Alternative Lending: Friend Or Foe?

Merchant cash advances can be a God-send for merchants unable to secure traditional bank funding and agents looking to supplement their income. But that boon often comes at a painful premium.

The merchant cash advance (MCA) is a common form of alternative lending offered by private lenders. Many independent sales organizations and agents offer these loans to supplement their income. But do they always make sense for merchants? To answer this question, a thorough analysis of this form of lending is useful. It will help merchants and ISOs alike understand the MCA’s different aspects from inside out.

Pros

– MCA lenders offer advances as low as $1,000 and as high as $500,000. It is not uncommon for a few lenders to pool their funds and offer amounts as high as $2 million.

– Underwriting criteria are more relaxed than those of banks, partly because of the following:

– MCA lenders do not have to abide by stringent banking rules and regulations because alternative lending is not yet fully regulated;

– Unlike financial institutions, MCA lenders do not base their decisions primarily on the borrower’s personal credit score;

– Tax liens and discharged bankruptcies may be overlooked;

– Other factors, such as credit card processing volume, gross sales, and the lender’s ability to collect on a daily basis, are taken into consideration;

– Funds can be delivered very quickly, often between three and five days after the initial submission date of an application. Upon successful repayment, renewals can usually be funded within 24 hours.

– An up-to-date balance sheet and other accounting records of the business are not usually required for advances of less than $50,000.

– Some MCA lenders will consider lending to seasonal and high-risk businesses.

– Unlike the practice of banks, existing personal, business-loan, and home-mortgage obligations do not result in an automatic decline.

– Payments are made on a daily basis and with a predetermined amount or percentage of the daily gross or credit card transaction volume.

– The MCA costs far more than a regular bank loan. However, when banks turn down the vast majority of loan applications, the MCA can make the difference between staying in or going out of business.

– If the cash advance results in a healthy return, the extra cost may well be justified. Every day costs the borrowers money if they do not have the funds to grow, invest in inventory and equipment, pay the bills on time, pay off taxes, and (potentially) incur tax liens that could adversely affect the borrower’s credit and Dun & Bradstreet scores.

Cons

– Merchants must account for their daily fluctuations in cash flow and make sure their bank account will have sufficient funds to make the daily payment.

– MCA lenders operate within an unregulated industry and with near-absolute impunity. That can carry disadvantages for borrowers through widely practiced sales misrepresentations and misunderstandings. In this environment, the exact meaning of words matters. Agents and brokers are not allowed to use the term “interest rate” because the term is reserved for a traditional loan within a heavily regulated banking industry. Sadly, many MCA lenders use the term “loan” because they know merchants are more receptive to it and may think it is a low-cost offering. The term for the cost of an MCA is “factor” because MCA lending involves purchasing future receivables instead of offering a loan.

– The MCA always has a short-term payback period ranging from three months to 12 months. Only a few MCA lenders are offering longer terms. Although helpful in certain circumstances, a short term can place a strain on the business’s ability to climb toward profitability.

– The overall cost increases with a shorter-term MCA. For example, a factor of 1.35 on an advance of $10,000 is equivalent to $3,500. If the term is 12 months, the cost (converting it to interest rate) is presumably 35%. But the true interest rate is higher.

– Other fees may be involved too, including one or all of the following: application fee, origination fee, closing fee, assessment fee, and inspection fee.

To see how MCA factors translate into annual interest rates, I have created the Factor to Interest Rate Equivalency (FIRE) table:

A shorter payback period pushes the actual interest rate through the roof. By the banking rules, these rates would be considered usurious and illegal. But alternative lending is not subject to banking laws.

It is noteworthy that commissions to an agent reduce the profit margin to the lender.

– MCA lenders usually do not offer an early payoff discount. So, prepayment will result in even higher return to the lender and cost to merchants. For example, if the borrowed amount is $10,000 for 12 months at a factor of 1.35, the total payback amount will be $13,500. If the borrower pays off the advance in the ninth month with the remaining balance of, let’s say, $3,000, the lender will have advanced to the merchant the amount of $10,000 minus the $3,000, or $7,000. The full return of $3,500 on $10,000 in nine months creates a further windfall to the lender and increased cost to the merchant. This is why such MCA lenders prefer to renew. The earlier, the better for them.

– In the above example, which happens very frequently, the hidden truth is that many MCA lenders do not pay their agents the full commission on the advances. This is called double dipping: They charge the merchant the full cost on the funded amount of $10,000 while paying the broker the commission only on the net funded amount of $7,000. The earlier the renewal date, the higher the return to the lender, the lower the commission income to the broker, and the greater the cost to merchants. The double dipping may or may not be illegal. Nonetheless, it is a dishonest and unscrupulous practice that should stop immediately.

The Office of the Undersecretary for Domestic Finance, U.S. Department of the Treasury, issued a Request for Information on July 20, 2015, and extended it through September 30, 2015. The request was entitled, “Public Input on Expanding Access to Credit Through Online Marketplace Lending.” All things being equal, online lending has the same effect as offline lending. Plus, some lenders offer their product both online and through their sales forces. A total of 107 comments were submitted. All the comments by lenders offered some general statistics as well as reasons that alternative lending is good for businesses. Interestingly, none of the responses disclosed the true cost in terms of the annual interest rate.

Higher cost does not strip an MCA of its value. On the contrary, because banks have stringent guidelines and are risk-averse, the willingness of non-traditional lenders to take higher risks is what makes the cash available. Higher risk deserves higher reward.

However, returns in this industry are unreasonably high, especially when the lender double dips. More importantly, it is crucial to know all the fees and terms so there will be a more-level playing field for merchants and agents alike; they deserve to be well-informed so they can make intelligent decisions.

Ideally, the MCA industry should be regulated by the federal and all state governments so that there can be a healthy balance between the expectations of all parties involved, as well as an end to financial tactics and practices that can have the unintended consequence of harming merchants and brokers alike.

—Alex Nouri is president of EFT Direct, Ann Arbor, Mich. He can be reached at alex@eft-direct.com.