What is a Merchant Reserve? And How Can You Help Manage them on Behalf of Your Merchants?

What is a merchant reserve, and how can you, as a merchant services sales office or agent, help your merchants manage this part of their processing relationship most effectively? What are the common pitfalls to avoid?

Let’s dive in. 

What is a merchant reserve, and when is it put in place?

A merchant reserve is an amount that is set aside to cover unplanned/uncovered merchant expenses such as uncollected chargebacks, debits such as returns, merchant account fees, etc. In a nutshell, it helps the ISO hedge against financial risk.

It is commonly required for higher-risk businesses that want to accept card payments. For example, future delivery businesses, merchants with significant chargeback history, or merchants operating in risky business verticals.

It can be collected as a lump sum amount to be set aside before a merchant even starts accepting payments, or more commonly, as a small percentage of each batch, typically 10-20%.

There are many flavors of reserves– rolling, capped, and more, so you’ll want to understand the terms of your merchant’s specific agreement.

Here’s the most important question to ask when a reserve is involved with a merchant account:

❓Do you trust your ISO to be a responsible fiduciary of your merchant’s funds?  True, the funds are held in a controlled account with the sponsor bank, but it is the ISO that normally ends up playing the role of gatekeeper over these funds.

You want to be sure that when it’s time to release reserve funds:
1)      Your merchant knows exactly how much is set aside in that account on their behalf. Sloppy accounting will get the better of many merchants.
2)      The funds are still there (this is more of a problem than most would like to admit) and
3)      They play by the terms of a fair reserve agreement and exercise good judgment.

Unfortunately, merchants that require reserves commonly end up getting mistreated. Sometimes they’re in a desperate place and unsavory payment players will take advantage. We share everything you need to know so that you can advocate for your merchants as their payments champion, protector of all things right and good.

Who Can You Trust to Manage Reserves for your Merchants?

How can you know whether you’re doing business with an ISO that can be trusted with fiduciary responsibility for your merchant’s reserve funds?
In our settlement platform, Pioneer, we can pull up our merchant reserve balance, then log into the sponsor bank where that balance is held, and see that these two numbers are living in perfect harmony… as they should be.  
That means that we know:
✔️ An exact merchant reserve balance for every merchant we’re reserving funds for in that account. 
✔️ If we drill down for any given merchant, we can see a detailed ledger of deposits and withdrawals that arrive at this balance.
Total Reserve Balance = Total of balances for each merchant = Total of reserve transaction ledger entries
This sounds simple and straightforward, right? The truth is that it’s not. And some players in payments struggle with this. They struggle because of:
➡️ Sloppy accounting. Treating this balance like a lump sum instead of the many important parts and pieces that make up this account. We’ll call this negligence. 
➡️ Improper accounting. Treating this balance like it’s a revenue line item instead of the asset and offsetting liability that this is. These funds don’t belong to the ISO and should never be treated this way. This is the exact scenario that led to the bankruptcy and demise of a very large payments player a while back. And unfortunately, that’s not the only case study where reserve funds have been misused.
➡️ Outsourced accounting without verification. They let their processor handle this for them, and they have no idea whether it’s being done properly. 

What happens when you don’t know the exact balance that you’re holding for each merchant and how you arrived at it?  Well, your reserve account starts to feel more like a Ponzi scheme. As merchants request releases, are you releasing them against their actual balance or another merchant’s? It seems fine and good until the funds run out and there is still someone making claim on those funds. 
So here are some qualifying questions you can ask your ISO to ensure they handle merchant reserve accounting properly:
❓ Where are your reserve funds held? (they should be held in a controlled account with the sponsor bank)
❓ How is the balance verified? (they should have to report a reconciliation to the sponsor bank on a regular basis and even better, the ISO undergoes a financial audit each year)
❓ If they’re holding reserve funds for one of your merchants, ask how can you see the balance, including the detailed ledger? You can easily verify this ledger against your merchant’s activity to be sure this is being done properly.

How to Help Merchants Account for their Merchant Reserve

If your merchants are having funds set aside in a risk reserve, it’s important for them to track exactly what’s in that account. 

Sloppy accounting gets the better of many merchants because here’s what they do when they book a merchant deposit for $100 sale and a 10% risk reserve is involved:

Revenue                                  $90
Bank Account             $90

Hey, wait a minute, where did that $10 go? It didn’t disappear into thin air, and it certainly shouldn’t be considered a cost of doing business. It’s sitting in the service provider’s reserve account on the merchant’s behalf. That means it’s an asset that should be sitting on the merchant’s balance sheet.

Instead, the deposit entry should look like this when there’s a reserve involved:

Revenue                                  $100
Bank Account               $90
Reserve Receivable     $10

As the merchant services provider adds funds to the reserve on the merchant’s behalf, that amount will climb on the merchant’s balance sheet, and they’ll know exactly what is owed to them in the event they stop processing. When should the merchant expect to get it back? That’s a complicated answer that depends on the unique circumstances of each merchant.  In general, the funds should be released as soon as the threat of any financial loss to the provider has passed.  

There are a lot of merchants who look at a reserve as an expense– a cost of doing business. And unless they’re planning on burning their merchant services provider by running up a big tab of uncollected chargebacks and high fees and then running, that’s a flawed approach.

Help your merchants properly account for their deposits, and you’ll help them hang onto the funds that are rightfully theirs.

What Happens When Merchant Reserves are Used to Cover Losses?

What happens when a risk reserve gets used for the purpose for which it was intended, that is, to cover losses?

Here’s an example.

My company, ABC Payments has a merchant services agreement with Fun Excursions. Fun Excursions provides exactly what its name describes to travelers visiting a popular vacation destination.

Fun collects payments up to 3 months in advance of the date they provide their services. They process $100,000 a month in card volume and have been doing business with ABC for the past several months, in which they’ve accumulated a $50,000 reserve balance.

A natural disaster wipes out Fun’s excursion fleet, and suddenly they are unable to deliver any of their services. They’ve collected $250,000 in payments for services they have not yet delivered. They start issuing refunds, but Fun has never been great at managing cash flow or their insurance policies, and after a while, there’s no money left in the bank to cover the returns. ABC terminates Fun’s payment processing account for failure to cover its obligations.

Fun customers are still reaching out for refunds, but the number is disconnected. Customers start contacting their credit card issuer to initiate a chargeback.

Fun continues to run up a chargeback tab, but Fun and its owners are nowhere to be found to cover this debt.

ABC can use the $50,000 reserve balance that it collected from Fun, but it finds itself with an additional $70,000 of uncovered chargebacks. Not to mention, it is also stuck covering the fees associated with processing these chargebacks.

Just when ABC thinks it’s done with covering the losses associated with Fun, a year later, more chargebacks trickle in. These have been initiated not by the cardholder, but by the issuing bank that is holding the balance for a delinquent cardholder. The issuing bank is doing what it can to minimize its own write-off debt.

All in all, ABC incurs a bad debt loss of $90,000. Even though ABC thought it was mitigating its risk by implementing a risk reserve, it wasn’t enough.

ABC can pursue Fun to collect this balance, but the chances of collection are slim.

What happens if ABC can’t cover this debt? The liability falls to the next party in line, the last of which is the sponsor bank. That is why the acquiring sponsor bank has the ultimate say in whether a merchant can stay or must go.

This scenario might seem far-fetched, but in the payments world, particularly for providers that frequently dabble in high risk, it happens more often than they’d like to admit.

How to Advocate For Your Merchants that Require Reserves

Set it and leave it – this is the mindset that we have too often in the merchant services industry. 

But there’s value in monitoring and checking in with your merchants, especially when it comes to ones that require a merchant reserve.

When a merchant reserve is first established, it is typically done at the start of a processing relationship. The ISO has no direct processing history to rely on. They rely on what the merchant has presented as part of the application package. The merchant could have omitted something, intentionally or unintentionally. 

Part of the risk the ISO is covering is that of the unknown. 

But there becomes a time when the unknown becomes a lesser part of the equation. The ISO can track the processing and chargeback trends reasonably well enough to better understand the likelihood of risk.

💡 Agents: this is the time to advocate for your merchants.
➡️ If a cap is not in place, you can ask for one.
➡️ You can request a partial release.

But don’t just do this for anyone, or you’ll become white noise. Only ask if you can make a reasonable case for your request.  That means doing your homework and giving reasonable background for your request.

This will also help you understand whether you’re working with a risk department that operates within reason. If they immediately dismiss you, you either haven’t done your homework properly or they have a my-way-or-the-highway mindset. If they operate within reason, they will be able to give you some concrete reasons to justify their position.

By advocating for your merchants, you can establish a solid relationship that lasts the length of their business, as well as provide a prosperous referral source.

Merchant Reserves: Everything You Need to Know

If you want to play in the high-risk space in merchant services, you’d better know your reserve terminology inside and out. And you should also understand what’s reasonable and what’s not when an ISO requests a merchant reserve.

Remember, an ISO is requesting to hold a reserve to minimize its financial risk. If they’re requesting a reserve, it should make sense given the financial risk they are exposing themselves to. That risk can vary based on the:
☑️ Business owner’s personal credit
☑️ Business type
☑️ The financial health of the business itself
☑️ Timeline between payment acceptance and service/product delivery
☑️ Processing history

A merchant must put up a lump sum of money to be held in reserve before they even start accepting payments. This is common for future delivery merchants with a long timeline between payment acceptance and delivery, but can also come into play for other scenarios. 

A set percentage of each merchant deposit is withheld in reserve and then automatically released after a set amount of time.

A set percentage of each merchant deposit is withheld in reserve, but not automatically released. Instead, the balance accrues until a set limit is reached.

To be a true advocate for your merchant services clients, study these terms carefully so that you know exactly what an ISO is expecting from your merchant. And if something doesn’t make sense to you, don’t be afraid to ask your ISO to provide justification for their reserve requirement.

What is a Reasonable Customer Acquisition Cost for Merchant Services?

What is a reasonable customer acquisition cost in the land of merchant services?

Well, like just about everything else in this world, it depends. But fortunately, with a little math, we can get closer to an answer for your specific situation.

First, you have to know your customer lifetime value. This is the amount you’ve earned for a single client over the course of your entire relationship with them. You can use averages here over a payments portfolio of business, but we’d highly recommend breaking these out based on similar merchant types since the margins can vary so widely.

You won’t earn the same amount on a restaurant client as you do on a B2B client, nor will you earn the same amount from a cash discount portfolio as you will an interchange plus one. The more specific you can get in your grouping, the more accurate you can be.

Now, subtract any direct costs of acquiring a single merchant account. If you always provide free equipment, use the typical amount you’d spend on a merchant in this type of portfolio. Again, more specific grouping leads to better results. A restaurant would need an expensive POS while a B2B client needs no equipment at all. If you provide an upfront signing bonus to agents, factor this in, too.

Next, we have to estimate what it costs us to support this business. We would recommend you come up with an operating expense % to apply. Take your operating expenses from your P&L and divide that total by your total residual income. Use amounts over an entire year to account for the cyclical nature of our business. Apply this percentage to the customer lifetime value.

For the sake of example:
Customer lifetime value: $2000 (100 months @ $20/month)
Upfront cost: $500 ($300 in equipment & $200 agent signing bonus)
Overhead applied: 10% ~ $200
Net: $1300

You could spend up to $1300 in customer acquisition costs and break-even, but let’s be real, no one wants to work for free. 

And we should also plan for a little wiggle room for the unknown and unexpected. 

So, a good starting point is 25-50% of this amount. Then you can adjust according to the trends and your comfort level.

Sometimes it can be hard to see money fly out the door on sales and marketing, but as long as you do the math and see positive ROI, you can increase your spend to drive more sales, and ultimately, more margin.

How to Identify Your Best Performing Portfolios

While you juggle payments relationships, are you trying to figure out which ones outperform the others in margin?

This can be a difficult task.

All things the same— business type, pricing, and Schedule A, you will still likely see consistent differences in margin between relationships.

There are legitimate reasons for this— card mix accepted by the merchant, method of acceptance, etc. And then there are illegitimate reasons. 🚨🚨🚨

So how can you tell one from the other?

Here’s where you can start:
💡If you’re getting summary level residual reporting from your provider, ask for more specifics— Interchange breakdown, assessment detail, etc. If they don’t have it or won’t give it to you, alarm bells should be going off. 🚩🚩🚩This is the most common place I’ve seen providers tweaking numbers for their own benefit.
💡Periodically recalculate the costs they’ve charged against your Schedule A to be sure they are accurately calculating them.
💡Compare merchant statements to the same items on your residuals— income, interchange, etc. to ensure accuracy.
💡Avoid relationships that offer a big front-end incentive. There’s a reason they’re willing to pay you upfront, and it’s not to your benefit.
💡Compare residual income as a percentage of billed fees on different providers every month to see where you’re outperforming others. It’s important that you’re comparing similar business types here. Review the data and watch for consistent trends.

Find a provider you can trust, but verify.

Many of our partners tell us that even though they think they have better pricing elsewhere, they see better margins with us. That is the power of transparency and accuracy.

Dig into the data and go get the income that’s yours.

What’s Considered a Fair Revenue Share in Merchant Services?

What is considered a fair revenue share on merchant residuals?

There’s no hard and fast formula. But consider revenue share a sliding scale that depends on these factors:

👉 The amount of training you need
👉 The amount of support the ISO provides to your merchants. A referral arrangement where you simply hand off leads will earn less than one where you provide ongoing service/support to merchants.
👉 The amount of liability the ISO is taking on your behalf. Low risk/card present payments portfolios have higher revenue shares than high risk ones.
👉 Your proximity to the processor. The closer you are to the party actually processing transactions, the more revenue share. If you’re an agent sending business to an ISO that sends it to another ISO, you’re getting a split of a split. There’s nothing wrong with this as they are likely providing support or resources not available to you closer to the processor. Just know where you stand and the parties involved.
👉 The number of freebies you receive. Getting free equipment? That’s fine, but understand it’s baked into the cost of your agreement.
👉 Access to proprietary software or technology.

What’s “fair?”
⚖️ The arrangement where both parties feel it is a mutually beneficial arrangement with potential for growth.

Homework assignment:
📝 Check your existing agreements to be sure you’re earning revenue share on every item billed. This is a common margin buster for sales agents/offices.

Streamline Merchant Onboarding

What is one of the worst habits we see in merchant services?  Rekeying application data over and over.

Why is this so bad? We’ll get to that in a second, but first let’s cover how it happens.

Agent collects information from the small business in the field.
Agent submits to their ISO.
ISO keys into their own CRM.
ISO keys into their processing relationship as well as any additional services like gateways.

This is:
❌ Inefficient
❌ Prone to error
❌ Often not very secure. Personal identifiable information is included here.

When is the last time you revisited your application process to eliminate redundancy and human error? Here are some tools you might deploy to tighten it up:
🔨API between interfacing applications, both internal and external, to eliminate rekeying.
🪚 Online application so that the merchant enters their own information, which feeds to your internal systems
🪛Data filters and rules to ensure validity of information collected (for example, routing number is 9 digits with valid check digit)

Yes, these things take time to implement but you’ll see a positive ROI shortly thereafter.

Plus, if you’ve ever boarded an account only to have the merchant’s first deposit bounce due to someone miskeying the account number, you might be highly motivated to make a change. That’s not exactly the best first impression.