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When Wall Street sneezes, Main Street catches a cold. It is an old aphorism, but it still rings true for merchants finding themselves increasingly locked out from traditional forms of financing.
That is creating opportunities for merchant cash-advance firms, which provide an alternative source of funding.
Cash-advance firms assess the merchant's past credit and debit sales-and, in some cases, check, automated clearinghouse and electronic benefits transfer transactions-to forecast their future sales. Then they purchase a portion of those future sales at a discount: for example, giving the merchant $20,000 in cash for $25,000 worth of sales.
The North American Merchant Advance Association estimates that in 2008 the industry will fund about $1 billion in advances. The group also says the sector is growing at about 25% to 40% annually. Yet only about 5% to 7% of merchants currently use merchant cash advances, so there is lots of upside.
Cash-advance firms say their products have wide appeal across most merchant types.
"Even really great business owners with great FICO scores are finding that they're getting letters from the bank saying your home equity line has been pulled or credit card level is reduced," says Diane Naczi, senior vice president of marketing at AdvanceMe Inc., a Kennesaw, Ga.-based merchant cash advance company.
Even so, some merchant types are more receptive to cash advances than others such as restaurants, which many banks are reluctant to fund even in flush times. And in September, Bank of America Corp. said it would not increase lending to McDonald's franchisees looking for help to fund upgrades that the chain demands.
All of that is creating opportunities for cash-advance firms. "Half of our business is restaurants," Naczi says.
Not surprisingly, cash-advance firms expect the tight credit market and an uncertain economy not only to continue, but to continue to play to their advantage well into 2009.
"It's an unprecedented opportunity that I don't think we'll see again in our lifetime," says Stephen
McDermott, chairman and CEO of Professional Merchant Advance Capital (ProMAC) , a Hauppauge, N.Y.-based merchant cash advance company , which targets merchants in the professional services,
business-to-business and health-care sectors. "The business owners that we're seeing right now, if you looked at them six months ago, could get traditional financing through a bank," McDermott says.
Some believe that cash will remain king well through the fourth quarter of this year.
Assessing Risk
"We're going to see in the banking side a return to stricter underwriting standards," says Michael Berman, chief operating officer of Outside Ventures LLC, the New York-based parent of Tribul Merchant Services. "All of the predictions suggest that Q4 retail sales will not be robust. [Financial institutions are] going to be somewhat conservative and wait until the Q4 checks are in before they decide what to do with merchant America."
By legal definition, merchant cash advances are not loans, but the inherent risk of buying future transactions sees cash-advance companies doing their best to quantify just how much risk a particular merchant holds.
For example, AdvanceMe typically considers approximately 70 factors, including recent credit card-processing histories, the industry that the merchant is in and its geographic location. It uses that information to forecast the applicant's credit card sales flow during the payback period, which usually is 12 months, and to calculate the discount at which AdvanceMe buys a portion of those sales.
AdvanceMe also looks at the owner's FICO credit score, although the company says that figure is not necessarily a deal-maker or -breaker.
"It doesn't kick you out," Naczi says. "We've done fundings to business owners who have a FICO score of 410, and we've denied business owners who have a FICO score of 800."
For merchants, part of a cash advance's appeal is that, unlike a conventional loan, they do not pay a set amount each month regardless of whether business is good or bad. So if the economy remains sluggish longer than the merchant or cash-advance company expected, the latter bears the brunt.
"The merchant repays his advance automatically, via our deducting a fixed, daily percentage of his transactions," says Nancy Drexler, vice president of marketing at SignaPay Ltd., an Irving, Texas-based ISO. "So if consumers are spending less at a location, and the merchant's daily transaction volume is down, the fixed percentage will remain the same, and the processor will simply recoup a smaller amount that day. That means that the advance takes longer to pay off, perhaps hurting the advance company a bit, but not likely the merchant."
First, Do No Harm
Cash advances can be a lifeline for merchants, but for the firms extending them the trick is not to give merchants so much rope that they hang themselves. That means giving the merchant only what it can afford to pay back without cutting too deep into its cash flow.
How deep is too deep? The answer depends on which cash-advance firm you ask, but it usually falls between 1% and 9% of the merchant's gross receipts.
"We won't go over 9% for any merchant," says Mark Lorimer, AdvanceMe chief marketing officer. "In some Standard Industrial Classification codes, that number is 1% or 2%, based on the fact that we know that if you take more than that out of the business, you're really eating into operating capital as opposed to what might be the average margin in that SIC code." SIC stands for standard industrial classification, a system of categorizing businesses.
"A lot of [our] competitors are giving merchants too much darn money and, by extension, taking too much of their gross receipts and putting them out of business," McDermott says. "I think that's a problem."
That is one reason of why it is important for cash-advance firms, and their ISO and agent partners, to understand the business dynamics and other nuances within each SIC code. But exercising restraint can be challenging when a merchant believes it can get more money from another cash-advance firm.
"We've had plenty of businesses that have said, 'We're going to go to your competitor because they're going to give us $20,000 more than what you're going to give me,'" says AdvanceMe's Naczi. "And our answer is, 'That's fabulous, as long as it doesn't put you out of business.'"
Keeping The Market In Check
Most cash-advance services are based on credit and debit transactions, but a few consider checks, ACH and EBT, too. One reason why cash advances based on checks is a niche play is because of concerns about merchants bypassing the mechanisms used to track those transactions.
"The only way I get paid back is if you put that check through the check reader," says David Goldin, president and CEO of AmeriMerchant LLC, a New York-based cash advance company. "Do you know how easy it is to walk that check to the bank? We looked at that model and passed on it. There's just too high a degree of risk of the merchant being able to circumvent the payback mechanism."
But firms such as ProMAC see opportunity there. (Besides checks, it also takes any electronic payment that is intermediated, such as ACH and EBT and credit cards.) One reason is because some merchants have far more check than credit or debit transactions, so focusing only on cards limits the amount of funds they are eligible to receive.
"When all forms of payment are considered, that amount is higher than when just credit cards (MasterCard Worldwide and Visa Inc.) are considered," says SignaPay's Drexler.
"We did a cash advance to a business that was doing approximately $400,000 a month in revenue, of which $30,000 was credit cards and $150,000 was in checks," says ProMAC's McDermott. "My competition can do 150% to 180% of their credit cards, that gets them to $60,000 to $70,000 [in funding]. For ProMAC, capturing $200,000 in electronic payments, we can advance them $200,000." That directly affects the ISO's and agent's commission.
"So with the same type of percentages based off of a $60,000 advance versus a $180,000 to $200,000 advance, that's a 300% increase," McDermott says. "It's three times the commission."
Accepting checks also can be a way for a cash- advance firm to cast a wider net, picking up merchants that do a lot or a majority of their transactions that way.
"To the extent that there's an opportunity to draw from a bigger pool, that's a positive," says Jeremy Brown, president and chief operating officer of Bethesda, Md.-based RapidAdvance LLC, whose offerings accept American Express Co. and Discover Financial Services transactions. "The check-advance programs are fairly new. They are not as stable, in my mind, as credit and debit card processing because you can easily deposit your checks at other banks."
On one hand, accepting checks can be a market differentiator for cash-advance firms, at least when selling to merchants that do not do most of their business with credit and debit cards. But on the other, it can be a negative in a merchant's eyes if they have to make changes to their procedures.
"We were testing it with a group of merchants that wasn't using electronic check-conversion services, so they had to change their standard banking [procedures] to be able to accept that," Brown says. "If you're not using it already, there are some factors that make it unattractive. Other [cash-advance firms] may have figured it out better. Time will tell."
Fewer Players, Lower Commissions?
If the market for merchant cash advances
remains strong, it begs a question: Will demand attract new entrants? For ISOs and agents, that possibility is worth pondering, if only because it could affect commissions because new entrants could try to buy market share by overpaying on commissions.
"I think there's always potential for new entrants, but they'll be cautious," says RapidAdvance's Brown. "They're going to want to fund smaller amounts of deals per month until they really learn the business. I don't see any new big players on the horizon."
Higher Capital Costs
Notably, as larger finance companies run into credit-access issues, it is not much of a leap to consider that small businesses also will.
"When you see household names such as GE or GM running into credit crunch, it's going to be a lot harder for a start-up, I would imagine," AdvanceMe's Lorimer says.
Funding is one reason why it seems unlikely that more companies will get into the cash-advance space. After all, the tight capital markets are a major reason why the cash-advance market is hot, so it could be tough for a potential new entrant to raise the funding required to fund advances.
In fact, Brown is among those who believe some incumbent cash-advance firms are feeling the financial pinch. (One exception is AdvanceMe, which picked up $140 million this spring from its existing backers, as well as from new investors such as Wells Fargo and Fifth Third Bank.)
"There aren't a lot of [cash-advance] providers left relative to a year, year and a half ago," says AmeriMerchant's Goldin. "There are a lot of resellers, ISOs and agents distributing the product. Anyone can distribute it. There's just a limited amount of capital sources and funding companies right now."
Meanwhile, as the cost of capital increases, cash-advance firms are passing that on to merchants in the form of higher rates. "The prices are actually going up," Goldin says.
If would-be cash-advance firms cannot break into the market, while some incumbents drop out, it will affect agent commissions. In December 2007, Goldin predicted in his blog that agent commissions would stabilize or decrease in 2008.
"We're still seeing that trend because a lot of small players came in and tried to buy market share by overpaying on commissions," Goldin says. "Some of them went out of business, and some of them realized that there's only so much you can pay per deal. We're starting to see the reverse trend now: agent commissions are starting to come down."
Vetting The Providers
One trend to watch for in 2009: As the variety of merchants using cash advances increases, these firms could wind up with stronger portfolios.
"I see [more] better-credit merchants taking the product than previously because they're going to be shut out from traditional loan sources for quite some time," Goldin says. "It's going to be an opportunity for [cash-advance] companies to have an even stronger portfolio than they did in the past."
A strong portfolio is one thing for ISOs and agents to consider when assessing cash-advance firms. So is the stability of the firm's funding sources. Yet another is how successful the firm is in retaining merchants that get advances. "We have a very high renewal rate: 75% of eligible businesses take another funding with us," says AdvanceMe's Naczi.
Besides retaining merchants, the cash-advance firm also should have a good track record of keeping ISOs.
"Ask for references: How long have different ISOs worked with you?" says RapidAdvance's Brown.
The bottom line is that, although cash advances is a growth market, it takes some homework to be successful-not just in terms of picking partners but in picking merchants, too. That is because as capital markets tighten further, so do the guidelines for who gets the cash.
"It's a great revenue opportunity [for ISOs]," Brown says. "But the ISO and agent have to recognize that they're going to get fewer deals approved and funded than two or three months ago." ISO
