Running a small business is challenging under the best of circumstances, and the COVID-19 pandemic certainly hit small enterprises particularly hard. Near the top of the list for entrepreneurs is the need for capital and especially business loans during times of stress or expansion. In recent years, a plethora of new non-bank loan products has entered the marketplace to address the cash requirements of these businesses.
However, one class of often predatory products known as merchant cash advances or MCAs has emerged as evidence that the cure can sometimes be worse than the disease.
MCAs are short-term business lending arrangements generally targeted at small businesses with little history or with poor credit who are unable to secure traditional bank loans or sub-prime lines of credit. Due to their eye-popping cost and frequently suffocating repayment terms, these products are often the last of the last resorts and can hasten the demise of an already wounded enterprise.
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Let's start with the basics. By law, merchant cash advances are not considered "loans" and are therefore generally not regulated by federal lending laws. They are structured as purchase agreements, wherein the lender agrees to buy a portion of a merchant's future receipts. This is similar to traditional accounts receivable "factoring" agreements used by retailers for decades. But here ends the similarity.
Emerging in the wake of the 2008 financial crisis, MCAs originally involved a cash advance repaid over time by giving the lender a stated percentage of credit card receipts. Inevitably the number of lenders exploded, and it became more common for the merchant to repay through weekly or even daily drafts directly from the company's bank account.
The amount to be repaid is determined by the contract "factor rate," typically requiring repayment of principal plus an additional 10% to 50% or more. Given most of these arrangements are relatively short, the effective annual percentage rate can easily exceed 100% or more. However, since these contracts are not strictly considered loans, they evade most states' usury laws.
The more aggressive purveyors of these agreements sometimes resort to tactics that should warn away responsible borrowers. For example, many require the business owner to supply bank account login information including password and security questions. Many demand personal guarantees as well, especially for borrowers with poor FICO scores (below 550 or so).
In extreme cases, the lender may demand the borrower sign a legal document called a confession of judgment. This is essentially a guilty plea in advance that allows the MCA lender to foreclose on the business in the event of nonpayment without any further court proceedings allowing the merchant no legal recourse. To describe these bottom feeders as sharks is an insult to the great white. Hundreds of small business owners arrived at work during the pandemic to discover their bank account emptied and frozen.
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The practice is so egregious that many states have barred the use of confessions of judgment altogether or limited them to borrowers within their own jurisdictions, but a handful of states still allow them, and Congress has been slow to address the issue. In addition, some borrowers have been harassed or even threatened with physical violence and the Federal Trade Commission has begun filing charges against some of the worst offenders.
To make matters worse, many MCAs impose so-called junk fees for ACH transfers, recording, administration, document preparation and any number of other additional dings that can add up to as much as 5% to 10% of the loan. The use of loan brokers as go-betweens can add another 10% to the bill.
Consider the following example. A small business is advanced $80,000, repayable in increments of $1,715 withdrawn by the lender each day from the company's bank account. The total amount repaid after 70 days is $120,000, equating to an obscene equivalent annual percentage rate of 260%. The loan also includes additional junk fees in excess of $2,000. And if the borrower becomes desperate enough to enter into additional MCAs simultaneously (a practice known as "stacking"), one can see how difficult it would be to escape the downward vortex. Think payday loans on steroids.
To be sure, most lenders catering to startups or less creditworthy businesses are not predators, and there are MCA options that may be worth considering with lower fees and effective interest rates if all else fails. But the merchant advance landscape is a minefield, and entrepreneurs should carefully consider all other options before turning to cash advances and then only with full knowledge of the costs and terms, and avoiding any advance confessions of judgment. Be sure to check the lender's credentials and review ratings with the Better Business Bureau. And if a lender or broker exerts undue pressure, walk away. Make that run. Appropriate regulation may come one day, but for now, it's definitely borrower beware.
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Christopher A. Hopkins is a chartered financial analyst in Chattanooga.