The Green Sheet Online Edition
May 09, 2016 • Issue 16:05:01
The alternative small business loan
In "The merchant cash advance," The Green Sheet, April 25, 2016, issue 16:04:02, I began a discussion on re-branding the merchant level salesperson (MLS) by taking the requisite steps to become an alternative financing specialist.
Researching the market challenges of small businesses reveals that many of them have issues in raising working capital based not necessarily on derogatory credit, but sometimes based on the fact that they are a small business in general. As mentioned in my prior article, many small enterprises need business financing of $25,000 to $40,000 only, and numerous banking institutions do not believe the costs of underwriting warrant such small requests, when they can instead use their resources to underwrite loans in the $500,000 to $2 million range.
I explained in my prior article that as a rebranded MLS, one of the products you could recommend to small businesses is the merchant cash advance (MCA), which, rather than a loan, is a purchase of future credit card receivables using a factor rate (or cost factor) to determine cost calculations.
A recap of the MCA
With the MCA, you have a purchaser (the MCA company that has funds to advance) and a seller (a merchant with, let's say, $40,000 a month in credit card processing volume). The purchaser would approach the seller and say, "How about I buy $50,000 of your credit card processing receivables in exchange for advancing you $40,000 tomorrow? To collect my purchase of the $50,000 in credit card processing receivables, how about I keep 20 percent of your monthly Visa/MasterCard processing volume going forward until the full $50,000 is collected?"
In this example, the MCA deal would be quoted as follows:
- Approval: $40,000
- Factor rate (cost factor): 1.25
- Total payback: $50,000
- Holdback: 20 percent
As long as the merchant (the seller) continues to process $40,000 a month in processing volume, the MCA firm (the purchaser) should collect the entire $50,000 in just over six months.
The alternative business loan
The MCA is a part of a bigger family within the financial technology industry (fintech), a term that is used to describe the startups being funded by venture capitalists in an attempt to gain a slice of market share, revenues and profits from traditional financial services. The MCA comes from a sector (or family) of fintech collectively referred to as marketplace or online lending. Included in this family is what I refer to as the "cousin" of the MCA (from the commercial side): the alternative business loan.
The alternative business loan is a true business loan, which means there will be a calculation of interest rates, fixed payments, fixed terms, an origination fee and a final disbursement amount after said origination fee comes out of the approved loan amount. The on-time payments from the loan are reported to the major business credit bureaus, which provides a side benefit of building a positive business credit history for the merchant borrower.
The reason the product is called an alternative business loan is to make a distinction in the marketplace from the traditional business loan. The alternative business loan allows for one to obtain a true business loan with a more liberal list of criteria and collateral requirements, along with a faster underwriting and closing process.
Short- and long-term options
There are a variety of alternative business loans available today, with some companies offering both loans and MCAs. While, in legal respects, the alternative business loan is different than the MCA, many companies offer both products as a way to serve a diverse array of industries, seasonal businesses, and cost-sensitive merchants.
The short-term alternative business loan is usually offered at companies that are traditionally known for their merchant cash advances. Terms are usually six to 18 months, with costs (interest and fees) averaging around 2 percent per month. So, for example, if a merchant approaches a lender doing about $500,000 a year in annual gross sales, the lender might approve the merchant for a $40,000 short-term alternative business loan with a 12-month term, with the following details:
- Loan amount: $40,000
- Origination fee: $600 (based on 1.5 percent of the loan amount)
- Disbursement amount: $39,400
- Total cost expense (including interest): $11,200
- Total repayment amount: $51,200
- Daily Payment: $203.17 (Based on 252 payments over the next 12 months that would come out through the automated clearing house (ACH) network every business day, Monday through Friday, except for federal holidays. There are about 21 business days per month, thus a six-month term would include 126 daily payments and a 12-month term 252 payments.
- Other fees: These might include a returned payment fee if a merchant's bank account contains insufficient funds when a payment is due, a late fee, or a credit provided if the merchant prepays a loan in full.
Long-term alternative business loans are usually offered by companies that only focus on peer-to-peer lending and not MCAs. They would usually have a "marketplace" of investors pooling money into their system, while on the other side the lender would lend out the funds to merchants in need of capital.
Terms usually range from 24 to 60 months, with actual annual percentage rates that range from 5.99 to 17.99 percent. Approval requires a higher quality profile that includes high personal and business credit scores; being profitable; good financials; good cash flow; good debt management; and no recent tax liens, judgment liens, or bankruptcies.
Tie-in merchant processing
Unlike the MCA, the alternative business loan does not directly integrate merchant processing into the payback procedure; however, you can always cross-sell merchant processing to the merchant if you are offering a short-term alternative business loan.
As mentioned, the short-term version is usually offered at companies that sell both the loan and the MCA product. Thus, they will usually want the merchant to submit bank statements and merchant processing statements. After underwriting, the firm will determine whether to approve the merchant for a loan or an advance. If a merchant is approved for a loan, you can still cross-sell merchant processing after analyzing their processing statements to know what the merchant is paying currently, using the following pitch:
"Your loan costs will be 25 percent in total for the 12-month term; however, if you switch your processing over to us, not only can we save you $250 a year in processing costs and provide you a free brand new EMV terminal, but we will also take 2 percent off your loan, taking it down to 23 percent in total costs."
The conversation continues
Members of the GS Online MLS Forum contributed to the general discussion of rebranding the MLS, as well as the concept of rebranding as an alternative financing specialist.
For example, forum member ccguy wrote, "Leading in with cash advance or technology, or any other alternative product is wise. I think you have to look at your market and decide on what you are going to do based on your area as not every area of the U.S. is the same. If I was to move to a smaller area, I would check to see who the competitors were first and then decide."
Ccguy shares many of the views that I hold in relation to rebranding, and in the next edition of Street SmartsSM, I will bring in commentary from additional industry players to continue moving the MLS rebranding conversation forward.
John Tucker is Managing Member of 1st Capital Loans LLC, as well as an M.B.A. graduate and holder of three bachelor's degrees in accounting, business management and journalism. Tucker also has over nine years of professional experience in commercial finance and business development. You can contact him by email at email@example.com or by phone at 586-480-2140.
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