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Small Business Financing

Cash Vanishes from Merchants' Accounts

In the midst of the worst economic contraction in decades, some small business owners are experiencing an additional—and brutal—cash squeeze, this time at the hands of their credit-card processors. The recession and rising business bankruptcies have prompted giant credit-card companies such as Denver (Colo)-based First Data and Atlanta-based Elavon to demand that some business owners maintain a cash reserve with the processors in order to protect against the possibility that customers may require refunds after the merchants have gone belly-up. Most processing agreements give the transaction giants the right to accumulate those reserves simply by holding back money the merchant is supposed to be paid after a credit-card transaction has cleared, often with little or no warning.

Dan Price, chief executive officer and co-founder of Gravity Payments, a card processor in Seattle, says he has seen "dramatically more" cases of reserves being created for small accounts in the past year. He says he has not asked any of his clients for reserves but has requested regular financial statements from customers that might pose a risk. Price says the size of reserves varies greatly, but it is common to require an amount equal to one or two months' worth of transactions.

The ramifications on even a well-established company can be dramatic. "In two weeks we would have been in bankruptcy," says Angie's List CEO Bill Oesterle, whose processor, Elavon, tried to withhold a reserve of $2.5 million from his $35 million company. Oesterle was instead able to change processors quickly, and with help from his lawyers, got his money back in about three weeks.

When a processor agrees to clear a company's credit-card transactions, the processor then becomes responsible for providing customer refunds. When an unhappy consumer asks their credit-card company for a refund, the credit-card issuer gets that money from the processor. The processor, in turn, pulls the money from the merchant's account. If the merchant has gone under, the processor has to eat the loss. With business bankruptcies on the rise, processors fear dishonest merchants might close up shop and skip town, leaving the processor on the hook for any refunds. "Before bankruptcy, some [unscrupulous] merchants will create lots of transactions," says Richard Speer, CEO of financial consultancy Speer & Associates, based in Alpharetta, Ga. Common triggers for the establishment of a reserve include a sudden surge in activity and individual transactions that have large dollar amounts.

The Danger of Success

Ironically, that may mean that the processor decides to hold a cash reserve just as a business appears to be booming. That's exactly what happened to Oesterle, whose Angie's List compiles consumers' reviews of contractors, doctors, and other services. The Indianapolis-based company and was growing at more than 50% per quarter as of July 2008, when Oesterle got a call notifying him that Elavon was holding on to $2.5 million in his credit-card transactions and intended to use that money for a reserve. Elavon also wanted to examine the 356-person company's financials, and cited Angie's List's surge in credit-card transactions as the reason for its concern. Holly Lytle, a spokeswoman for Elavon, says that while the company cannot comment on individual customers, it has not changed its policies on reserves and that the triggers for creating a reserve are stated in customers' contracts.

Oesterle was lucky. He got a phone call. Ron Gregory, owner and chief executive officer of 3-person Cheyenne (Wyo.)-based trucking company RAD Enterprises, says he found out First Data had withheld nearly $7,000 from his account when he happened to check the balance in March. Gregory had dumped a previous processor because of its high fees and signed on with First Data in February after seeing a promotion at his local Sam's Club.

Gregory says First Data canceled his contract after he complained but told him they planned to hold onto his $7,000 for six months. Gregory aired his woes on and says his next stop will be small claims court. These days his $1.5 million company will only accept cash, checks, and money orders. "I can't afford to hand someone $7,000 and not earn any money on it," Gregory says. Elizabeth Grice, a spokeswoman for First Data, says the company cannot discuss individual clients for confidentiality and security reasons. In an e-mail, she says that although the company has not changed its risk management process, due to the tough economy, "merchants' financials may not be as strong now and thus they fall into a higher risk category." She adds that in the overwhelming majority of cases, customers are not required to carry reserves.

Bad PR

Jerrod Menz used a different tactic when Wells Fargo Merchant Services tried to create a $200,000 reserve against his company's sales. The president of A Better Tomorrow, a $4 million, 50-person drug and alcohol treatment center in Murrieta, Calif., noticed in February that some credit-card transactions weren't appearing in his corporate account. When Menz called to complain, he was told his business was "high risk" and that unless Menz put up a $200,000 reserve, Wells would hold onto his cash until it accumulated that amount. It had already held back $18,000.

Menz says a $200,000 reserve may have forced him to make layoffs, so he put out a press release blasting Wells. Within a day, he says, a Wells executive called him and the money was released. In a statement, Wells spokeswoman Allison Olson says that while the bank can't comment on specific cases due to customer confidentiality and privacy issues, the situation was "resolved to the satisfaction of the customer." The bank says reserves are only taken when businesses present a "high risk" and that doing so protects consumers who may need refunds. Unfortunately, it does so at the expense of entrepreneurs who are already struggling with a nasty economy and an unwelcoming credit market.

Barrett is a senior correspondent for BusinessWeek SmallBiz. Quittner is a staff writer for BusinessWeek in New York.

Barrett is a senior correspondent for BusinessWeek SmallBiz.
Quittner is a staff writer for BusinessWeek in New York.

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