There’s an App for That

You know companies like PayPal, Shopify, and Square as high-tech payment processors. Lately, they’ve applied that technology to the established business of merchant cash advances, with promising results.

Long the mainstays of the merchant cash-advance business, alternative lenders are facing competition from a new breed of players—tech companies with street cred in merchant processing.

This new generation is not like its predecessors, which provide capital to small businesses that banks avoid because of thin credit histories and few hard assets. Instead, interlopers like PayPal Holdings Inc., Square Inc., and Shopify Inc., are offering cash advances to deepen ties with merchants they already serve.

By bundling cash advances in with their core services, tech companies can position themselves as one-stop shops that can help grow a merchant’s business through providing payments processing, technology, and financing.

“It’s tougher for a customer of a tech company offering payments processing to jump ship to another processor if the merchant has a cash advance through the tech company,” says Jared Drieling, director, business intelligence, for Omaha-based acquiring consultancy The Strawhecker Group.

Small-merchant financing, which includes merchant cash advances and loans, is a more than $500 billion market, according to David O’Connell, a senior analyst for Boston-based Aite Group’s Wholesale Banking team. Alternative lenders, of which there are about 50 extending financing to small merchants, have about a 13% share of merchant cash-advance and loan applications closed, he adds.

“Alternative lenders serve a purpose, but the question is, how much more can they increase their share of the market?” O’Connell says.

The tech companies are more bullish about their growth prospects. As they see it, focusing on their customers positions them to tap into micro-merchants and entrepreneurs who need small amounts of cash but have been underserved by other cash-advance providers.

Shopify Capital, the financing arm of Ottawa, Ontario-based merchant platform Shopify Inc., will make cash advances for as little as $400 and as much as $500,000. Square Capital, the financing arm of San Francisco-based Square, says the average amount its merchants finance through cash advances and loans is about $6,000.

By comparison, New York-based Strategic Funding Source Inc., which has been in the business since 2006, typically provides financing in the $150,000 to $350,000 range, and higher amounts as needed, says chief executive Andy Reiser.

Reiser’s company is pivoting into other forms of lending, but even within the cash-advance market, he doesn’t see the tech interlopers as direct competitors. “No one comes to us for small amounts of cash,” he says. “Our clients are seeking larger amounts of funding than a Square customer. The tech lenders are specialty players focused on providing financing to their customers.”

‘A Marketing Strategy’

Merchant cash advances are funds advanced against a merchant’s future card receipts. Lenders typically charge a percentage of the money advanced. A restaurant in need of $50,000 in cash for new kitchen equipment, for example, would have to turn over to the lender $60,000 in future card receipts to cover the lender’s 20% fee and principal. The lender claims 20% of the merchant’s daily card receipts until the total is paid.

If the merchant has higher-than-expected card receipts during the repayment period, the cash advance can be paid back sooner. Lower-than-expected card receipts can lengthen the payback period. Payback terms for cash advances are typically 10 to 12 months.

Rates for merchant cash advances start at 20%, on average, and can run as high as 40% or more in some cases. That makes them more expensive than a bank loan, which can carry an interest rate starting in the mid-single digits and go as high as the low teens.

Advancing smaller amounts of cash, however, has not slowed the growth of the tech companies. Since its launch three years ago, Square Capital has extended more than $1.5 billion in merchant cash advances and loans, including $251 million in business loans during the first quarter of 2017, a 64% increase over the first quarter of 2016. Default rates on cash advances and loans are 4%, the company says.

Since March 2016, Square Capital has been making only loans to merchants. As with a cash advance, merchants taking a Square loan repay the loan, plus fees charged by Square, using a daily percentage of card sales processed through Square. The difference between a loan and a cash advance, a Square spokesperson says, is that a merchant can make additional payments or repay the loan in full before the end of its term with no prepayment penalty, something merchants cannot do with a cash advance.

While Square Capital’s loan product is a plus for merchants looking to shorten repayment schedules, it is essentially a cash advance that has been repackaged, Drieling says.

One reason tech companies may be seeing the need to market cash advances as loans, Drieling says, is that the high rates charged for cash advances and the potential for repayment schedules to fluctuate based on a merchant’s card business have created a stigma around the product that causes some small merchants to shy away.

“Calling it a loan as opposed to a cash advance is a marketing strategy to create a better perception, rather than providing an actual loan,” Drieling says.

To further reassure merchants, Square details all costs associated with the financing so that merchants are clear there are no hidden fees.

PayPal, too, has jumped on the bandwagon to rebrand cash advances. It calls its advances working capital. PayPal merchants can select the size of the cash advance they’d like. Approval depends on their PayPal sales. Merchants can make additional repayments without any additional charges.

In its most recent annual report, PayPay listed receivables of $558 million in 2016 for PayPal Working Capital, up from $421 million a year earlier, a 33% increase. PayPal attributes the growth to wider availability of the company’s credit products domestically and internationally. In addition, 90% of businesses that pay off a loan or cash advance reapply for funding.

Overall, PayPal Working Capital has provided more than $3 billion to more than 115,000 businesses since its launch in September 2013.

While not as large yet as the lending arms of other tech companies in the cash-advance game, Shopify Capital has provided $60 million in funding through the first quarter of 2017 since its launch last April.

Modeling Risk

One advantage PayPal, Square, and Shopify have over traditional cash-advance providers when it comes to managing risk is that, as merchant processors, they have direct insights into their merchants’ daily card receipts. Those insights help predict a merchant’s ability to repay a cash advance.

PayPal uses an internal risk model built with merchant data that weighs such factors as a merchant’s annual payment volume, payment-processing history with PayPal, and repayment history with PayPal Working Capital. The model assigns a risk score between 350 and 750. The higher the score, the lower the risk.

“We generally expect that merchants to which we extend a working capital advance will have … scores greater than 525,” PayPal says in its 2016 annual report. “We generally consider scores above 610 to be very good and to pose less credit risk. We assess a participating merchant’s … score on a recurring basis.”

PayPal Working Capital is only offered to existing PayPal businesses. Merchants are charged a flat fee that is displayed upfront as the total cost for the loan. Repayment schedules range from nine to 12 months and are recalculated regularly based on the merchant’s PayPal volume.

Shopify is using its internal merchant data to not only develop risk models, but identify and prequalify merchants to which a cash-advance offer can be extended. The typical payback time for a Shopify cash advance is 10 to 11 months.

“Some of the factors we use to identify merchants in need of capital include inventory replenishment and marketing cycles,” says Saad Atieque, product manager for Shopify Capital.

Renewal rates for Shopify Capital advances are in the 70% range. Merchants can have funds deposited in their account within two business days.

‘Still Bullish’

Ironically, as tech companies rush into the cash-advance market, many of the more established alternative lenders are scaling back on that business. Instead, they’re offering more traditional loans and equity lines of credit.

“Cash advances are less than 20% of our business,” says Reiser. “There are still many businesses that turn to cash advances because the lion’s share of their revenues come from card receipts, but we have found that there are lots of businesses that don’t generate a lot of card sales, but still need funding and can’t get it from a bank.”

Earlier this year, Strategic Funding Source acquired Capify’s business in the United States. Capify, known as AmeriMerchant until July 2015, sold its U.S. operations because it is more bullish on growth opportunities for merchant cash advances and other alternative financing options in Australia and the United Kingdom, Capify chief executive David Golding told Australia’s Sky News earlier this year.

One type of loan popular with merchants that don’t generate a lot of card sales, such as wholesalers, is an automated clearing house loan. Similar in structure to a cash advance, an ACH loan debits a merchant’s bank account daily for repayment, as opposed to card receipts. The duration of ACH loans is typically less than 24 months.

“This is a financing product that is based on a merchant’s total sales, which lets us reach a broader merchant base,” says Mark Cerminaro, chief revenue office for Bethesda Md.-based RapidAdvance. “We are still bullish on cash advances, but the market is evolving in terms of the products alternative lenders are offering.”

Alternative lenders’ push to offer loans has also helped improve their credibility with potential partners that can broaden their reach to merchants. Office Depot, for example, offers financing to its small-business customers through RapidAdvance. JPMorgan Chase & Co. has partnered with New York-based OnDeck Capital to offer small-businesses loans. Restaurant-platform provider UpServe, which offers payment processing, has partnered with Square Capital to offer financing to its customers.

“Partnerships can lower customer-acquisition costs and drive more business,” Reiser says. “Acquisition costs can run 30% of profits. The right partner complements your business by providing access to each other’s customer base.”

Strategic Funding has partnerships with a variety of firms, including equipment-leasing companies.

More Transactions

But the merchant cash advance is not going away any time soon. Tech companies entering the merchant cash-advance business stand to open a potentially lucrative new revenue stream. And they get an even bigger payoff with the opportunity to retain customers using their processing platforms.

Further, by providing small merchants the capital they need to grow their business, tech companies stand to benefit by having more card transactions running through their platforms.

“As a merchant’s primary service provider, the tech companies can not only see a small merchant’s cash flow and ability to repay a cash advance, but offer them speed of approval and flexibility around the terms of the financing, which merchants care about,” says Zilvinas Bareisis, a London-based senior analyst for the financial-services consultancy Celent. “That makes them well-placed in this business.”