COMMENTARY: Common Errors in Merchant Funding And How To Fix Them

As I see it, there are three main areas of vulnerability for merchant cash-advance (MCA) providers:

1. Incorrectly assessing the risk. What systems do you have in place for being able to analyze and manage your risk? Many MCA funders come into the market with six months’ runway and then go out of business. They jump in too quickly, start funding everything that comes their way, and don’t price their risk accordingly.

2.  Overpaying on commissions to try to win deals. Today, the commission on the automated clearing house program is 10% of the funded amount. When I started in this business, it was only about 6%. In a rising-commissions environment, what are some ways to mitigate risk? Here’s one suggestion: If your current rate is 10% now on a regular deal, consider putting down 8% on the day of funding, while the remaining 2% gets paid out daily at the deal pace. This way, if the deal goes bad a couple of weeks or a month in, you may only pay 8.5% or 9%, instead of the full 10%.

3. Going out too long on deals, or lending too much too soon. It’s a common pitfall to structure deals that go out longer than a business can sustain—that is, extending too long a term on the deal. Most deals are considered too long after six months.

In terms of deal size, funders need to think intelligently about growing their portfolios, carefully measuring the amount of risk they take on from the outset. The rule of thumb is, the larger and/or longer the deal, the higher the risk.

An average deal size of 5% or under of your total capacity is a good place to start. If you gradually increase your average deal size until your portfolio gains critical mass, you can start bringing those larger transactions into the portfolio without getting wiped out if one deal goes south.

Here are some safeguarding actions you can take to protect yourself from risk:

First, you really need to know your area: what your program is and what type of risk you’re targeting. While in theory you’d wish that your entire client list is A-paper, the reality is that there will always be a mix. It’s easy to fall in the trap of going out there and funding everything: too many dollars advanced, for too long, and with too much paid in commissions.

This means that you have to anticipate your pipeline of needs to be able to project what you can deploy. Some debt lines that are structured as asset-based loans have non-usage fees. So if you take out a $30 million line of credit, and you can only advance a fraction of that, you’ll be incurring non-usage fees that could potentially destroy your profit.

Today, the single most useful investment you can make is in technology. When you get started in this business, having the means to gather data and make correlations is extremely important. Technology helps you reduce risk, allowing you to see how merchants are managing their bank cash flows, accounting systems, PayPal, Quickbooks, etc.

So in sum, there are ways that alternative funding providers can mitigate risk. It always starts by taking a good, hard look at how your organization is set up to fund. I hope these abbreviated guidelines will help you to keep your enterprise afloat. Ours is a tricky business, and we have to share our knowledge if the industry is to remain viable and relevant over the long term.

David Rubin is the founder and chief executive of eProdigy Financial LLC, New York City. He can be reached at ceo@e-Prodigy.com.