Running a small business is tough at the best of times, and the COVID-19 pandemic has certainly hit small businesses 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 have entered the market to meet the cash flow needs of these businesses.
However, a 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 loan arrangements typically aimed at small businesses with little track record or poor credit who are unable to obtain traditional bank loans or subprime lines of credit. Due to their exorbitant cost and often suffocating reimbursement terms, these products are often the last resort and can precipitate the demise of an already hurt business.
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Let’s start with the basics. By law, merchant cash advances are not considered “loans” and therefore are generally not regulated by federal lending laws. They are structured as purchase contracts, in which the lender agrees to buy a portion of a trader’s future earnings. This is similar to the traditional accounts receivable “factoring” arrangements that have been used by retailers for decades. But here the similarity ends.
Emerging in the wake of the 2008 financial crisis, MCAs originally involved a cash advance that was repaid over time by giving the lender a set percentage of credit card receipts. Inevitably, the number of lenders exploded and it became more common for the trader to repay in weekly or even daily instalments directly from the business bank account.
The amount to be repaid is determined by the “factor rate” of the contract, typically requiring repayment of the principal plus an additional 10% to 50% or more. Since most of these agreements are relatively short, the APR can easily exceed 100% or more. However, since these contracts are not strictly considered loans, they escape the usury laws of most states.
The more aggressive providers of these deals sometimes resort to tactics that should put borrowers on notice. For example, many require the business owner to provide bank account login information, including a password and security questions. Many also require personal guarantees, especially for borrowers with poor FICO scores (below about 550).
In extreme cases, the lender may require the borrower to sign a legal document called a confession of judgment. It is essentially an up-front guilty plea that allows the MCA lender to seize the business for non-payment without any further legal process allowing the merchant no legal recourse. Calling these bottom feeders sharks is an insult to the great white. Hundreds of small business owners have arrived at work during the pandemic to find their bank accounts drained and frozen.
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The practice is so egregious that many states have banned the use of judgment confessions altogether or limited them to borrowers in their own jurisdiction, but a handful of states still allow them and Congress has been slow to address the issue. . Additionally, 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, registration, administration, document preparation, and a number of other additional fees that can add up to 5-10% of the ready. Using loan brokers as intermediaries can add another 10% to the bill.
Consider the following example. A small business receives an $80,000 advance, repayable in $1,715 increments withdrawn by the lender each day from the business’s bank account. The total amount refunded after 70 days is $120,000, which equates to an obscene equivalent annual percentage rate of 260%. The loan also includes additional junk fees exceeding $2,000. And if the borrower becomes desperate enough to simultaneously enter into additional MCAs (a practice known as “stacking”), one can see how difficult it would be to escape the descending vortex. Think payday loans on steroids.
Granted, most lenders that cater to startups or less creditworthy businesses aren’t predatory, 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 only with full knowledge of the costs and terms, and avoiding any prior admission of judgement. Be sure to verify the lender’s credentials and review ratings with the Better Business Bureau. And if a lender or broker exerts undue pressure, walk away. Run this. Appropriate regulation may come one day, but for now, borrower beware.
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Christopher A. Hopkins is a Chartered Financial Analyst in Chattanooga.