What Does the Merchant Cash Advance Industry say about America?

Last week, CNN Money ran an article about the merchant cash advance industry and riskier forms of financing.  While I applaud the reporter, Jose Pagilery, for his efforts to point out how many small business owners are turning to riskier forms of financing, I am not sure he went far enough to explain the implications of the collateral crisis, and how it's hurting small business.

Let me explain.  It’s common knowledge that credit has tightened dramatically for small business owners and entrepreneurs throughout the recession.  What is less discussed, is what they’ve done to survive and where they have turned for help.

For small retailers and service providers, many of them who lack collateral that lenders are looking for, the answer has been the merchant cash advance industry.  A typical loan is six months long.  Here is how it works.  A merchant has a need for cash.  Within a few days, they can typically get a cash injection of about one month of their sales.  As soon as the money hits their checking account, they start paying the loan back in daily increments.  Often times, the money is debited directly from their checking account or credit card sales.

The offer is tempting.  As an example, the lender says, we’ll give you $25,000, and you will pay us back $7,000 over 6 months.  The borrower typically focuses on the $7,000, and calculates the interest rate in their head accordingly.  “So they’re going to charge me in the high twenties for the money.”  But the reality is that the interest rate is dramatically higher than that, because the money is being paid back in six months instead of twelve.

The other reality of these loans is that it’s really tough to pay back an investment in six months when the fees are included. Typical loans have paybacks of 5, 7, or 10 years.  Imagine going to the car lot to buy a car and apply for financing?  You get a loan offer back and you’re going to have to pay for the car over six months.  That’s the nature of these loans.

Typically, after two or three months, when a lot of the money has been spent, the lender comes back and offers the borrower a renewal.  They can get some money in their kitty.  They’ve become used to the daily payments, and they take the extra dough.  Meanwhile, the lenders fees keep adding up.

Lending programs like this have skyrocketed though the recession.  How big an industry is it?  The answer is that I don’t think anybody knows.  But if you run the numbers, you quickly realize that these loans are putting small business owners on a dangerous, high interest tread mill.

This is one of the results of the banks and the regulators creating such tough standards for small business lending.  However, I don’t think we have begun to see the fallout yet.  Eventually, the high fees and cumulative expensive debt will catch up with these businesses, and they will no longer be able to keep up.  By that point, the alternative lenders will have made hansom returns.  But the small business might not survive.

I want to be clear.  There is a need for these lenders in the market right now.  They will tell you that they’re fulfilling an important need and they are.  From time to time at MultiFunding, we put clients in these types of loans.  However, this option should be reserved for clients that have no other options - they HAVE to make payroll or pay taxes - or there is a viable exit strategy. Unfortunately, this form of financing is being presented as the first and best option in too many scenarios.

It is wrong for us to accept this type of lending as the new norm.  We’re putting America’s job creators, the small business owner, at such a disadvantage.  These issues are far more relevant and pressing than the tax and regulatory relief the politicians are running around talking about.

Over the next few months, we will continue to put forth proposals and ideas about how we can work our way out of the collateral crisis.  We hope that you will join the debate.