The 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," said Marc Gardner, President and Chief Executive Officer of North American Bancard. 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."
North American Bancard has four cash advance options, so 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 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.
It was this concept AdvanceMe Inc. attempted to patent in 1997. Its patent was overturned in a court ruling in August 2007. An appeal is pending.
"I think larger, more conservative companies were sitting on the fence, waiting to see how that court case played out before entering the market," said David Goldin, President and CEO of AmeriMerchant Inc. "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.
Glenn Goldman, CEO of AdvanceMe, said there are more competitors in the market than there were two years ago and fewer than six months ago. "Cash providers are squeezed from both sides," he said.
"When they suffer defaults, they lose cash flow, and as a result, their funders charge more, require they put up more capital themselves or take away funding altogether," he added. Thus, providers that do not have their own capital have probably met with difficulty.
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.
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.
"As a result, we are seeing our processing partners look to our product to create what we call footprint growth: generating more revenue from existing customers," Goldman said. "We generate more income for our partners - their commissions - but also, with our product, merchants must stay with their processing partner for the duration, averaging 27 months, which greatly extends the average processing life."
Goldman said AdvanceMe has seen a marked increase in applications, but simultaneously, the company's approval rate has dropped a few percentage points. "You would expect approval rates to drop in this kind of economy," he said.
AdvanceMe funds 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," Goldman said.
Goldin expects 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," he said. "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.
"I get calls every day," Goldin said. "We want to be sure that people entering the industry aren't motivated just by a quick buck.
"We are already starting to see some of these brokers who can't find a funding company to still work with them after a couple of months because the bad debt on their paper is so high."
The adolescent merchant cash advance industry is grappling with growth issues, too.
"During 2007 we saw a bidding war between merchant cash advance companies to attract new sales agents and ISOs to resell their product," Goldin said. Many of those new cash advance companies were inexperienced and had a steep learning curve.
"After factoring in the bad debt associated with the product and the quality of deals submitted by certain agents, many merchant cash advance companies have come to the conclusion they can't make money by paying the ISO commissions they were paying," Goldin noted.
"So I expect we'll see lower commissions during 2008. You can't stay in business funding bad deals.
"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 commission structure; it lowered its referral commission from 4% to 3% and dropped its residual commission from 0.2% to 0.08%. "We monitor our accounts diligently, and we've tightened our underwriting," Chung said.
Gardner said he saw many companies trying to "buy business with high upfront compensation. But I don't think they realized what they were getting into, and over the last few months, we've seen several competitors who didn't have their own capital close down."
North American Bancard hasn't changed its compensation structure. "But we always rewarded against on both the front- and the back-ends," Gardner said. "The agents get the majority of their compensation, of course, on activation.
"But they also received something on completion. We're not talking about 30-year mortgages here. On average the window is six months. That way our agents share in our long term success."
Stephen Sheinbaum, CEO of Merchant Cash & Capital, has observed a "groundswell" of funders who offer more reasonable commissions and demand a better quality application.
"And the smarter ISOs are taking more of a long-term approach," he said. "Is it better to earn $1.50 now, but the funder goes out of business, or take $1 now and know you'll still be working with the funder in three years?
"A fair allocation of risk and reward is simply better all the way around."
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."
North American Bancard instituted 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," Sheinbaum said.
A number of cash advance providers have come to believe that the agents who thrive are those who lead with cash advance rather than processing.
"It's a fabulous way to prospect," Gardner noted. "Imagine a restaurant owner who does not have access to bank financing, and you ask for the opportunity to meet with them by providing a free terminal or a lower rate in comparison to providing a 100K in working capital? Which offer do you think will open that door faster?"
Gardner also cited an 80-plus percent renewal ratio, which fosters low attrition and more incremental revenue.
Sheinbaum added that while the feet-on-the-street approach still works, many of the most successful agents also either develop relationships with channel partners or invest in direct marketing, online lead generation, and search engine optimization techniques.
"The most successful are those who understand their customers, and understand their customers businesses," Goldman said. "I know it's not sexy, but that is still fundamental for success."
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," Gardner said. "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."
Gardner has 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," Gardner said. "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."
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.
Sheinbaum said he is "bullish" on 2008 for Merchant Cash & Capital, but "it could get a little Darwinian for the industry. And that's probably a good thing overall."
"It takes a challenging economy to weed out the stronger players and test their business models," Goldman noted.
Goldin said 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.
"It may be harder for agents to get deals approved and some small, inexperienced companies may go under or be acquired.
"But in the long term it will be more beneficial for both the sales agent or ISO and the merchant cash advance industry."
Goldin and other 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," Sheinbaum said. 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," Goldman said.
"You must know your customer; understand his business; and never, ever, supply more capital than they can support ... and not one dollar more."
AdvanceMe created and posted a white paper on best practices entitled Know Your Customer and Other Guidelines for Responsible Merchant Cash Advance Providers at www.mcabestpractices.com/documents/WhitePaper_June2007.pdf.
Cash advance is clearly a growing trend in the payments industry. But, down the road, will cash advance reach a saturation point at which the value proposition to ISOs and MLSs is no longer a winning proposition?
If so, a different trend will likely take hold, and time will tell what that will be.
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