By Mitchell D. Levy
Merchant Cash and Capital LLC
It is no surprise that in these uncertain economic times, small-business owners face challenges when it comes to raising capital, whether for growth, expansion or just to help with cash flow. Yet merchants need access to capital to enable their businesses to grow and to help bolster our economy.
However, despite what we read about the federal government's Troubled Asset Relief Program and the pressure on financial institutions to lend, the vast majority of small business owners cannot borrow money.
Approximately 10 years ago, a cottage industry known as merchant cash advance (MCA) was established. MCA provides alternative financing for small-business owners who cannot obtain traditional financing.
MCA is similar to traditional accounts receivable factoring with one glaring exception: while traditional factors finance a merchant's existing receivables, cash advance companies advance funds against future receivables and anticipate that those future receivables will be generated by the merchant.
There are substantial risks to MCA providers. An MCA is not a loan, so there are no personal guarantees, collateral, late fees or predictable payments. Instead, a provider receives a fixed, agreed upon percentage of a merchant's future credit card transactions until the provider has received the total amount of future receivables that it has purchased. Because of the risks an MCA funder is subject to, traditional MCA factor rates are high, often in the range of 1.38 over a projected six- or seven-month term, meaning that if an MCA provider advances $10,000 on day one, it is expecting to collect $13,800 over a six- or seven- month period.
That sounds like an excellent return for the provider, assuming the merchant accepting the advance stays in business and generates subsequent credit card receivables within the anticipated timeframe.
Now, put yourself in the shoes of the merchant. Is that $10,000 advance fool's gold? Is it a good idea for a small-business owner to sell $13,800 of future credit card receipts over an extended period for $10,000 up front? Sounds expensive, but let's consider the options.
With traditional providers of capital having basically closed their doors to America's small business owners, where is the business owner to turn? Bank loans, to the extent available, take months to close, require extensive documentation, personal guarantees, collateral, and are accompanied by late fees and penalties.
Many small-business owners in this economy have challenging personal credit and limited funds in the bank. MCA offers merchants the opportunity to grow their businesses and improve their lives.
Let's consider an example. Pizzeria 1 has been in business for four years. The owner has a small yet profitable business, selling $800,000 of pizza annually, earning an annual net profit of $80,000, or 10 percent. Two blocks down the road is Pizzeria 2. But this business is struggling, losing money because of a high cost of goods, despite doing $500,000 in annual sales.
As a result, the owner of Pizzeria 2 is looking to sell the business for $75,000, along with an assignment of the lease, which has five years remaining. On the other hand, the owner of Pizzeria 1 is looking to expand.
Assuming the merchant can generate the same net profit at Pizzeria 2 as at Pizzeria 1 (10 percent of gross sales, though the profit could be greater given economies of scale), the owner of Pizzeria 1 concludes that operating Pizzeria 2 could generate an additional net annual profit of $50,000.
Yet despite the profitability of Pizzeria 1, the merchant does not have the free cash flow to write a check for $75,000 to buy Pizzeria 2. The merchant has a 650 credit score and an average daily bank balance of less than $250, so the business will not qualify for a Small Business Administration or bank loan. In the world of traditional finance, the owner of Pizzeria 1 will hit a dead end, despite having a real opportunity to acquire Pizzeria 2.
What the owner of Pizzeria 1 does have is $50,000 in monthly credit card sales. An MCA funder will likely allow that merchant to leverage that $50,000 in credit card sales for the $75,000 needed to purchase Pizzeria 2. So, would the owner of Pizzeria 1 be making a wise decision by taking that MCA funding?
Let's consider the economics of the transaction using the assumptions identified above. In order to acquire the $75,000 needed to purchase Pizzeria 2, the owner of Pizzeria 1 will need to sell $103,500 of future credit card receivables ($75,000 x 1.38 factor rate). So the cost of the funds from the MCA provider will amount to $103,500 for the business owner.
Thus, for a one-time cost of $103,500, the owner of Pizzeria 1 will be buying a business - Pizzeria 2 - that will generate annual profit of $50,000 (10 percent of $500,000 in annual sales) for each of the five years remaining on Pizzeria 2's lease. For a short-term cost of $103,500, the new owner of Pizzeria 2 will generate a gross profit of $250,000 ($50,000 x 5 years remaining on the lease).
A recent Wall Street Journal online article supported the conclusion that the MCA industry is growing and accepted. But, in order for merchants to make proper decisions for their businesses, they must consider alternative options, the article stated.
One can only assume that, in today's economy, a traditional bank loan will be out of reach. In addition, a bank loan will take far more time to close than a cash advance and will require more paperwork, personal guarantees and collateral.
The merchant will also have to pay the bank's legal fees and run the risk of penalties and late fees in the event scheduled payments are missed. None of these requirements apply to a cash advance.
Well, with a bank being eliminated as a capital funding source, where else can the small business owner turn? There are always friends and family. But it is a rare merchant who wants to be in debt to friends and family and even rarer to want to take them in as partners who have a say in how the business is operated.
Some merchants look to professional investors or venture capitalists for funding. But it is difficult to imagine a professional investor providing capital for such a small transaction. Additionally, dealing with venture capitalists requires difficult discussions with respect to equity and control.
These are not issues which the owner of Pizzeria 1 is going to have experience dealing with. And why should the owner of Pizzeria 1 want a partner, as a venture capitalist would demand? After all, the merchant has already demonstrated the ability to make money.
With other capital sources unavailable to our merchant, let's return to the MCA industry and look at its evolution. The owner of Pizzeria 1 has a healthy credit score and positive bank balances. MCA industry data will indicate that business owners with high personal credit and positive bank balances are considered "premium" merchants.
As a result, this merchant may be able to qualify for so-called "gold" or "diamond" MCA programs, which are generally longer programs with lower factor rates. Should this be the case, the owner of Pizzeria 1 will have a lower cost to attain funds, enabling a quicker return on the investment in Pizzeria 2.
Of course, equating the rise of the MCA industry to, say, the California Gold Rush of the mid 1800's has limits. The comparison does not take into account socioeconomic differences between then and now. But the economic basics have not changed. People have always strived for better lives for themselves and their families, whether by prospecting for gold or leveraging the value of their businesses.
MCA is therefore hardly a case of prospectors chasing after fool's gold. While it may not be an example of the return of the Gold Rush either, it does demonstrate that, in certain circumstances, MCA provides an important and accepted form of small business finance in difficult times.
Mitchell D. Levy is Co-Chief Operating Officer at Merchant Cash and Capital LLC, where he co-manages the company's commercial business development, which is primarily in the hospitality industry. Formerly, Mitch practiced bankruptcy law in New York and served as a senior executive of a publicly traded restaurant holding company. Mitch can be reached at 800-796-0136 or via email at mlevy@merchantcashandcapital.com.
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