business cash advance
Are Loan Underwriting Algorithms Limited?
March 15, 2014As news of OnDeck Capital’s $1 billion milestone spread yesterday,
Crossing the $1B mark in small business loans from OnDeck to #smallbiz around the country! Great way to end the week! pic.twitter.com/U3KUNxjyez
— Noah Breslow (@noahbreslow) March 14, 2014
I couldn’t help but reflect on a major detail revealed about their operation a week prior in American Banker. OnDeck’s underwriting system is not as fully automated as they would have us believe. For the last few years its been said that their success is related to their advanced underwriting algorithm which analyzes thousands of factors. We were reminded of such recently in a Bloomberg interview:
Such capabilities have been received with both awe and skepticism. Do factors like social media activity really make a difference in how loans perform? OnDeck’s CEO, Noah Breslow has openly acknowledged that many of their algorithm’s innovative factors carry little to no weight. Things like credit history, cash flow, and profitability still have a major impact in approval.
American Banker revealed that 30% of all loan decisions at OnDeck are human made. That’s a shockingly high percentage for a company that has 56 employees with backgrounds in math, statistics, computer science, and engineering. Furthermore, as human involvement is reserved for the larger deals, 30% of all loan decisions could easily be 50% of all actual dollars loaned. That would seem to prove that computer automated underwriting is a far greater challenge than anyone could have been led to believe.
With 7 years in business and a tech savvy board of directors that would make most billionaires blush, one has to wonder why so much human involvement is still necessary.
More than a year ago, UK payday lender Wonga almost acquired OnDeck but the deal fell apart in the late stages. Wonga’s CEO is a strong believer that human involvement in underwriting leads to poor decisions not better ones. As was quoted in The Guardian,
Asking for a loan from a financial institution had traditionally involved making a strong first impression – putting on a suit to see the bank manager – then rigorous questioning, checking your documents and references, before the institution made an evaluation of your trustworthiness. In a way, it was exactly the same as an interview, but instead of a job being at stake it was cash.
Damelin found this system old-fashioned and flawed. “The idea of doing peer-to-peer lending is insane,” he says. “We are quite poor at judging other people and ourselves – you get to know that in your life, both with personal relationships and in business. You realise that we’re not as good as we think we are at that stuff, and that goes for almost everybody. I certainly thought I was much better at it.”
That begs the question if that mentality can be applied to (1) lending in the US as opposed to the UK and (2) to businesses as opposed to consumers.
Fast growing merchant cash advance provider Yellowstone Capital hasn’t fully subscribed to the theory that automation is better. In an ISO&Agent interview, Managing Partner Isaac Stern said, “A computer-generated algorithm is no substitute for human analysis when brokering big loans. There are companies making decisions about merchants without ever speaking to them. You cut out a lot of important information.”
Peter Renton, the founder of both Lend Academy and the LendIt Conference shared with me that, “it is very true that [business lending] requires an entirely different skill set when it comes to measuring risk.”
I think a lot of this explains why peer-to-peer lenders like Lending Club were able to get very big very quickly. Pre-packaged factors like FICO score can still largely predict consumer loan performance. That helped them scale because FICO is widely understood and believed to be reliable. Future business performance on the other hand is a mystery. The stock market is a great example of that unknown. Expectations of future performance change every nano-second.
All one thousand variables examined by a computer could confidently signal a lender to approve a loan to a restaurant. But 30 days later when a brand new competing restaurant opens up across the street, all that analysis goes out the window. Loan performance may be nothing like you possibly expected.
Is it any surprise that OnDeck isn’t fully automated? In my opinion, no. But when 30% of all loan approvals are human based, that should be a strong indication that computers can’t go all the way.
Wonga’s Damelin might have it backwards. Humans might be better judges of people than any algorithm could aspire to be. An algorithm creates scalability though. OnDeck would not have broken the $1 billion mark without one. It could just be about allowing a computer to do as much of the human work as possible without delivering significantly worse loan performance results. If you can at least get close to the performance that your best and brightest human underwriters could produce, that may be considered success.
Join the Industry March Madness Competition
March 11, 2014
Ready to test your NCAA basketball skills against your friends and foes? Join the industry’s 2014 March Madness Competition hosted by Merchant Cash Group! (league password: mcg589)
Merchant Cash Group will be providing a Grand Prize of $250.00* to the overall winner and keeping with tradition all participants will receive a trophy highlighting their not so stellar accomplishments.
I did really well in it last year. How well you ask? So well that Merchant Cash Group bestowed upon me this trophy:
So maybe I didn’t do so great. But I have grand plans in 2014 especially with my alma mater making the tournament for the first time since 1999. I hope you guys are ready for the Blue Hens. I have them making my final 4. Think I’m a fool? Show me up and:
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Merchant Cash Group is a direct merchant cash advance provider and was the awesome co-host of the last 2 industry fantasy football challenges.
*You do not need to be a referral partner of MCG to participate but the Grand Prize of $250 will only be awarded to partners. Non partners will receive $100.00
Is There Cause for Alarm?
March 8, 2014
Brick and mortar chain stores died this week, after a long illness. Born along Main Street, raised in shopping malls across post-World War II America, the traditional store enjoyed decades of good health, wealth and steady growth. But in recent years its fortunes have declined. Survived by Amazon.com and online outfits too numerous to list.
– CNN 3/7/14
Just a day after Jeremy Brown’s new CEO Corner post appeared on DailyFunder with an overt bubble warning, CNN’s Chris Isidore alluded that the era of brick & mortar retail may be drawing to a close. In Isidore’s brief sensational article, he fingers an overabundance of retail space, a weak economy, and the Internet as the culprits behind Main Street‘s decline.
In the broad alternative business lending industry, the sentiment is quite the opposite. Small business demand for working capital is surging and no one is predicting anything less than stellar growth for the foreseeable future. But is the growth real?
Jeremy Brown is the CEO of Bethesda, MD-based RapidAdvance and he explains the growth may not be what it appears to be on the surface. Some cash providers are overpaying commissions, stretching out terms longer than what their risk tolerance supports, and are growing by funding businesses that have already been funded by someone else (a practice known as stacking).
If the industry collectively booked 50,000 deals in 2013 and increased that to 100,000 deals in 2014, you’d have 100% growth, or at least it would appear that way on the surface. What if the additional 50,000 deals funded this year were not new clients but rather additional advances and loans made to existing clients? It’s a lot easier to give all of your clients money twice instead of acquiring new ones.
This all begs the question, is demand for non-bank financing really growing by leaps and bounds? Or does it just appear that way because those that have already utilized it are demanding more of it?
Brown left his readers with this conclusion, “There will be a rebalancing at some point. And it will not be pretty.”
Chime in with your thoughts about this on DailyFunder.
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When Will the Bubble Burst? by Jeremy Brown will also appear in the next print issue of DailyFunder. If you haven’t subscribed to the magazine already, you can do so HERE.
Hello Square Capital
March 1, 2014We’ve seen copies of this notice posted on a few websites now:
Square, the well-known micro-merchant processor with celebrity CEO Jack Dorsey is debuting a merchant cash advance program. Truthfully, I’m not surprised in the slightest. Come on in Square, the water’s fine!
What is still interesting to this day is the realization that so many small business owners have never even heard of the concept. You can check out comments by people on the mr. money mustache forum regarding Square Capital here.
Sell my future credit card sales? What the HECK?!
It’s a 16 year old industry now my friends. One of these days it’d be nice if people just knew this product existed. That seems to be the hardest part…
The Growing Divide
February 28, 2014
It wasn’t too long ago that everyone in this industry knew everyone else. If not personally, then at least through their credit inquiries or UCC names. You crossed paths and acknowledged each other. It was a small world then. Today, not so much.
As the barriers to entry have remained low, the simplicity of ACH repayment has drawn in people by the thousands to become brokers, syndicates, and funders. Anyone can be any one of those three or all three at the same time. There’s still the originals out there, the guys who go to the trade shows and visit offices regularly to stay in touch. But then there’s another crowd, the newcomers that don’t file UCCs, attend shows, or interact much with everyone else. They’re funding a half million, a million, or even $5 million a month and no one really knows they exist except for their own clients. The merchant cash advance industry which was once a shadowy market in its own right now has its own shadowy sector within it.
At the Factoring 2014 conference in April, the President of Fora Financial is poised to debate the Business Development manager of Credit Cash on the subject of whether or not merchant cash advance transactions are true sales. The truth is that I have seen so many variations of funding contracts out on the street that the merits of that debate may be flawed. No one knows what a merchant cash advance is anymore. It’s a point I argued in You Can’t Ask How Big it Is Without Defining What it is in January’s issue of DailyFunder.
The industry is made up of people that deal in daily payments. How these deals are structured vary widely. Indeed there is a growing divide.
Emotions are running high in 2014 and some grievances are practically coming to blows. Stacking is as polarizing a debate as Obamacare. There are folks that believe there is no precedence for dealing with stacking, but stacking is as old as MCA.
Many years ago it was cut and dry. If one company purchased the future revenues of a small business, it was contractually impossible for a second company to buy that same block of future revenues. “How could someone else buy what has already been sold?” so the argument went…
In 2007-2008, stacking was a merchant problem, whereby small business owners would devise ways to get double or triple funded in a very short amount of time so that each company didn’t know about the other until long after the money had been wired. Much of the arguments in favor of stacking back then came from the merchants themselves who felt that MCA contracts bordered on being unlawfully restrictive because it prevented them from obtaining virtually any outside financing unless the MCA was satisfied in full. Without the capital to satisfy their entire outstanding MCA balance, they were locked into renewing with the same company indefinitely with little leverage to negotiate future terms, so the argument went…
Today, it’s the funding companies that bear the brunt of criticism from their peers for stacking, mainly because they do it willingly and are not being deceived by merchants. It is perceived as a funder problem.
In March of 2008 (a full 6 years ago), the Electronic Transactions Association (ETA) established the following guidelines on the issue in their MCA white paper:
In order to effectively manage risk and prevent a merchant from becoming over-extended, merchants should not knowingly be allowed to “stack” advances (obtaining an additional advance when an outstanding balance on a previous advance exists). In the event additional advances are sought, the original advance should be paid off directly to the previous Merchant Cash Advance Company [MCAC] by the new MCAC (to ensure that the merchant does not retain funds due to the previous MCAC) with a portion of the proceeds given on the current advance.
The ETA calls for many common sense standards such as fair retrieval rates, sound underwriting, and legal collections practices. The advice is timeless and I suggest everyone read it. The industry might be growing apart but many of the fundamentals are the same.
Still, with the new crowd of near-anonymous funders, it is impossible to know what everyone’s intentions are. Given the low barriers to entry, there’s also the question as to whether or not the newcomers are legally prepared to book such deals. The industry is fraught with risks and always has been.
I just hope that as the divide grows, we are all united by a common goal, acting in the best interest of small businesses.
How to Value a Merchant Cash Advance Company (or Alternative Lender)
February 9, 2014If you’re at all interested in the future of the merchant cash advance industry, you need to read Wall Street Evaluates Merchant Cash Advance in the first issue of DailyFunder. It offers a fresh perspective through the eyes of financiers outside the industry looking in.
Names include:
- Jason Gurandiano, Managing Director in Deutsche Bank’s Financial Technology Group
- David Cox, Managing Director at Evercore Partners
- Thomas McGovern, Vice President at Cypress Associates
- Steven Mandis, adjunct professor at Columbia Business School.
The article is relatively broad but it communicates some very important points:
1. Some players in the space exist as lifestyle businesses. They’re not scalable, their success is largely attributed to what the owner does for it, and company’s long term vision is to basically make sure the owner takes home a nice paycheck.
2. Some of the big players in the space are on similar growth trajectories. Nothing differentiates each of them from the pack, and none of them really have an advantage over the other.
3. EBITDA is a bad valuation measure and growth is a good one.
On point #1, a lifestyle business is no good to a professional investor in this space. Aside from the success usually being owner-dependent, one question an investor is certain to ask a prospect is, “If I gave you $100 million today, what would you do with it?” There are many wrong answers to that question. If you said solicit more ISOs, buy more leads, or hire more sales people, they’re going to wonder why you haven’t done those things already.
On the same token, those answers would communicate that you’re going to do the exact same thing you’re already doing. It’s a mistake to think that scaling in such a manner will keep the original margins intact. It also does nothing to protect the company against change or enable it to grow exponentially.
On point #2, it’s great to be big, established, and growing at a moderate pace, but what good is that to an investor looking to double, triple, or quadruple their money? And who’s to say that a moderate growth strategy will continue as it has in the past?
Many many many (did I say many yet?) people have come into this space with visions of grandeur, to be bigger than CAN Capital in less than 24 months. What do their plans usually consist of? Pay higher than average commissions and fund deals they shouldn’t be funding. To date, none of those companies are bigger than CAN Capital and some of them are out of business. A growth plan can’t consist of funding deals you don’t want to and paying commissions you can’t afford. That’s called a suicide mission and it’s very effective.
Some big funding companies may appear sustainable on the outside but they’re woefully fragile on the inside. Jason Gurandiano said it best with this quote, “The general knock on merchant cash advance has been that they are an ISO-centric model.” I’m not discounting the value of ISOs in this business. To some extent they rule the roost, and that’s the problem in the eyes of investors. Many merchant cash advance companies rely on a handful of symbiotic relationships. The ISO relies on the funding company for commissions and the funding company relies on the ISO for deals. But what happens if:
- The ISO is enticed with higher commissions or better service with somebody else
- The ISO’s deal flow slumps
- The ISO goes out of business
- The ISO uses unscrupulous sales practices when selling the funding company’s product
- The ISO uses their relationship as leverage on the funding company to make bad decisions
- The funding company needs to reduce commissions but the ISO can’t sustain it
An ISO-dependent merchant cash advance company doesn’t have much control over growth. Believe me, I’ve been on those phone calls where the ISO is asked to send more business. But what happens if they have no more to send? Or what if they would just rather do most of their business elsewhere?
Again, there is absolutely nothing wrong with a purely ISO-centric model in general, but it is much less attractive to investors looking to do a deal in this industry and that’s the theme of this post.
Point #3 is unique because it addresses the how to value a company once you’ve found one worth investing in. Earnings Before Interest Taxes Depreciation and Amortization (EBITDA) is not a viable valuation formula here as it doesn’t make sense to measure the worth of a company dependent on expensive debt by stripping away the cost of that debt.
According to Aswath Damodaran, debt to a financial service company should be treated like a raw material. In his 2009 paper, Valuing Financial Services Firms, he states, “debt is to a bank what steel is to a manufacturing company, something to be molded into other products which can then be sold at a higher price and yield a profit.” It is a perfect analogy for a merchant cash advance company.
Damodaran’s analysis covers a range of situations but I find an Asset Based Valuation intriguing. It states, “How would you value the loan portfolio of a bank? One approach would be to estimate the price at which the loan portfolio can be sold to another financial service firm,” There isn’t a lot of precedent for that in this industry unfortunately. Damodaran continues though with, “but the better approach is to value it based upon the expected cash flows.” For certain, one would have to take into account the renewal rate, renewal commissions, the average recovery timeframe, and the default rate.
If you bought $100 million in RTR today, how much would you get back 1 year from now or 2 years from now? This number is going to differ from company to company.
An Asset Based Valuation might be in order for a funding company that is winding down and shedding its existing portfolio, but it’s not appropriate for one with growth. One should assume that they’re buying a growing business when investing in a merchant cash advance company, not a packaged portfolio.
One question an investor might ask is, “what am I buying?” The average merchant cash advance company can be perceived as nothing more than a vehicle to maximize the spread between revenue and borrowing costs. They’re not really businesses in the traditional sense, more like arbitrageurs. They buy leads and/or they pay commissions, there are some fixed costs, but there’s not a whole lot more to it. There are virtually no barriers to entry and anybody can replicate the model. So you invest in the people who are doing it currently and their system (assuming it’s working so far). The value of that might only be equivalent to 1x – 4x annual profit. Why pay more when competition can drag margins down, regulations could disrupt the space in the future, or the investor could just as easily start their own company with the funds they have instead?
With that said, the average merchant cash advance company is more attractive to a lender than an equity investor. Additionally, they can also offer a nice monetary return by allowing people to participate in the funding of individual deals. Both are indeed what many investors choose to do, either lend money to these companies or syndicate. Why buy the cow when you can get the milk for free?
Merchant Cash Advance companies that make the headlines with big equity investments are not average. They create value, rather than just engage in arbitrage. They’re building something, changing something, disrupting something. They don’t profit off spreads in the market, they create the market and dominate it. Today this typically happens through technology, and not just any technology, but technology that leads to substantial future earnings. There’s a difference between spending a million dollars on a platform to make things more efficient and spending a million dollars on a platform that causes earnings to increase by 1,000%. Too many companies view technological investments in the former sense, a cost that eats into the spread instead of one that can blow the roof off of it.
Investors are looking for companies that plan to soar from Point A to Z, not ones that are moseying along from A to B.
RapidAdvance was said to have gotten an Enterprise Valuation in excess of $100 million when being acquired by Rockbridge Growth Equity. For the most part that number reflects Total Debt + Total Equity – Cash. When you buy a company, you’re buying their debts as well. 90% of their enterprise value could potentially have been the value of their outstanding debts. Of course I doubt it was, but it should put their eye opening valuation into perspective.
Contrast the RapidAdvance deal with the most recent valuation of Lending Club at $2.3 billion. Lending Club earns substantially lower returns per deal but they have an engine for growth that is virtually unmatched. In the month of August 2012, they booked $70 million in loans. In January of 2014, they booked $258 million. That’s 3.7x the monthly volume they were doing less than 18 months ago. That’s what an investor calls an opportunity.
How do you value a merchant cash advance company? There’s no easy way to do it and it largely depends on whether or not they’re an arbitrage shop chugging along or one creating substantial value.
There’s plenty of free milk out there. Why would someone pay top dollar for your cow?
– Merchant Processing Resource
Meet the New UCCs
January 27, 2014
For all the small businesses that have gotten funded over the last few years, it’s been said that merchant cash advance companies and their lending counterparts have only filed UCCs against 50,000 unique merchants (not saying that’s correct). It’s an impossibly small number but those that have been in the industry a long time know that deals get recycled again and again. Some merchants have been using this product for a decade now. They jump from funder to funder or they stay with one for a long stretch until one doesn’t want to do business with the other anymore. I’ve seen merchants with a UCC history so long and so chronologically perfect that it’s like reading the book of Genesis. AdvanceMe begat funder B who funded the merchant for 365 days and begat funder C who begat funder D who put the merchant on a starter and begat a 2nd location with funder E, who begat 3 more funders each offering the merchant a 6 month program, Amen. And now they’re applying again still in 2014. Don’t get me wrong, it’s great that businesses have been able to put outside capital to use again and again, but it couldn’t hurt to have some fresh faces.
The market is saturated, the old school UCC market anyway. Businesses that have used a cash advance historically can potentially get up to 1,000 calls a year by UCC poachers trying to convince them to switch, stack, or do something else. It makes a lot of companies not want to file a UCC, and many don’t or they mask their filing name because of it.
Other companies in the greater alternative lending space would say, “A UCC? Why would we file that?” In the case of purchasing future revenues, it makes sense to put a public claim on assets purchased. Future revenues are an indeed an asset. But to an unsecured creditor, there are no claims to assets. So when I spotted Lending Club in the wild funding a business, I couldn’t help but check to see if they filed a UCC-1. They didn’t and they don’t. Unsecured business credit cards don’t file them either. I don’t think any unsecured creditor can.
With no UCC-1 on record, is merchant cash advance’s newest competitor invisible? Not quite. Each loan serviced on Lending Club’s platform is registered as a security with the SEC. Each deal has a prospectus and investors rather than “syndicates” can choose to participate in the loan based on limited information provided about the borrower. These loans only range up to $35,000.
Since each loan is registered with the SEC, all of that information is public. But there’s one catch, Lending Club’s borrowers are anonymous. As an existing investor on Lending Club’s platform, I can only see the borrower’s credit score range, location, and other basics. It’s like browsing leads on iBank and deciding which ones you want to buy but instead of paying to get their personal information so you can contact them and collect docs to underwrite, you have to fund them right then and there based on what you see. You never ever get to find out who they are or see their docs.
Here’s a screenshot of a real live business loan listing that any of their registered investors can participate in:
28 people are already participating in this loan. I think the smallest you can contribute is $25. Each loan gets filed with the SEC, which anyone can look up using Edgar.
But what you and I can see on the site seems to be all you can see in the SEC filings as well. Business location, credit, loan terms, and date filed, but nothing that identifies them personally. Unless of course you are smarter than I am and find a way.
Lending Club has made $3.5 billion in consumer loans in just a few short years. I have no doubt that they will be a billion dollar player in the business loan market as well. It sure would be nice to find out more about who they’re funding,especially since their cap is $35,000. There’s a good chance they’ll be underserving their clients’ capital needs.
The guys who figured out reverse UCC searching in MCA early made a fortune. Could reverse SEC filings be the next gold rush?
