Loans
The Deal
May 25, 2014When times are tough, small businesses take chances. Last year, a family run business in Cohasset, MA made a snap decision and agreed to a $75,000 loan with infinity percent interest, literally. The principal was completely repaid in just 74 days but as per the contract, they still had to make fixed interest payments for as long as the business was open.
It wasn’t necessarily a good deal. Heck, some might think it was a really bad deal, but they got the cash when they needed it. The perpetual fixed payments kicked in after the principal was repaid because the lender structured them as royalty fees. A normal merchant cash advance will take a percentage of a merchant’s sales up until a predetermined amount has been satisfied, but this deal required a percentage forever. Is Wall Street running amok yet again? Shouldn’t people be monitoring stuff like this?
As it would turn out, about 6.5 million people were witness to this transaction. More than half of those people, most of whom are hard-working American families, cheered the business owner on. That’s because this deal had nothing to do with Wall Street and did not involve a commercial loan broker.
The business is named Wicked Good Cupcakes and it’s a deal they made on Shark Tank, a hit TV show on ABC. Kevin O’Leary loaned them $75,000 and took a percentage of every sale until he was repaid just 2.5 months later. Since then he is taking a permanent royalty of 45 cents per cupcake sold.
As quoted in the Boston Business Journal
“The royalty deal has worked great for us,” said Tracey Noonan, the CEO of the company.
Many people told her immediately following the deal that she was stupid. But today, Wicked Good Cupcakes is doing better than ever.
O’Leary, whom the business owners called an “angel in disguise” has referred to the deal as one of the most phenomenal ever made on the show. Wicked Good Cupcakes is actually on pace to do $3 million in revenue in 2014.
While it’s true that part of their success is due to the appearance on the show, nowhere does it say that entrepreneurs have to agree to take a deal if offered one. That means the owners could have walked away from O’Leary’s offer and still experienced the same post-show hysteria of celebrity. But they needed the money… and there was an offer on the table. It wasn’t the best deal, but it was A deal.
And that’s the nature of business. Everything is about circumstances. You could be flush with cash or in a pinch, growing fast or playing defense. All the while opportunities and obstacles approach from every turn.
Unlike consumers who are afforded protections from making decisions that might not be in their best interest, small businesses are free to pursue whatever strategy they want. The best part about capitalism is that you’re the master of your own destiny.
The terms O’Leary offered to Wicked Good Cupcakes were not unique. Just recently in the 12th episode of Season 5, he offered a $100,000 loan to Tipsy Elves that once repaid, would still require payments in perpetuity in the form of a royalty fee for every sale. That’s an equivalent APR of infinity. In the end, they turned it down and went with Robert Herjavec’s equity offer instead.
Many viewers have taken to twitter to share their doubts about the viability of the Tipsy Elves business model, which is selling ugly Christmas sweaters. That healthy dose of skepticism is something alternative lenders are no strangers to, and as such they tend to price their deals accordingly.
Even deal making that is done on TV in front of millions of witnesses can go sour. Just ask Marcus Lemonis, the star of the TV show The Profit, who recently made a deal with a business in my own backyard, A. Stein Meat Products in Brooklyn, NY. After learning the business was on the brink of insolvency, Lemonis offered them a cash lifeline in exchange for buying their Brooklyn Burger brand at a bargain price of $190,000. In any other circumstances, that deal might not have happened.
Lemonis expeditiously wired them the cash, but never got what he paid for in return. Mora and Buxbaum, the owners, claim the funds were a loan but they have never made a payment. Defaults like these happen every day, especially in alternative business lending.
Hated to do it but here's the update on stein meats and Brooklyn burger. I tried not to but was ignored for 90 days. http://t.co/4oyYOiXK68
— Marcus Lemonis (@marcuslemonis) May 16, 2014
The entrepreneur applies for a business loan, the loan gets made, and the borrower quickly defaults. The result is that the price goes up for the next guy. That’s the risk part that lenders always talk about, the odds that they’re not going to get paid back. If every business repaid their loans, the average cost of financing in alternative business lending would probably be about 6% a year, around what an A rated personal loan costs on LendingClub, instead of the high double digit or triple digit rates that exist now.
Even Kevin O’Leary isn’t taking any chances, hence he protects himself by charging infinity percent interest, and America thanks him every Friday night for blessing entrepreneurs with an opportunity. It’s not the best deal, but it’s A deal.
Small business owners are sophisticated enough to make tough decisions all on their own. That’s the reason we can put them in the public eye, in front of more than 6 million people who either cheer for their success or literally cry out for their demise. These entrepreneurs don’t go on Rainbow & Unicorn Tank, they go on Shark Tank. Sometimes the entrepreneurs walk away with a partner, sometimes they get a loan with infinity percent interest. In the end, it’s their choice, a choice that 36,000 small businesses hoped they would have in 2012. That’s how many applied to be on the show that year.
Business is business and a deal’s a deal. The ball’s always in your court…
Quotes from Kevin O’Leary
Business is war. I go out there, I want to kill the competitors. I want to make their lives miserable. I want to steal their market share. I want them to fear me and I want everyone on my team thinking we’re going to win.
Here’s how I think of my money – as soldiers – I send them out to war everyday. I want them to take prisoners and come home, so there’s more of them.
You may lose your wife, you may lose your dog, your mother may hate you. None of those things matter. What matters is that you achieve success and become free. Then you can do whatever you like.
I’m not a tough guy. I’m just delivering the truth and only the truth and if you can’t deal with it, too bad.
Nobody forces you to work at Wal-Mart. Start your own business! Sell something to Wal-Mart!
Don’t cry about money, it never cries for you.
The only reason to do business is to make money; that’s the only reason for doing business.
Money has no grey areas. You either make it or you lose it.
Working 24 hours a day isn’t enough anymore. You have to be willing to sacrifice everything to be successful, including your personal life, your family life, maybe more. If people think it’s any less, they’re wrong, and they will fail.
I have met many entrepreneurs who have the passion and even the work ethic to succeed – but who are so obsessed with an idea that they don’t see its obvious flaws. Think about that. If you can’t even acknowledge your failures, how can you cut the rope and move on?
I don’t mind rude people. I want people that I can make money with, so if their executional abilities are good, and they’re arrogant and rude, I don’t care.
Can you handle it?
The Real Impact on Small Business
May 22, 2014
It’s not easy being in the lending business. Just talking about money can make people uncomfortable. Bringing up how much money you have, don’t have, or wish you had is like bringing up politics at Thanksgiving dinner. It’s taboo in this society. It’s even rude to ask somebody how much they make a year. That’s one of two reasons why being a lender or loan broker is so difficult, you’re forced to dive head first into emotionally charged waters.
The second reason is telling an applicant ‘no’. It feels personal even if it’s not. “It’s just business,” the bearer of bad news will say, but it never feels that way. I know that firsthand through my experience as both a broker and an underwriter. Rejection is a painful experience for an applicant no matter how professional they are.
But sometimes you get to tell an applicant ‘yes’ and that can be an emotionally moving experience as well. Looking back, the only applicants I ever heard cry were the ones that got approved. Some of those approvals were expensive but they were given an opportunity in a world where up until that point, no one was willing to give them any opportunity at all. They were the forgotten businesses of America.
PayPal’s VP of SMB Lending recently said that he feels “blessed to be serving this higher need.” Blessed was an interesting word choice. Being able to support small businesses doesn’t just make him feel happy or hopeful or satisfied, it makes him feel blessed.
What is the real impact that alternative financing companies have on small businesses? Thanks to the funding companies who took the time to find out. Today, we can see for ourselves:
Above is just a small handful of the testimonials you can find on the websites of CAN Capital, Kabbage, RapidAdvance, Fora Financial, and Merchant Cash and Capital. Real businesses, real stories, real impact.
And there you have it…
Big Deal #2 Struck in MCA Industry
May 21, 2014
Another day, another capital raise for some company or other involved in alternative business lending. That’s the way it is these days, but the news about the American Finance Solutions (AFS)/CapFin Partners deal announced on Wednesday is markedly different.
It’s the Rockbridge Growth Equity (RGE)/RapidAdvance deal all over again, the welcoming of a major MCA company into a wider lending family. Though the release does not specify the amount of equity CapFin Partners acquired in the transaction, nor any valuation figure, the headline literally says it’s significant.
CapFin Partners is also a significant investor in Contintental Business Credit (CBC), an asset-based lender that’s been in operation since 1989. The CapFin deal will bring AFS and CBC together strategically. As said in the release, “the union of these two financial lending companies will widen the portfolio of services offered, which now include merchant cash advances, factoring and asset based loans.”
The design is strikingly similar to the RapidAdvance/RGE deal.
AFS/CapFin
The investment and close relationship with CBC will provide operational expertise, a diversified client base and a larger pool of capital for funding customers
RapidAdvance/RGE
By aligning with Rockbridge, we will leverage our new relationship with its portfolio of companies, bringing best practices and expertise to nearly every aspect of our business.
Both funders were founded in the pre-recession era, giving investors a chance to review performance and returns both through good times and bad.
Two years ago I predicted that “MCA will simply assimilate into other financial products.” As is the case with these two deals, it’s already becoming just one product out of many offered by financial institutions. Elsewhere in the industry, MCA companies are offering true loans to stay competitive and some funders are passing on MCA completely to focus just on traditional business loans with terms up to 10 years and traditional interest rates.
The AFS deal proved yet again though that there is a market to buy (or buy into) established reputable merchant cash advance companies. That should give hope to new funders that are trying to formulate a long-term exit strategy.
Congratulations to American Finance Solutions.
Throw Out the 5 Cs?
May 19, 2014
The 5 C’s of lending? “Throw that book out” says Darrell Esch, VP of SMB Lending for Paypal. At the Federal Reserve Bank’s New York Small Business Summit last week, critics hammered away at the high rates being charged by some alternative business lenders.
In the first video below, PayPal’s small business loan program (which is a textbook merchant cash advance) is characterized as too expensive and not transparent.
APRs? Business owners don’t think that way, says Esch:
The transparency debate is a hot topic in alternative business lending. Merchant cash advance industry hater Ami Kassar pressed me on the transparency issue just last week over twitter, to which I conceded transactions structured as loans should clearly state an APR, even if that metric is not the most relevant or helpful.
What confuses me is Kassar’s belief that an APR represents the “real cost.” It is nothing more than an annualized metric. Many people understand APRs, but many do not. My point is that an APR is a mathematical formula that may or may not be relevant and may or may not be understood.
In fact, Bankrate.com’s loan calculator helps borrowers ascertain the true cost of their loans by helping them calculate what they really need to know, the total dollar amount to be repaid. And with that reality, alternative business lenders and their merchant cash advance counterparts are speaking the language of their clientele by making the dollar for dollar cost as transparent as possible.
After all, business owners regularly borrow at rates that exceed 3,500% APR via overdrafts.
Kassar claims that more than 50% of borrowers substitute MCAs for something else once they’ve learned the “real cost” of such financing. This implies that all of his clients have better options, a circumstance which generally isn’t true of small businesses that use merchant cash advances or high cost business loans. Deficiencies in Credit Score, Capital, or Collateral tend to disqualify them in the real world.
This debate leads us down the same road every time. Should businesses rejected by low rate lenders be banned from accessing credit because the options available to them now are too expensive? “No,” a critic would say. “They should just be charged a lower rate.” But considering the risk, could a lender survive drastic price cuts? With all the competition in today’s market, alternative business lenders have been slashing rates to as low as they can possibly get them… for now.
But to critics like Kassar, things like profitability are an afterthought. What’s profitability got to do with the price of a loan?
@financeguy74 @Reuters What does that have to do with the price of cheese ?
— ami kassar (@akassar) May 15, 2014
I wonder if his clients who have exhausted all their options choose a low rate SBA loan that they can’t get once he has educated them about the high cost of a merchant cash advance. Oh wait…
Esch suggested throwing out the 5 Cs. I don’t think that’s a good idea. It’s leeway that’s needed, not discarding the book altogether. That leeway comes at a cost.
Questioning the costs that alternative business lenders charge is a beautiful example of the free market at work. They’re an easy target for criticism, yet a badly needed component of the American economy. No harm can come from keeping them honest. But as Esch commented on how he feels about what he does, “I feel blessed to be serving this higher need.”
A Look at Data Security
May 17, 2014
In the latest issue of DailyFunder, Cheryl Conner explored data security in the alternative business lending industry. Its basis was rooted in the ETA’s 2008 Merchant Cash Advance White Paper that stated Merchant Cash Advance companies must be PCI compliant.
That white paper was drafted in a different era, particularly when 99% of all transactions required a payment processing split rather than ACH debits. It’s true also that it specified companies “that handle sensitive payment related information”, namely cardholder data as part of its regular business operation.
Credit card processors that engage directly in issuing merchant cash advances are naturally already subject to PCI compliance, but for the funding companies that aren’t in the processing business, they’re basically off the hook. Indeed a spokesperson for the PCI Security Standards Organization informed Conner that “PCI standards apply to payment card data branded by one of the five founding brands, which means any entity that accepts, processes, transmits or stores account data from a PCI branded payment card should be applying PCI DSS for the protection of that data.” She went on to say that PCI DSS doesn’t apply to bank account data.
So while PCI compliance does not have a place in alternative business lending, it raised the question as to whether or not there were other privacy regulations that do, particularly the Gramm-Leach-Bliley Act (“GLBA”) of 1999. According to the FTC, the GLBA “requires financial institutions – companies that offer consumers financial products or services like loans, financial or investment advice, or insurance – to explain their information-sharing practices to their customers and to safeguard sensitive data.” The law is broad enough to cover any financial institution that is engaging in activities that are financial in nature.
The GLBA imposes a host of requirements on these financial institutions, including the need to establish an information security program to protect customer information.
But as is the recurring theme in alternative business lending, such rules do not govern institutions that engage in business-to-business transactions. On the FTC’s website, it states:
Under the Rule, a “consumer” is someone who obtains or has obtained a financial product or service from a financial institution that is to be used primarily for personal, family, or household purposes, or that person’s legal representative. The term “consumer” does not apply to commercial clients, like sole proprietorships. Therefore, where your client is not an individual, or is an individual seeking your product or service for a business purpose, the Privacy Rule does not apply to you.
Similarly, I’ve been told that the Consumer Financial Protection Bureau does not have jurisdiction over business-to-business transactions, even if one party is a sole proprietor. In a business-to-consumer transaction, there’s an assumption that the consumer may not be as sophisticated as the business and thus deserving of protections. In the course of two businesses engaging in business, it would be extremely difficult to draft rules that only protected one side as both are free market equals.
While there may not necessarily be any laws that regulate security or privacy in commercial transactions, there are plenty of benefits to following GBLA-like guidelines. For one, it could be used to build goodwill with clients. Additionally, security and privacy are sure to be examined during the course of a due diligence audit by potential investors. In this day and age, a breach of privacy or security could permanently disrupt a business’s ability to maintain the good faith of the public.
Do you feel that alternative business lenders are doing a good job?
—-
Note: I am not a lawyer and this post should not be considered legal advice.
Would an APR Help?
May 14, 2014Merchant cash advance industry hater Ami Kassar added to his collection of rants today in the Wall Street Journal by writing about the True Costs of Cash-Advance Loans.
Bloomberg BusinessWeek writer Pat Clark, knowing full well that Kassar and I have sparred online, tweeted:
curious what @financeguy74 thinks RT @akassar: The true cost of cash advance loans: my latest @wsj column http://t.co/BjyqMgM8Uz
— Patrick Clark (@pat_clark) May 14, 2014
My response:
Do I think merchant cash advances when structured as loans should include a prominently displayed APR on the contract?: Yes, though I believe this is less helpful than the dollar for dollar cost explanations that are already presented. But in the name of maximum transparency, it would be a good thing to have on there.
Do I think less business owners would use such loans if the APR was prominently displayed?: No
If DealStruck can make their model work, then great. What I want to know is, what happens to the businesses they won’t approve?
Alternative Lending: Big Government and Big Data
May 7, 2014– Professor Michael Barr at LendIt 2014
One of the clear themes of the LendIt 2014 conference was that borrowers are willing to pay extra for speed and convenience. Regulators have taken note of this trend but they’re still supportive of the alternative lending phenomenon anyway. Truth be told, the government is acting like a weight has been lifted off its shoulders. Ever since the 2008 financial crisis, the feds have prodded banks to lend more, but they’ve barely budged, especially with small businesses. Non-bank lenders have relieved them of the stress and all they need do now is make sure everybody plays nice.
Professor Michael Barr, a former US Treasury official, key architect of the Dodd-Frank Act, and Rhodes Scholar, believes the best way forward is to empower consumers. That’s something lenders can accomplish through education and transparency. On transparency, he cited many of the commendable practices that credit card companies and mortgage companies have implemented, but did not fail to note that these were forcibly instituted through regulation (Hint hint…).
When a LendIt attendee asked Barr to name someone in the alternative lending industry that is a great role model for transparency, Barr answered by saying, “I haven’t seen anyone in the industry doing things the way I would do them in regards to education and disclosure.” On the path towards transparency, “the potential is not yet realized,” he added.
While it sounded as if he favored eventual regulation of alternative lending, he offered all in attendance advice to prevent it. “Take the high road to prevent regulatory interest,” he said.
Barr’s sobering presentation also covered the Consumer Financial Protection Bureau (CFPB) and the role they might play in alternative lending, if any. Payday lenders and debt collectors were their primary supervisory targets he said, but added the “the CFPB has the flexibility in the marketplace to address problems before they occur.” That flexibility essentially gives them jurisdiction over whatever they decide they want to be in their jurisdiction.
Sophie Raseman, the Director of Smart Disclosure in the U.S. Treasury Department’s Office of Consumer Policy appealed to the industry in a different manner. “Small businesses are at the heart of the economy. We want to serve you [alternative lenders] better so that we can better serve them,” Raseman pleaded. As part of that, she came bearing gifts, a reminder that the federal government had loads of data available via APIs at http://finance.data.gov. The government wants to make sure we have access to as many tools as possible, most likely to help drive borrowing costs down. If you need to verify someone’s income, Raseman recommended the IRS’s Income Verification Express Service.
The Income Verification Express Service program is used by mortgage lenders and others within the financial community to confirm the income of a borrower during the processing of a loan application. The IRS provides return transcript, W-2 transcript and 1099 transcript information generally within 2 business days (business day equals 6 a.m. to 2 p.m. local IVES site time) to a third party with the consent of the taxpayer.
The irony with this service is the two business day timeline, though I haven’t confirmed if that’s still the case. Delays and archaic data aggregation methods are the exact things alternative lenders are trying to overcome. Kabbage comes to mind as the length of time it takes for them to go from application to funding can be as quick as 7 minutes, a time frame I found to be reality after watching the demonstration by Kabbage’s COO, Kathryn Petralia.
Kababge’s blazing speed is made possible by access to big data, which made Petralia an excellent choice to have on the Big Data Credit Decisioning Panel. She was joined by Noah Breslow of OnDeck Capital, Jeff Stewart of Lenddo, and Paul Gu of Upstart.
Stewart, whose company lends internationally presented the idea of mining not just data on social networks, but the photographs on them. One possibility was measuring whether or not borrowers appeared in photographs with other borrowers known to be bad, or whether or not they hung out with undesirables such as ex-convicts. He was a big believer in association risk, speculating that friends of bad borrowers also made them more likely to be bad borrowers themselves.
Breslow of course said you have to be careful with the noise of social media as there can be a lot of false signals. Does that mean there are big data problems then? Upstart’s Paul Gu said, “we have small data problems” in reference to why there seems to be so much trouble evaluating applicants that have little to no credit history. Gu believes that basic information such as where a borrower went to college, their major, and their grades can be used as an accurate predictor of payment performance and his company has acquired the data to back that up.
Somewhere along in the discussion though the meaning of automation got twisted. OnDeck for instance has an automated process, yet humans play a role in 30% of the loan decision making. Does that mean they are not actually automated? Breslow clarified that aggregating data from many different sources using APIs and computers was automation and that there was still a role for humans. The goal is to make sure that humans aren’t doing the same things that the computers are doing.
“The world’s greatest chess human can beat the world’s greatest chess algorithm,” said Lenddo’s Stewart. “Humans should be pulling what the algorithms can’t think of,” added Breslow. He presented an example of an applicant satisfying all of an algorithm’s criteria but sending up a red flag at the human level. “Why would the owner of a New York restaurant live in California?” Breslow asked. That’s something an algorithm might get confused about. It might mean nothing or it might mean something.
“Algorithms are probabilistic,” Stewart reminded the audience. They spell out the likelihood of repayment, they don’t guarantee it.
For Kabbage, algorithms and automation have been instrumental in allowing them to scale. “I don’t need to hire a lot more people to serve a lot more customers,” Petralia explained.
“Let the data speak for itself,” Breslow proclaimed. And there is a lot of statistically interesting data. “People with middle names perform better than people without them,” added Breslow.
For Gu, borrowers with degrees in Science, Technology, Engineering, and Mathematics fare better than their academic peers, though he wouldn’t reveal which major is #1. That information, while probably available to OnDeck, likely plays little or no role. “There is a lot more data to analyze on the business side than the consumer side which is why [things like] the social graph is a little less relevant,” Breslow said.
In the end, lenders don’t need to go on a wild data goose chase to learn all about their prospective clients. Kabbage applicants for instance are asked to provide their online banking credentials in the very first step of the applications. “A lot of people would be surprised as to the amount of data borrowers are willing to share,” Petralia proclaimed. Indeed, many alternative business lenders and merchant cash advance companies are analyzing historical cash flow activity using third party aggregating services like Yodlee, something that requires the client’s credentials.
During Kabbage’s earlier demonstration, some members in the audience worried that factors such as deposit activity could be gamed. Petralia assured them that their algorithm was sophisticated enough to detect manipulation and at the same time explained that they analyzed far more than just deposit and balance history.
Perhaps all this technology though has gone overboard. Is it possible to predict performance just based on what the applicant says? Believe it or not, “the language someone uses is an indicator of default probability,” Stewart said. But even that kind of detection has become automated. “Lenddo uses semantic analysis. People tend to use different words when they’re desperate.”
Who knows, a year from now getting a loan might be as easy as picking up your phone and saying, “Siri, send money.” Just make sure to delete all the photos of you hanging out with criminals off your phone first. A lender might use them against you.
