February 25, 2008 • Issue 08:02:02
Accelerating cash advance
he merchant cash advance industry has evolved dramatically since The Green Sheet’s initial lead story on the phenomenon just over two years ago (“Merchant cash advances open doors,” Oct. 10, 2005, issue 05:10:01″). The basic concept is simple: The cash provider buys future credit card receivables, which the merchant provides as a daily percentage of those revenues.
“Say a merchant desires 100K in working capital,” The merchant “would sell 135K in future credit card sales. Twenty percent of the merchants’ daily deposit is split-settled to fund the receivables which were purchased.”
Not every transaction would be identical to this, but this is an indicative example.
While cash advances on receivables is not a new concept, advancing cash for credit card receivables of goods or services not yet purchased was rare before the turn of this century, mostly because it was risky for cash providers.
And that risk is what most providers cite when explaining the fairly hefty fee that accompanies this type of transaction – the equivalent of 17%-35% if it were a loan in the same amount as the advance.
But the fairly simple concept of taking a split off the top as the credit card payments are processed makes the repayment of the advance simpler and slightly less risky.
Funders in, funders out
“I think in the next year or two we’ll see larger ISOs and even banks entering this market.”
Woochae Chung, American Microloan Managing Director, said once the court ruled against AdvanceMe’s patent “the floodgates opened. We saw at least a dozen new companies enter the market.”
But while the court case freed companies from the threat of litigation or paying patent royalties, the liquidity crisis drove others out.
Significantly, experiences with the economic downturn in the last 90 to 120 days have negated perceptions that the industry has wide margins and plenty of room for error.
Recession wins, recession woes
Given current economic conditions, it’s likely organic business growth – which occurs when existing customers prosper and grow – will not be particularly robust in 2008.
Some firms fund merchants with a Fair Isaac Corp. (FICO) score as low as 411 or as high as 817. “The recession won’t change that on the lower end, but we are seeing more merchants with high FICOs applying,”
The recession will spur increased demand for cash advance services. “Merchants who could take out loans against the value of their home will have a harder time getting needed cash that way, and they’ll turn to merchant cash advances,” They’ll be better credit qualified applicants.
“But there will also be merchants who are hurt by the recession that will be higher-risk and will take longer to repay or even be driven out of business. Hopefully, those two trends will balance each other out, but it’s a crapshoot.”
In addition, the subprime lending industry crisis has driven a large number of former subprime mortgage brokers into the industry
The adolescent merchant cash advance industry is grappling with growth issues, too.
“In the second and third quarters of 2007, we walked away from a lot of business because we couldn’t rationalize the terms being offered merchants. That discipline paid off in the fourth quarter when we grew 75% and closed out a record year.”
Changing economic conditions have led American Microloan to change its structure; “We monitor our accounts diligently, and we’ve tightened our underwriting,” Chung said.
“A fair allocation of risk and reward is simply better all the way around.”
Fraud expansion, fraud detection
Chung has also seen two or more funding companies overlap funding for the same merchant. “No one can sustain that level of debt,” he said. “Eventually it will bankrupt the merchant.
“Funding companies have to be on the lookout for that and check to be sure that the previous funding has been repaid. It’s not good for the merchants; it’s not good for the funders. Sooner or later it will go bad for everyone.”
Application fraud is already on the rise. “From an underwriting standpoint, you really need to be utilizing your ‘A’ game,” Gardner said. “You can really take a loss if you don’t successfully filter out fraud.”
Recently instituted are a number of fraud detection procedures that include sending stealth shoppers equipped with camera phones to do random checks of inventory or count the number of POS terminals. The company also has a rigorous identity fraud detection process.
The growing understanding of the merchant cash advance business has made it easier to sell because merchants no longer need much explanation of how it works. But it has a downside.
“Unscrupulous agents have been coaching merchants on how to abuse the system: installing two or more terminals and running only a fraction of the purchases through the designated terminal, for example,”
Loans denied, cash approved
The biggest criticism the industry faces is the very high cost merchants pay for cash. And those who are eligible for traditional bank loans would probably be better off going that route.
But traditional banks are not meeting the needs of small businesses that might have few material assets but healthy receivables – mostly pledged through credit card debt.
And retailers with strong but seasonal sales may prefer a merchant cash advance because traditional loans are paid back monthly in even amounts, whereas with a cash advance, merchants’ payments are proportional to their sales. They pay more in strong sales months and less in weak ones.
“No one is denying that this is expensive capital,” The point is for some merchants, it’s the only capital they may be able to get. It’s a fraction of the cost of a consumer payday advance.”
For example a repeat customer that obtained cash advances to expand his pizza franchise. “He told me that he considered it much less expensive than his previous friends and family funding,” When you fund that way you often give away a piece of your business. The 35% he gets here can be bought out in time, and he still owns 100% of his business. Independence is important to entrepreneurs.”
2008 practices, predictions
American Microloan’s growth has remained steady, and strong, at 50% a year. Chung doesn’t anticipate that changing in 2008, though he said the default rate for the industry on the whole has risen sharply over the past couple of years. He anticipates the funders that survive the recession will be those that underwrite carefully and monitor their accounts consistently.
“It takes a challenging economy to weed out the stronger players and test their business models,”
2008 “could go either way, but I think overall it will be a positive year for the merchant cash advance industry. Demand for the product will continue to grow, especially with the recent credit crunch.
Industry leaders are forming a nonprofit trade association for the merchant cash advance industry, which they hope to debut soon. They are in the process of establishing best practices to protect merchants and cash providers.
“It’s important for the industry for cash advance companies to have a ‘MATCH list,’ to combat the serious problem of fraud,” MATCH derives from the Member Alert to Control High-Risk database. It contains information on merchants who have been terminated for cause.
“Successful cash advance providers must have three things: access to competitively priced funds; solid scoring and underwriting models; and the most critical of all, a fundamental understanding of best practices,”
“You must know your customer; understand his business; and never, ever, supply more capital than they can support … and not one dollar more.”
Cash advance is clearly a growing trend in the payments industry. But, down the road, will cash advance reach a saturation point?
If so, a different trend will likely take hold, and time will tell what that will be.
Bill Hoidas
District Sales Manager
Larger B2B/MOTO/Internet Accounts
Product Development Manager
Matrix Payment Systems
(847) 381-3482 office
(847) 381-4289 fax
http://paymentconsulting.net
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Son, that whosoever believeth in him should not perish, but have
everlasting life.
