry and has a complete record of all business names, addresses, phone numbers, principal names, EIN numbers, principal SS numbers, principal addresses, known aliases, and reasons why the previous account was terminated.
It is not automatic that a merchant will be declined for a merchant account just because they are on this list. For example- if merchant A was terminated five years ago because he had too many charge backs in his software company- but he nevertheless repaid the debt and today he is opening a restaurant, well in many cases he can still get approved. But, if he was terminated as a principal of that software company and tried to start a similar business, he will have some challenges getting an account. If it is exactly the same business and he hasn’t paid the previous charge backs- it’s almost impossible to get a merchant account.
If a merchant is on the TMF- he or she should consult with an industry professional and see what the options are. In some cases merchants are removed from this file. Reasons a business or principal can be placed on this file include: unpaid charge backs, fines or other losses caused to a bank or MSP, factoring- running transactions for another business, illegal cash advances- running one’s own card through the system in order to obtain a cash advance, fraudulent activity, too high of a charge back ratio (typically over 2% for a few months), violation of Visa, MC, Amex, or Discover card brand rules, and more.
Average Transaction Size: As you’ve already learned, the higher the transaction size, the greater the risk. Many consumer’s will not take the time to dispute small transactions, usually under $50. But, as the transaction size grows, the transaction or product or service is subject to greater and greater scrutiny by the consumer. Take into account other factors now such as the reliability of the product, the product claims, etc. If a consumer paid $3,000 for a set of golf clubs- guaranteed to improve his swing, and his handicap did not improve, he’ll most likely dispute the transaction because of the size and the products failure to perform as advertised. If a consumer paid $5 to a parking meter, and somehow did not get the correct credited time, most likely the consumer will write that transaction off to bad luck and not take the time to dispute it. So- Size Matters!
Monthly Volume: The merchant’s anticipated monthly volume is taken into account when underwriting a merchant account. For example, the merchant may have good credit and does web design projects ranging from $5,000 to $10,000. The merchant has a net worth in the company of $25,000 and a personal net worth or $25,000- combined $50,000. Because the average transaction size is high, these are subject to potential dispute and charge back. If all other factors look good, the MSP or bank might consider approving the account but limiting the amount of volume the merchant can process in one month. If this merchant requests a volume of $500,000 per month, the volume exposure may be risky to the MSP or bank. If the merchant has dispute troubles they may not have enough net worth to cover the possible losses. In this case the MSP or bank may approve the account with a volume restriction (example: $50,000 per month).
Conversely, the merchant may have very little net worth but opens a convenience store with an average ticket of $8- in which case the volume might not be a consideration because there’s little to no fear of charge backs.
Prior Processing History: If a merchant has processed transactions previously, the prior processing history tells an underwriter quite a bit about the business. For example, let’s say an art dealer sells paintings in the range of $15,000 each. Normally this could be considered a very risky business. But the business has been around for years and the recent processing history shows no charge backs and very few refunds. The history alone might be enough to make a positive decision on accepting the account.
Prior processing history allows us to review several items: Volume, transaction size, charge backs, retrievals and refunds. A retrieval is a request for information from the card issuer to the acquirer (merchant bank) about the transaction. Sometimes retrievals are an indicator of possible future charge backs, likewise are refunds. Large amounts of refunds and retrievals elevate risk levels.
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