Why Payment Firms See Opportunity in Small-Business Lending

When mom-and-pop merchants need a loan, they are increasingly turning to some big names in the payments business, which are quickly becoming noteworthy players in small-business lending.

Within the last three years, PayPal, Amazon and Square have all begun offering credit to their existing business customers. American Express, which historically straddled the line between payments and lending, is also competing for these commercial borrowers.

The volume of this type of merchant financing remains relatively small for now. But it is growing fast, as payment firms take advantage of a short-term credit environment that is favorable to lenders, as well as the long-term growth in electronic payments and their own central role in that trend.

What makes these new loan products from payment companies different from what came before is that in order to qualify for credit, a merchant must process transactions on the lender's network.

That mandatory relationship gives companies like PayPal and AmEx two advantages over banks, marketplace lenders and other competitors in small-business lending.

First, the payment networks have instantaneous access to a plethora of sales data, which is useful during the underwriting process.

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"Traditional banks may not see, and most of them don't see, spending on a monthly, daily and within-a-day basis," said Ed Jay, an executive vice president of merchant services at Amex. "We feel like we can predict in a better way who is going to pay back their loans."

Second, the payment companies have the ability to deduct loan repayments directly from the revenue they collect on behalf of the merchants. That reduces the risk of default.

These advantages seem likely to grow over time. That is because an increasing share of payments are being processed electronically. In the U.S., retail e-commerce sales totaled 7% of total retail sales in the first quarter of this year, up from around 3% in 2006, according to Census data.

"As more payments are processed through electronic rails, financial institutions' visibility into individuals' and businesses' cash flow and spending patterns will increase, improving their ability to extend loans to customers previously less understood," the World Economic Forum, which hosts the annual summit of business and political leaders in Davos, Switzerland, stated in a report released earlier this week.

PayPal, which processes payments for sellers on eBay, launched its Working Capital product in the U.S. in 2013. The company started offering similar loans to merchants in the U.K. and Australia late last year.

PayPal now distributes more than $2 million per day in loans to merchants, according to Darrell Esch, its vice president of small-business lending. That is more than double the company's loan volume in July 2014.

For small businesses that borrow from PayPal, speed and convenience are key selling points. When business owners apply for credit, they select the percentage of their daily PayPal sales — from 10%-30% — that they want to pay toward the loans. Because PayPal already has a lot of information about its business customers, the application process typically only takes about 3-5 minutes, Esch said.

"The funding happens instantly," he added. "By the time they toggle over to look at their PayPal account, the funds are already there."

New York-based American Express launched its Merchant Financing product in 2011. Last year the company extended just under $1 billion in credit as part of the program, according to Jay.

Retailers can borrow as much as $2 million and are given the option of repaying the loans within a month, or under a one-year or two-year term. Jay said that Amex views the product as complementary to its small-business credit cards.

Square, based in San Francisco, charges its business customers a fixed percentage of the daily sales that they process through the company's payment network, so the borrower pays more when sales are higher and less when they sag. Merchants that are more active on Square are more likely to receive a credit offer, according to the company.

Square Capital, which launched in May 2014, remains smaller than some of its competitors. In April, Square provided nearly $25 million in small-business financing, according to a recent press release.

Seattle-based Amazon, which offers payment services to small businesses that sell products through Amazon Marketplace, launched its lending program in 2012. Last year Amazon hired Nick Talwar, the former head of Visa's North American credit card business, to run Amazon Lending, which is open to merchants on an invitation-only basis.

It makes sense for payment companies to lend to their business customers, particularly at a time when only a tiny percentage of loans are going bad, said William Phelan, president of PayNet, which provides credit ratings on small businesses.

He noted that the payment networks can see the early warning signs when a small business starts to struggle — for example, by delaying by a few days the payment of a business-credit-card bill.

But Phelan also warned that business lending could lead to big losses for payment firms during the next recession. That is in part because small-business owners often do not have deep pockets to tap when times get tough.

"Today it looks great, but we won't be in this benign credit environment forever," he said. "When bad things happen, they'll happen very, very quickly."

Many of the small companies that are turning to payment companies for loans are restaurants and other relatively risky ventures that likely could not get a bank loan. So the payment companies may pose a more direct threat to merchant cash advance firms, marketplace lenders that focus on small-business lending and other higher-cost financing sources.

Stephen Sheinbaum, founder of Merchant Cash and Capital, acknowledged the new competition, but noted that payment companies are underwriting small-business borrowers based on only the percentage of their sales that are processed on that particular network. That limits the size of their loans.

"Generally speaking, a merchant will be able to qualify for much more money from us," Sheinbaum said.