Acquiring: Looking to Go Mainstream

Peter Lucas

Flush with new investment, firms that lend to merchants against credit card receipts are more optimistic than ever. Now, they’re laying plans for fixed loans and advances against cash, checks, and alternative payments.

It’s been a tough economic recovery for retailers. Not only is consumer spending mired in a malaise, but the stricter credit standards imposed by banks have made it tough for small and mid-size businesses to get the capital they need to expand.

For small merchants unable to qualify for a bank loan or line of credit, they have few options for obtaining financing short of a personal loan, remortgaging their home, or taking high-interest-rate credit card cash advances

Enter the merchant cash-advance (MCA) provider. Often working in concert with an independent sales organization, the MCA advances merchants capital against future credit card receipts for a premium above the amount advanced.

On the face of it, at least, MCAs make it possible for small and mid-sized merchants whose revenue is generated primarily from credit card receipts to obtain financing they might not otherwise be able to qualify for or afford.

But MCAs need access to capital, too. Enter the private-equity investor. Over the past 18 months, an infusion of new capital from private-equity firms, hedge funds, debt buyers, and even banks has been pouring in to MCAs.

In February, Palo Alto, Calif.-based venture-capital firm Accel Partners infused $30 million into Kennesaw, Ga.-based Capital Access Network Inc., parent company of AdvanceMe Inc. and New Logic Business Loans Inc.

San Francisco-based Wells Fargo  & Co. is providing credit lines to Capital Access and Bethesda, Md.-based RapidAdvance, two of the largest merchant cash-advance providers. Wells also has marketing partnerships with AdvanceMe and New Logic, enabling them to market directly to Wells’s small-business customers.

In 2011, Atlanta-based receivables-investment company Vion, which buys charged-off credit card receivables, formed a partnership with New York-based MCA Strategic Management Funding Sources to provide cash advances between $400,000 and $3 million to mid-size merchants. By partnering with Vion, Strategic Management Funding has been able to expand its reach beyond small merchants.

Shakeout Survivors

These deals are just the tip of the iceberg. Several startup MCA firms, such as Atlanta-based Kabbage Inc., are popping up across the payments-industry landscape, thanks to capital from private-equity firms. Kabbage is backed by such investors as Menlo Park, Calif.-based venture-capital firm Mohr Davidow Ventures, which provided $17 million in capital, and the investment arm of Atlanta-based United Parcel Service.

“There is a lot of interest now among private-equity investors, hedge funds, banks, and other types of investors in merchant cash-advance providers, because the tighter underwriting standards for traditional small-business loans are making merchant cash advances a more viable alternative for merchants in need of capital,” says Jannine Dall’Orto, a senior manager for Linthicum, Md.-based First Annapolis Consulting.

But if MCAs are providing investment opportunity for private equity, they’re also benefiting from the largesse. “Without new investors, merchant cash-advance providers only have so much capital they can make available to merchants,” observes Dall’Orto.

The return on investment for a merchant cash advance is very attractive, as much 30% or more in some cases. A merchant taking a $25,000 cash advance, for instance, will turn over $30,000 in credit card receipts over the next six to 12 months.

“The premiums charged merchants on cash advances can be much higher than the interest they pay on a loan, but not every merchant in need of cash can qualify for a loan,” says Christine Pratt, a senior analyst for Boston-based Aite Group. “Investors in merchant cash-advance companies can earn a good rate of return.”  

Payments experts can only estimate the MCA industry as a multibillion-dollar business, since MCA providers are privately held companies and most don’t disclose financial information.

One of the few MCAs to disclose the amount of financing extended to merchants is AdvanceMe, which has currently advanced 60% of its $1 billion in equity since the fourth quarter of 2008, according to chief executive Glenn Goldman.

AdvanceMe is one of a handful of major players in the industry, along with about 25 to 30 smaller companies considered to be niche players, according to Dall’Orto. The overall number of MCA firms is less than in 2008. “There was a shakeout in 2008, but the opportunity to get capital to small businesses that banks are turning down for loans is attracting new players,” she adds.

Eyeing the Mainstream

Despite providing merchants with billions in financing, merchant cash advances are considered to be a niche business, since the business model behind them depends on merchants that accept a high volume of credit card transactions.

“The focus has always been on merchants with high credit card receipts, which has limited the marketplace for merchant cash-advance providers,” says Pratt.

Improving market conditions, however, have MCA firms optimistic they can become mainstream funding sources for merchants. “The number of players coming into the industry, the amount of financing available to merchants, and choice of products are all growing the business and moving it into the mainstream,” says David Goldin, chief executive of New York City-based AmeriMerchant Inc.

Another factor fueling MCA firms’ optimism is that default rates on merchant cash advances have fallen significantly since late 2008, when the economy nosedived and many merchants closed their doors in the months that followed. In 2009, default rates on many MCA portfolios averaged 12% to 13%, according to Dall’Orto. Today, the average default rate is a more palatable 4% to 5%.

The declining default rates on merchant cash advances coincide with a steady decline in small-business bankruptcies. During the second quarter of 2012, such bankruptcies declined nearly 17% from the first quarter, according to Equifax Inc.’s Small Business Bankruptcy Report released in August. It is the fourth straight quarterly decline in small-business bankruptcies and the lowest bankruptcy rate for the second quarter since 2007, according to the report.

Despite improving economic conditions for small businesses, many continue to be rejected for bank loans and credit lines due to stricter bank underwriting guidelines. That trend is also fueling optimism among MCAs that they can shed their niche status.

“A lot of banks rely on a FICO score as part of the lending decision, but we don’t. Instead, we use a lot of data sources, some of them proprietary, that provide deep insights into a merchant’s business so we can properly score and manage the risk levels of their business,” says Goldman, who adds AdvanceMe’s default rate is in the low single digits. “This lets us extend financing to merchants of all sizes that are good credit risks, but get turned down by banks.”

Since AdvanceMe was launched in 1998, the company has had $275 million in underperforming cash advances, according to Goldman. He adds that not all those advances were written off.

‘Short-Term Financing’

While many private-equity firms are investing in established MCA companies to broaden their reach to merchants, others are backing startups that target niche merchant categories.

Kabbage, for example, advances between $500 and $50,000 to small businesses, including online merchants selling on eBay, Amazon, Yahoo, and other marketplaces. Since going live in late 2010, Kabbage had advanced $32 million to online merchants through August 2012 and has struck marketing partnerships with UPS and Intuit Inc. through its QuickBooks accounting application.

“A lot of small online merchants only need a few hundred or a few thousand dollars to expand their business, but don’t have many options to secure that kind of funding,” says Kathryn Petralia, chief operating officer and co-founder of Kabbage. “The attractiveness of a cash advance to small merchants is that it does not require merchants to put up collateral. It is instead being secured with future credit card sales.”

Like all MCA firms, Kabbage determines the amount of cash to be advanced against the merchant’s credit card receipts. Kabbage charges merchants 2% to 7% of the amount advanced for a 30-day payback period and 10% to 18% for a six-month payback. On average, merchants repay the advance in four months, according to Petralia, who adds the company is testing $100,000 cash advances.

Merchants apply for a Kabbage cash advance online. Upon completing the application, the merchant’s business profile is scored using such data as daily, weekly, and monthly deliveries made through UPS, the number of bidders on items for sale by auction in their store, actual sales, and their ratings in online social-media communities, such as Facebook.

Once a merchant is approved, the cash advance is deposited in its PayPal or checking account, from which Kabbage withdraws a monthly principal and interest payment, the amount of which is determined by the length of the advance. For a six-month cash advance, Kabbage withdraws one-sixth of the amount owed each month.

Unlike Kabbage, other MCAs collect a percentage of a merchant’s daily credit card receipts, which includes principal and interest. If the card receipts fall below projected levels for any length of time, the amount the merchant pays adjusts accordingly, as it is not a fixed payment.

“The idea is not to hinder the merchant’s daily cash flow, but be sure we get repayment and repeat business,” says Mark Cermino, senior vice president of sales and marketing for RapidAdvance, who adds that if a merchant’s card receipts are less than expected for a lengthy period of time, the payback period can be adjusted.

RapidAdvance, which targets merchants with annual sales of up to $15 million, advances between $5,000 and $250,000 to merchants for up to 12 months. Once a merchant has repaid 60% of the cash advance, it can apply for more cash.

“Merchants look at this as short-term financing that they can use for inventory, new equipment, and other operational needs for their business,” says Cermino.

Conflict Along the Way

With many MCAs flush with new capital, some are expanding their product offerings to include cash advances and fixed-payment loans to merchants that generate the bulk of their revenue from cash, check, and alternative electronic payments, as opposed to credit cards.

The amount of the loans and cash advances is based on a merchant’s total gross receipts. The new strategy is expected to considerably broaden MCA providers’ reach.

“There are small and mid-sized merchants in need of cash that generate the majority of their sales from cash and check, even alternative payment options like PayPal,” says AmeriMerchant’s Goldin. “If the risk can be kept low, why not extend financing to these merchants.”

AmeriMerchant will advance money to merchants with total gross sales of at least $250,000 a year. The company also offers merchants the opportunity to purchase inventory, which is financed 100% upfront by AmeriMerchant, against total gross receipts. Repayment schedules are similar to those for cash advances.

With reams of in-house data on the performance of their own merchants and merchant categories in general, the move into fixed-payment loans is not a huge leap for MCAs. Indeed, most MCAs offering loans leverage their basic cash-advance model, i.e., lending a percentage of total receipts for 12 to 18 months. What makes a loan different from a cash advance is that the merchant makes a fixed payment.

New Logic Business Loans Inc., AdvanceMe’s sister company, lends up to $150,000 per merchant location. Only merchants that have been in business under the same management for at least two years can apply.

Still, for all the current optimism, there has been conflict along the way, even patent suits. In 2007, AdvanceMe sued AmeriMerchant, claiming infringement of its patented cash-advance process.

AmeriMerchant countered that the process for merchant cash advances was a common practice before AdvanceMe patented it. It won the case. Nevertheless, AdvanceMe appealed the decision, which was upheld in appellate court.

Now, with that case behind it, AdvanceMe is looking ahead. Says Goldman: “Servicing merchants’ financing needs with new products is becoming a bigger part of this business.”

Alphabet Soup: MCAs And ISOs

Making merchants aware of alternative financing requires marketing, and among the best marketing tools merchant cash-advance (MCA) providers have at their disposal are independent sales organizations.

Bethesda, Md.-based RapidAdvance, for example, has relationships with more than 1,000 ISOs. “Our product adds value to an ISO’s offering so they don’t have to sell strictly on price,” says Mark Cermino, senior vice president of sales and marketing for RapidAdvance.

One drawback to relying heavily on ISOs for marketing is that cash advances are a product with which they are not intimately familiar, which can hinder their desire to sell it.

“When I worked for a merchant cash-advance firm, several ISOs told me cash advances were not a big part of their business, because the product is a different animal for them to sell,” says Jannine Dall’Orto, a senior manager for Linthicum, Md.-based First Annapolis Consulting. “Successful marketing requires the use of multiple channels and marketing partnerships.”

While the increased flow of capital into MCA firms and diversification into loans is injecting new life into MCAs, the big question facing MCA providers is whether they can successfully make the move to mainstream status.

“MCA firms are making an attempt to diversify and they are seeing more interest from private-equity investors, but the primary focus is still on serving small merchants that generate mostly credit card receipts,” says Dall’Orto. “Until that focus changes, the jury is out on whether they can make the transition from niche to mainstream status.”

As long MCAs depend on small, high-volume credit card merchants, it seems likely they will need to depend, at least in part, on ISOs.