merchant financing

What Would Barney Frank Say?

July 16, 2014
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While crowd funders navigate the JOBS Act and a possible revision to what constitutes an accredited investor, non-bank business lenders are raising eyebrows with sky high interest rates. Annual Percentage Rates (APRs) are reaching into the triple digits and critics are reaching for their megaphones to say something about it.

Unfortunately APRs don’t spell out the true dollar for dollar cost, a flaw pointed out by OnDeck Capital CEO Noah Breslow in regards to daily amortizing loans. In the June Access to Capital Small Business Panel, Breslow explained that a 60% APR loan could actually only cost 15% on a dollar for dollar basis over 6 months simply because of daily amortizing.

Still, the figures make for enticing headlines and it is to be expected that they will come under greater public scrutiny as time goes on.

In an opportunity I got to speak one-on-one with former Congressman Barney Frank in June, he offered some pretty interesting thoughts on the governance of business to business transactions.

Former Congressman Barney FrankFrank, who was the key author of the Dodd-Frank Wall Street Reform and Consumer Protection Act that was signed into law in 2010, was a longtime champion of consumer financial protections. But he sings a different tune when it’s all about business. Many people may not realize that he opposed the Durbin Amendment of the Dodd-Frank Act, the addition that placed caps and restrictions on debit card interchange fees. Federal restrictions on how much a business can charge another business? Not his thing…

Unsurprisingly then when I asked him if he’d be in favor of a federal cap on business loan interest rates, he sternly replied, “no.” He went on to say that he supported transparency in business loan transactions, such that the borrower should be easily able to identify the terms, but that the premise behind consumer loan protections was that consumers were less sophisticated.

Curiously, there are a few states that impose caps on commercial interest rates, making the regional landscape for high rate business lenders a little bit tricky. In a recent publication by financial law firm Hudson Cook, they spelled out federal laws that already govern business loans.

To date there has been no legislative activity related to merchant cash advance or alternative business lenders. If such discussion did arise though, it’s ironic to say that one of the most liberal congressmen of the last decade, a man who wrecked Wall Street, would stand to make an excellent champion of the alternative business lending cause.

I never thought I’d say this, but too bad the guy retired.

Access to Capital – A Dose of Reality

June 15, 2014
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So much for a lack of transparency… While sitting directly next to Maria Contreras-Sweet, the head of the Small Business Administration, OnDeck Capital’s CEO corrected U.S. Senator Cory Booker’s comments about the APR of their loans. High teens? Not so, said Noah Breslow who explained their average 6 month loan has an APR of 60% even while costing only 15 cents on the dollar.

Why is access to capital so expensive? Rob Frohwein, the CEO of Kabbage said that up until recently his company was borrowing funds at a net rate of more than 20% APR. In order to turn a profit, they had to lend at a rate much higher than that.

The Access to Capital small business panel included:
Maria Contreras-Sweet – Head of the U.S. Small Business Administration
Noah Breslow – CEO, OnDeck Capital
Rohit Arora – CEO, Biz2Credit
David Nayor – CEO, BoeFly
Rob Frohwein – CEO, Kabbage
Paul Quintero – CEO, Accion East
Rohan Matthew – CEO, Intersect Fund
Jonny Price – Senior Director, Kiva Zip
Jeff Bogan – SVP, LendingClub
Steve Allocca – Global Head of Credit, PayPal
Jay Savulich – Managing Director of Programs, Rising Tide Capital

The Real Impact on Small Business

May 22, 2014
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the truthIt’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
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big dealAnother 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.

The investment and close relationship with CBC will provide operational expertise, a diversified client base and a larger pool of capital for funding customers

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.

Would an APR Help?

May 14, 2014
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Merchant 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:

merchant cash advance APRMy 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?

Securitization Begins in Alternative Business Lending

May 1, 2014
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ondeck capital securitizationIt’s official, alternative business loans can now be pooled up and sold off to investors. On Wednesday, OnDeck Capital announced a $175 million transaction made possible by issuing fixed rate notes backed by their loans.

Their Class A notes were rated BBB by DBRS while the Class B notes received a BB.

According to DBRS, BBB grade are of “Adequate credit quality. The capacity for the payment of financial obligations is considered acceptable. May be vulnerable to future events.

BB grade are “Speculative, non-investment grade quality. The capacity for the payment of financial obligations is uncertain. Vulnerable to future events.

While it’s popular to refer to alternative business lending as highly speculative and fraught with risk, it’s notable that a highly respected ratings agency would not officially bestow OnDeck’s loans with a label to match that. A single B would’ve signified a highly speculative investment and CCC, CC, and C would signal danger. But OnDeck’s Class A notes are up to snuff as investment-grade level material.

OnDeck has been dogged by critics over the last few years, most of whom are their competitors. The argument goes that their practice of undercutting the rest of the industry on rates is doomed to fail. Those theories are bolstered by the very public knowledge that they have yet to turn a profit. Back in March, CEO Noah Breslow was quoted in the Wall Street Journal as saying they were “imminently profitable“, an optimistic yet openly ambiguous indicator of where they stand. Since they are not a publicly traded company, they are not required to disclose their financial statements.

While DBRS serves to validate OnDeck’s policies and approach, word that they had achieved “investment-grade” status did little to pacify their critics. Yet, for a company that places a remarkably heavier focus on credit modeling and technology infrastructure than the majority of their peers, there is always the possibility that OnDeck is actually as smart as they want everyone to believe. Four months ago it was reported that “fifty-six of their 225 employees have backgrounds in math, statistics, computer science, or engineering.” Contrast that with some of the small and mid-sized players that are largely focused on ISO recruitment and sales.

While I haven’t seen a prospectus in its entirely, I’ve learned there are quite a few ground rules in place for these notes. For one, these loan pools have to be diversified. That means no secretly packaging up all the loans in a risky zip code in Nevada and selling them off as a BBB rated note. There are concentration limits in place to reduce risk. Below are the maximum thresholds allowed in a pool based on their location:

Obligor Located in California 20.0%
Obligor Located in Florida 15.0%
Obligor Located in New York 15.0%
Obligor Located in Texas 15.0%
Obligor Located in Any Other State 10.0%

loan applicationIf a concentration limit is exceeded, the issuer is required to maintain additional credit enhancement. I’m not surprised at all that California, Florida, New York, and Texas are singled out. In addition to being among the most populous in the country, they are the heaviest users of alternative business loans and merchant cash advances. There’s also the theory that Floridians are statistically the least likely to repay a loan, as openly discussed in The Joy of Redlining, a controversial assessment borne out of the peer-to-peer lending crowd.

There are other concentration limits to adhere to such as the OnDeck Score range (not FICO score range), size of the outstanding principal, industry type, and repayment time frame.

Notably, recognition and acceptance of the proprietary OnDeck Score in concentration limits is a major achievement for them. Breslow previously referred to the OnDeck Score as “the Main Street equivalent of FICO” in American Banker.

Additionally, OnDeck’s reliance on ISOs/brokers for originations is shrinking. In 2013, their direct marketing channel accounted for 43% of their deal flow, compared to only 12% back in 2010. This is a step in the right direction for them financially as broker commissions are on the rise. Increasing the direct marketing percentage will serve as a hedge against increasing third party origination costs.

So what’s next?
For now, OnDeck Capital can enjoy the liquidity gained through securitization and focus on more important things like growth and profitability. Profits are a must in the current IPO environment. Payment company Square had their IPO hopes dashed when word of their losses were leaked to the Wall Street Journal. That came as a shock to the general public. Meanwhile everybody already has an idea of where OnDeck stands, sort of. They’re either brilliant or doomed to fail. I’d say an independent assessment that they’re capable of issuing investment grade notes, increases their odds of brilliance.

Whatever your feelings, they have set a powerful precedent for secuitization. As these notes were reportedly oversubscribed, investors will be looking to their competitors for a taste. OnDeck just whet the appetite. Additional securitization in this industry could be right around the corner. One might say it’s… imminent.

What if there were Trigger Leads?

April 27, 2014
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Just recently, a user in DailyFunder’s forum complained that a deal of his had been poached by a competitor. There’s nothing new about that story, but it is what followed that drew interest. He was in the process of renewing his client for additional funds, when out of the blue popped up a competitor that called his client to tell them not to sign the contract they had in their hands until they heard his better offer.

As it was suspiciously timed and curiously specific, he decided to reach out to the alternative lending community for their thoughts. One possible conclusion offered was that the competitor was being fed trigger leads.

Trigger leads?????????????????

Forget UCCs folks. UCCs detail transactions that have already happened and we’ve all seen what they’ve done to the merchant cash advance and alternative business lending industry. Companies are scared to file them now. But what if all of your competitors were notified every time one of your deals was submitted to underwriting? You get the app signed, you submit the file, and the next day 10 companies have called your client to offer them a better deal on funding than whatever terms you were about to offer. What gives?

Popular in the mortgage industry, the credit bureaus can actually sell credit inquiry data to lenders. So imagine every time credit gets pulled on a deal, the merchant’s info is sent out to your competitors for a fee.

Dave Sullivan explains Trigger leads below:

There was no way to tell for sure if that was what happened in this situation, and I’ve yet to hear of trigger leads being used in the alternative business lending industry but if someone was getting them, I’m sure they’d want to keep their source top secret.

Can you imagine what kind of chaos would ensue if this became commonplace in our industry?


Regulatory Paranoia and the Industry Civil War

April 11, 2014
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Stacking is on everyone’s minds in the merchant cash advance (MCA) industry but that war is little more than smoke compared to the fire burning in our own backyard. One of the major topics of debate at Transact 14 has been Operation Choke Point, a federal campaign against banks and payment processors to kill off the payday lending industry and protect consumer bank accounts. Caught in the mix are law abiding financial institutions, some of which if affected, could potentially disrupt the merchant cash advance and alternative lending industries. Both have become heavily dependent on ACH processing. Could their strength become their Achilles heel?

Indeed, there was a rumor circulating around the conference that a popular ACH processor in the MCA industry is no longer accepting new funding companies. I know the name but was not able to confirm it as fact. There is a two-fold threat on the horizon:

1. The probability that ACH processors in this industry are also processing payments for payday lenders or other high risk businesses.

2. The likelihood that a bank or ACH processor would take preemptive action and terminate relationships with merchant cash advance companies and alternative business lenders, not because it’s illegal but as a way to make their books squeaky clean.

The sentiment at the conference however was that MCA providers and alternative business lenders had little need to worry. While Operation Choke Point specifies online lenders, they are narrowly defined as businesses making loans to consumers. MCA and their counterparts do not fall under that scope, even if they themselves lend exclusively online.

Is regulation coming?
There seems to be both a call for and paranoia about regulation, especially in the context of stacking merchant cash advances and daily repayment business loans. On the popular online forum DailyFunder, several opponents of stacking are under the impression that regulators will be busting down doors any day now to put an end to businesses utilizing multiple sources of expensive capital simultaneously. Many insiders who have had their merchants stacked on view the issue as both a legal and a moral one. Opponents get worked up about it for many reasons. They believe any one or multiple of the following:

  • The merchant can’t sell something which has already been contractually sold to another party.
  • That the merchant ends up borrowing and selling their future revenues at their own peril, endangering their cash flow and their business.
  • That the stackers endanger the first lender or funder’s ability to collect.
  • That the merchant taking on stacks won’t be eligible for additional funds with the first company, hurting the retention rate.

Stacking is not illegal, but it may be tortious interference. That allegation is the one that gets thrown around the most, but it’s important to recognize that actual damages are an integral part of any such case. If I stack on your merchant and the deal performs as expected for you, then what damages would you have suffered? But if I stack on your deal and it defaults 3 weeks later, you might be able to allege that I was the cause of it.

Insiders on DailyFunder’s forum that wonder how they might be able to get stacking to stop, only need to follow the example of what a few select funders are already doing, going on the offensive. The first thing one west coast MCA company does when they have a merchant default is find out if there was a stack that came on top of them. If they find out who it was, they send the offending funder a bill for the outstanding balance. That may sound cheesy, but given their industry prowess and litigious nature, they said that some stackers quietly mail them a check, rather than risk things escalating to the next level. The threats only hold weight of course if you’re actually prepared to bring the case to court.

I’ve spoken with dozens of proponents for stacking, many of sound character, high intelligence, and business acumen. They buck the stereotype of stackers as sleazy wall street guys with pinky rings. Few of these proponents believe that future revenue is a precise asset. It’s been said that, “future revenues are unknowable and possibly infinite. A business should be able to sell infinite amounts of these future revenues if there are investors out there that will buy them.” The general consensus on this side of the aisle is that a 2nd position stack, or “seconds” are here to stay. There’s a sense of calm and conviction, as if seconds were a boring subject of little contention. Many are okay with thirds “if the math works” but discomfort sets in on fourths, fifths and beyond. If they believe it’ll be a good investment, they’ll do the deal. They scoff at the notion that they’d willingly chance putting a merchant out of business since that would jeopardize their own investment.

To date, I’ve seen no data to support that stacking causes merchants to go out of business. I would not be surprised if there was a correlation between defaults and stacks, but that would not imply causation. A business that is on its way towards bankruptcy regardless may be able to obtain a few stacks in the process as a last ditch effort to stave it off. When the business finally fails, it may appear to look like the stacks caused it, even if they didn’t.

For those that don’t want to play cat and mouse with threats and lawsuits, there’s a growing call for regulation, both self-regulation and federal. That call feeds off the paranoia that regulators are knocking at the industry’s door already anyway.

In regards to self-regulation, insiders have been looking to the North American Merchant Advance Association (NAMAA) to create rules and become an enforcer. It’s no secret that their members are opponents of stacking, but as a powerful body of industry leaders, they’re up against a threat of their own, antitrust laws. Creating rules and enforcing them could be construed as anti-competitive. In truth, a lot of the MCA industry’s growth over the last 2 years can be attributed to stacking. A private association of the largest players actively working to establish rules to squash the fast growing segment of new entrants could indeed be perceived as anti-competitive.

But that doesn’t mean NAMAA is powerless to promote their views. Following in the footsteps of the Electronic Transactions Association, they could create a set of best practices, host workshops, and offer courses and sessions to train newcomers on these best practices. Such benefits and opportunities are a standard in the payments industry, but nothing like it is available in MCA or alternative business lending.

But is it too late for self regulation?
With all the government enforcement occurring in the rest of the financial sphere, fears of imminent federal involvement in MCA and alternative business lending are not unfounded… or are they?

In the wake of the financial crisis, the Consumer Financial Protection Bureau (CFPB) was formed to protect consumers in financial markets. The CFPB was instrumental in Operation Choke Point and they would be the most likely federal agency to field complaints about stacking. Unlike the Office of the Comptroller of the Currency which has jurisdiction over banks, the CFPB’s oversight extends to non-bank financial institutions. They’re the wild card agency that has financial companies across the nation on their heels.

I had the opportunity to speak with a former lead attorney of the CFPB off the record today about the definition of consumer. Could a small business be construed as a consumer? The short answer was no. The long answer was that there is no specific definition of consumer at the CFPB but it was meant to represent individuals. Although businesses at the end of the day are run by individuals, I got a pretty confident response that the CFPB would not have jurisdiction over a business lending money to a business, even if it was a very small 1 or 2 man operation. If they were acting in a commercial capacity, then they’re no longer consumers.

The other side of her argument was that it would take up too much resources to take on a case where the victim class was basically outside of their scope. The CFPB already has enough on their plate.

Is the government busy?
I also spoke with a few lobbyists and payments industry attorneys off the record and the unilateral response was that MCA and alternative business lending were not on any agenda, nor does the government have the resources to juggle something that is basically…insignificant in their eyes.

In the grand scheme of financial issues, a few billion year in small business-to-business financing transactions isn’t worth anyone’s breath. “A business acting in a business capacity was unhappy with a business contract they entered into? Take it up in civil court,” I imagine a regulator might say.

Regulators aren’t completely in the dark about MCA. Just a month or two ago, several industry captains and myself included were contacted by the Federal Reserve as part of a research mission to basically find out what this industry even was. The feds appear to have stumbled upon the MCA industry as part of their research into peer-to-peer lending. Who would’ve thought a 16 year old industry could be so stealthy?

If the big PR machines like Kabbage, Lending Club, and OnDeck Capital didn’t exist, I’m inclined to believe no one in the government would’ve heard of MCA for at least another 10 years. In 2014, they’re just now discovering it.

My gut tells me we’re a long way from any kind of regulatory enforcement. In a session I attended at Transact 14 today, a former member of the Department of Justice and a current member of the Office of the Comptroller of the Currency both offered examples of cases that took 3-8 years before there was an enforcement action. In each scenario, they alerted the parties there was a problem and they were given time to correct it. They had to show progress along the way and eventually when no such progress was made after years of warnings, they acted.

In the conversation of regulation, alternative business lending and MCA are relatively tiny. Lending Club does more in loan volume each year than the entire MCA industry combined. So long as there’s no fraud involved, small business-to-business financing transactions are not likely to make it on the agenda for federal regulators for a long time. That doesn’t mean it won’t be there some day in the future.

I think it was Brian Mooney, the CEO of Bank America Merchant Services that said in the Transact 14 roundtable discussion that if something feels wrong in your gut, don’t do it. Debra Rossi, the head of Wells Fargo Merchant Services added that you can’t tell a regulator, “I didn’t know.” Keep those suggestions in the front of your mind.

No police
For the foreseeable future it’s on us as an industry to find a resolution to stacking. There’s no such thing as the cash advance police. On one side is tort law. On the other is creating best practices and actively educating newcomers. That’s where the blood boiling debates need to turn to. After all, there’s already a large crowd that yawns over seconds, a group that wholeheartedly believes a stack is just as legitimate as a first position deal.

Instead of waiting for a referee to call foul on somebody, I think 2014 is the year to realize that you might be stuck in the room with the person you hate. Could you bring yourself to tolerate them for years to come?

Blind spot
We should consider that the greatest threat to the industry may not come from within, but from outside. More than 50% of MCA/alternative business lending transactions are repaid via ACH. Government action on ACH providers or the banks that sponsor them could end up hitting this industry as collateral damage.

One metric that banks and regulators consider is the return rate of ACHs, namely the percentage of ACHs rejected for insufficient funds or rejected because the transactions weren’t authorized. Daily fixed debits run the risk of rejects and boost the return rate. Could the frequency of your rejects eventually scare the processor into terminating the relationship? With the pressure they’re getting from the Department of Justice, there’s always the possibility.

Data security is another sleeping giant to consider. Do you keep merchant data safe? Are you protected from hackers?

Know your merchant. The push towards automated underwriting seems dead set on eliminating humans from the analysis. But what if the algorithm misses something and loans get approved to facilitate a money laundering scheme? Or what if it approves a known terrorist?

If you’re paranoid you’re doing something wrong, then maybe you are doing something wrong even if there’s no current law against it. Follow your gut, create value, and work together. Who knows, maybe one day there will be an ETA-like organization for MCA and alternative business lending. Now is a good time to be proactive.

Is Alternative Lending a Game of Thrones?

April 8, 2014
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Funding KingsIt was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us…

This blog has been many things over the years, all of it relative to who the reader was. It has encouraged and deterred, informed and confused, made people laugh or stoked their anger. The merchant cash advance industry it spoke of had been small. Annual funding volume was a billion or two or three, a blip of a blip on nobody’s radar. There was a sense of unity, a shared objective amongst competitors. They were guided by one dictum, “grow, but don’t rock the boat.”

But opportunity enticed everyone, the good, the bad, and the unexpected, and it brought a relatively peaceful chapter to an end. Winter is coming, Eddard Stark would likely say of the uncertainty that hangs in the air. Merchant cash advance has become a spoke in the alternative lending wheel that is spinning forward uncontrollably. Non-bank financing has become a worldwide phenomenon virtually overnight, setting the stage for the lords of funding to play a game of thrones. Investors with bottomless pockets are emptying them, government agencies are assessing the landscape or crafting responses, and journalists stand ready to shape public opinion.

This is a transformational moment in human history, perhaps bigger than what Facebook did for social media. Individuals are taking control of the monetary supply. Strangers pay each other in bitcoins, neighbors are bypassing banks for loans and lending to each other instead, and businesses are rising and falling with the funding they get from other private businesses. Winter is coming for traditional banking. The realm calls for a new king.

Wonga’s epic rise is being countered by both regulatory and religious resistance, and the man who dared the world to lend algorithmically has admitted defeat. Peer-to-peer lenders have encountered massive regulatory setbacks on their road to stardom and merchant cash advance companies are currently engaged in a civil war over best practices. Winter is coming indeed.

The Kings

funding battleLending Club
In what is perhaps their first step towards an IPO this year, Lending Club is reducing transparency over its loan volume. Up until April 3rd, anyone could see how many loans they issued on a daily basis. Now this information will only be available quarterly. Peter Renton in his Lend Academy blog shared his belief that the move was entirely tied to the impending IPO. “Without this daily loan volume information their stock price will be less volatile and they will be able to “manage the message” with Wall Street every quarter,” Renton wrote.

OnDeck Capital
OnDeck Capital is also in contention for an IPO this year. A year ago a company executive hinted that becoming a public company would not be on the agenda for consideration until 2015, yet I am hearing rumors that they may make a late 2014 go at it. Such rumors hold weight in light of reports that they are cleaning up their ISO channel. Insiders on DailyFunder are saying that resellers with abnormally high default rates are in jeopardy of being cut off.

OnDeck Capital is unique in that outsiders chastise them for their rates being too high while insiders argue their rates are too low to be profitable. It’s a classic example of how tough the court of public opinion can be on a lender even if they are not getting rich off their loans.

Kabbage came and conquered the entire online space before anyone had a chance to blink. PayPal, ebay, Amazon, Etsy, Yahoo, Square, they claimed those territories for themselves and then launched an attack into the brick and mortar space. Kabbage’s secret value is their patents. They are a serious player on a serious path.

CAN Capital
CAN Capital’s greatest weakness is their lifespan. They’ve managed to stay on top after 16 years in the business but that makes them old enough to be Kabbage’s grandfather by today’s tech standards. As a pre-dot com era business, it’s impossible to argue against their sustainability. If anyone has alternative lending figured out for both the good times and the bad, it’s CAN Capital.

The Lords

The Government
alternative lenders fightPeer-to-peer lending has already been under strong scrutiny from the Federal Government. Lending Club and Prosper are regulated by the Securities and Exchange Commission these days, but they may never be free of oversight. Just two months ago, the Federal Reserve published a report on trends in peer-to-peer business lending. They hinted at further regulation.

As small business owners are increasingly turning to this alternative source of money to fund their businesses, policy makers may wish to keep a close eye on both levels and terms of such lending. Because such loans require less paperwork than traditional loans, they may be considered relatively attractive. However, given the relatively higher rate paid on such loans, it may be in the best interest of the business owner to pursue more formal options. More research is required to understand the long-term impact of such loans on the longevity of the firm and more education to potential borrowers is likely in order.
– a 2014 Federal Reserve study

The Merchants
Once upon a time nobody talked about alternative lending online except for the companies offering it. Merchants didn’t talk about it with each other or there were too few businesses to give rise to centralized discussions. Today, merchants communicate and compare notes:

Merchants discuss PayPal’s working Capital program:

Merchants discuss Square’s merchant cash advance program:

Merchants discuss Kabbage:

OnDeck Capital’s 30+ Yelp Reviews:

Potential Lending Club borrowers make their cases:

The Machines
Are computers better predictors of performance than humans? Some people think so. This debate will play a pivotal role in the future of alternative lending.

The Media
Public opinion will be at their mercy.

The Vulnerabilities

funding battleCommissions
The bigger alternative lending gets, the juicier the stories become. Just last week, Patrick Clark of BusinessWeek dove head first into the reseller model, revealing insider commissions, the truth about buy rates, and the alleged antiquated practice of enlisting a broker to secure funding. On trial was a documented 17% commission, an example I believed to be an extreme case. For a long time commissions ranged between 5% and 10% on average. But there are some big names paying up to 12 points and others boasting of 14. All were topped by the mass solicitation I received a few days ago that promised a 20% commission. These kind of figures if they continue will become an easy target for journalists looking to portray the industry in a negative light.

There is a raging civil war within the merchant cash advance community specifically over stacking. This is the instance that a merchant sells their future revenues to two or more parties at the same time, leading to multiple daily deductions from their sales. This debate is bound to spill out into the mainstream if it cannot be resolved on its own.

Some funding companies intend to license their automated underwriting technology to banks, potentially handing the keys of alternative lending’s greatest asset (speed) to traditional bankers. It is unlikely that banks would engage in some of the high risk deals that alternative lenders target but they could recapture the top credit tier borrowers that have been flocking away from them.

Also at stake here is the sustainability of algorithmic underwriting. There are critics that believe computers appear to make great decisions during good economic periods but suffer during downturns. Do the technology based funding companies have enough data to weather a future economic storm?

So many things are happening at once, that it’s impossible to know what fate awaits the realm. Will there be a new king or will alternative lending fall apart like a house of cards?

For those of us climbing to the top of the food chain, there can be no mercy. There is but one rule: hunt or be hunted.
-Frank Underwood

May the best man win.

Merchant Cash Advance Syndication: Crowdfunding?

March 28, 2014
Article by:

merchant cash advance syndicationYou might not have known this, but one of the most lucrative opportunities in merchant cash advance is the ability to participate in deals. It’s a phenomenon Paul A. Rianda, Esq addressed in DailyFunder’s March/April issue with his piece, So You Want to Participate?

Syndication is industry jargon of course. You probably know the concept by its sexier pop culture name, crowdfunding. For all the shadowy rumors and misinformation that circulates out there about merchant cash advance companies, they’re similar to the trendy financial tech companies that have become darlings of the mainstream media.

Did you know that many merchant cash advances are crowdfunded? To date, no online marketplace has been able to gain traction in the public domain aside from perhaps FundersCloud, so crowdfunding in this industry happens almost entirely behind the scenes. There is so much crowdfunding taking place that it’s becoming something of a novelty for one party to bear 100% of the risk in a merchant cash advance transaction. Big broker shops chip in their own funds as do underwriters, account reps, specialty finance firms, hedge funds, lenders, and even friends and family members of the aforementioned.

Merchant cash advance companies find themselves playing the role of servicer quite often, which is coincidentally the model that Lending Club is built on. A $25,000 advance to an auto repair shop could be collectively funded by 10 parties, but serviced by only 1. Each participant is referred to as a syndicate. This is not quite the same system as peer-to-peer lending because syndicates are not random strangers. Syndication is typically only open to businesses, and most often ones that are familiar with the transaction such as the company brokering the deal itself.

In the immediate aftermath of the ’08-’09 financial crisis, some merchant cash advance companies became very mistrusting of brokers and deal pipelines were going nowhere. Underwriters had a list of solid rebuttals for deals they weren’t comfortable with. “If you want us to approve this deal so bad, why don’t you fund it yourself!,” underwriters would say. Such language was intended to put a broker’s objections over a declined deal to bed. But with all the money being spent to originate these deals, it wasn’t long until brokers stumbled upon a solution to put anxious merchant cash advance companies at ease. “Fund it myself? I’d love to, but I just can’t put up ALL of the cash.

And so some brokers started off by reinvesting their commissions into the deals they made happen. That earned them a nice return, which in turn got reinvested into additional deals. Fast forward a few years later and deals are being parceled out by the truckload to brokers, underwriters, investors, lenders, and friends. There’s a lot of money to be made in commissions but anybody who’s anybody in this business has a syndication portfolio. The appetite for it is heavy. Wealthy individuals and investors spend their days cold calling merchant cash advance companies, brokers, and even me, trying to get their money into these deals. They know the ROI is high and they want in.

crowdfundingThat’s the interesting twist about crowdfunding in the merchant cash advance industry. You can’t get in on it unless you know somebody. There are no online exchanges for anonymous investors to sign up and pay in. It requires back door meetings, contracts, and typically advice from sound legal counsel. A certain level of business acumen and financial prowess are needed to be considered. These transactions are fraught with risk.

In Lending Club’s peer-to-peer model, investors can participate in a “note” with an investment as small as $25. This is a world apart from merchant cash advance where it is commonplace to contribute a minimum of $500 per deal but can range up to well over $100,000.

Lending Club defines diversification as the possession of more than 100 notes. At $25 a pop, an investor would only need to spend $2,500. With merchant cash advance, 100 deals could be $50,000 or $10,000,000. By that measure, syndication is crowdfunding at the grownup’s table, a table that doesn’t care about sexy labels to appease silicon valley, only yield.

Strange merchant cash advance jargon keeps the industry shrouded in mystery. Did you know that split-funding and split-processing are terms often used interchangeably? Or that they have a different meaning than splitting? Or that the split refers to something else entirely?

Do you know what a holdback is or a withhold? How about a stack, a 2nd, a grasshopper, an ISO, an ACH deal, a junk, a reup, a batch, a residual, a purchase price, a factor rate, or a UCC lead?

Paul Rianda did a great job detailing the risks of syndication, but there is one thing he left unsaid, and that’s if you’re going to participate in merchant cash advances, you better be able to keep up with the conversation.

At face value, syndication is nothing more than crowdfunding. But if your reup blows up because some random UCC hunting ISO stacked an ACH on top of your split while junking him hard and upping the factor with a shorter turn, you just might curse the hopper that ignored your holdback and did a 2nd. And on that note, perhaps it’s better that the industry refrain from adopting mainstream terminology. We wouldn’t want everybody to think this business is easy. Because it’s not.

One factor to consider is the actual product being crowdfunded. In equity crowfunding, participants pool funds together to buy shares of a business. In crowdlending, participants pool funds together to make a loan. But in merchant cash advance syndication, participants pool capital to purchase future revenues of a business. An assessment is made to predict the pace of future income and a discounted price is paid to the business owner upfront. That purchase price is commonly known as the advance amount.

Syndication has more in common with equity crowdfunding than crowdlending. If you buy future revenues and the business fails, then your purchase becomes worthless. There is typically no recourse against the business owner personally unless they purposely interfere with the revenue stream and breach the agreement. Sound a bit complicated? It is, but crowdfunding in this space is prevalent nonetheless. To get in on it, you need to know someone, and to do it intelligently, you better know what the risks are.

If you want to sit at the grownup’s table and syndicate, consult with an attorney first. There’s a reason this industry hasn’t adopted sexy labels. It isn’t like anything else.

General Solicitation or Crowdfunding?

Fund it and Ask Questions Later

March 25, 2014
Article by:

foaming at the mouthEver since OnDeck Capital stopped doing verbal landlord references, the underwriting landscape of alternative lending has changed dramatically. Kabbage will supposedly fund applicants in just 7 minutes. Everybody’s under the gun to streamline their process, fund deals faster, and produce record breaking numbers month after month.

And why shouldn’t they? Investors are practically foaming at the mouth to get in on any and all kinds of alternative lending. Even Lending Club has thrown in the towel by no longer allowing investors to ask applicants questions. Prior to March 19th, applicants on Lending Club’s platform had the option to answer standardized questions about themselves and their purpose for seeking out a loan. This was set up to help investors feel more informed and comfortable. Once the loan was posted, prospective investors could ask the applicant additional questions of their own to help them decide if it was a deal they wanted to participate in. For example, “what are the interest rates on the credit cards you claim you want to consolidate?” That’s a fair question to ask someone seeking a debt consolidation loan.

Lending Club did away with the Q&A in the name of privacy but conceded in their blog that people are funding deals so fast that no one cares what applicants have to say.

We know that in the past some investors enjoyed reading these descriptions and answers, but as the platform has grown, fewer and fewer investors are using this approach to inform their decisions. Fewer than 3% of investors currently ask questions and only 13% of posted loans have answers provided by borrowers. Furthermore, loans are currently funding in as little as a few hours – well before borrower answers and descriptions can be reviewed and posted.

Loans are being fully funded by institutional investors and mom & pop investors before the applicant can even finish filling out the questionnaire.

raging bullThe demand to invest outpaces the amount of loans that Lending Club can originate. In a call I had with Lending Club today as a potential investor, I was told that businesses were not even allowed to invest on their platform at this time because they’ll take up all the loans and leave nothing for the average mom & pop investors, the ones which have made their peer-to-peer fame possible.

In the Lend Academy blog forum, mom & pop investors debated the usefulness of the Q&A system. Some argued that responses from applicants allowed them to weed out folks with poor spelling and grammar. Others believed that a poorly worded response was better than someone who didn’t respond at all because it showed that they actually cared about the loan they were applying for.

There were folks that analyzed the applicants language on a scientific level, with one going so far as to cite this study: Peer-to-Peer Lending The Relationship Between Language Features, Trustworthiness, and Persuasion Success.

I am reminded of my underwriting days conducting merchant interviews prior to a final decision. There were applicants that looked good on paper that came across as completely clueless about their business over the phone. Like beyond clueless. And then there were applicants that looked ugly on paper that really impressed me with their command of business subject matter. What shocked me were the former and it’s a testament to how tricky business lending is. Those phone calls impacted my final decision all the time.

But in today’s world where funders are dealing in kilos of cash instead of nickels and dimes, there’s a growing impatience over non-automated things like interacting with the applicant. Fund the deal and ask questions later!

FUND!!!The vast majority of merchant cash advance companies still conduct applicant phone interviews and there’s a part of me that hopes that never changes. As investors grow restless for new pools of loans or advances to participate in, I fear there will be more underwriting sacrifices to satisfy that demand.

It was only a year ago that I laughed at my friend in commercial banking when he told me a small business loan application begins with lunch and a few rounds of golf. “It’s about relationships,” he said. That couldn’t be less true in peer-to-peer lending where the goal is to know as little as possible about where the money is going. I see that mentality creeping into merchant cash advance as well. Sure, there are folks that point to thousands of data points aggregated through online sources but it only takes a 5 minute phone call to determine that an applicant is completely full of crap.

Maybe Jeremy Brown of RapidAdvance was on to something. When Will the Bubble Burst?

Join the discussion about this on DailyFunder.

Kabbage Has Leverage With Patents

March 23, 2014
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kabbage PatentsIf you’re planning on introducing new technology to the merchant cash advance or alternative business lending space, you might want to start filing a patent, or else end up violating someone elses.

I’ve brought up Kabbage and patents before, but another one of theirs caught my attention. In their invention named, Method and Apparatus to Evaluate and Provide Funds in Online Environments, they claim the right to an automated application, scoring, approval, and funding model for online businesses.

Will their claim interfere with what the rest of the industry is already doing or has set their sights on?

Kabbage CEO Rob Frohwein is no amateur to the intellectual property game. With more than 30 patents to his name, Intellectual Asset Magazine once referred to him as one of the world’s top intellectual property strategists. That makes Kabbage a rather dangerous foe in the booming world of alternative lending.

The above referenced patent is summarized as:

(a) receiving mandatory information about a user and storing the mandatory information in an electronic computer database; (b) allowing a user to choose whether to enter optional information about the user, and upon receiving the optional information, storing the optional personal information in the electronic computer database; (c) computing a score using the mandatory information and optional information if provided; and (d) determining whether to approve a transfer of funds using the score, and upon approval initiating an electronic transfer of funds from a cash server to an account associated with the user, (e) wherein upon the user entering the optional information the user receives an incentive.

If you read through the entire description of the patent and scan through the photos, you’ll notice they included an option for applicants to submit additional data that could reward them with a higher approval. Such data includes sharing all their LinkedIn and Facebook friends with Kabbage, which Kabbage says it will use to systematically evaluate, determine the ones that are business owners, and solicit them.

Additionally, it outlines how such optional data could be used in their assessment of the applicant:

site metric significance
FACEBOOK user has more friends favorable
FACEBOOK user has less friends unfavorable
FACEBOOK fan page existsf or user favorable
FACEBOOK no fan page for user unfavorable
FACEBOOK more people like user’s fan page favorable
FACEBOOK less people like user’s fan page unfavorable
FACEBOOK more people comment on user’s fan page favorable
FACEBOOK less people comment on user’s fan page unfavorable
FACEBOOK new articles posted more frequently on user’s favorable fan page
FACEBOOK new articles posted less frequently on user’s unfavorable fan page
TWITTER user has more followers favorable
TWITTER user has less followers unfavorable
TWITTER user’s followers have more followers favorable
TWITTER user’s followers have less followers unfavorable
LINKEDIN user’s company has more employees favorable
LINKEDIN user’s company has less employees unfavorable
LINKEDIN user’s profile has more views favorable
LINKEDIN user’s profile has less views unfavorable

In their filing they also submitted what they believe to be the definition of a merchant cash advance.

A merchant account advance is an advance by an advancing party that uses a seller’s merchant account in order to receive payments by the seller for the amount advanced. For example, a seller uses their merchant account to receive payments by credit card (e.g., VISA, MASTERCARD). Once payments are processed the amounts go directly into the seller’s merchant account. When a merchant account advance (or “merchant cash advance”) is made, when a payment is processed, instead of it going directly into the seller’s account the payment may go directly into an account of the advancing party. There are alternative ways to implement merchant cash advance, including a simple advance against future receivables, but when these receivables are received they still go into the existing payment account.

That last line totally acknowledges the ACH payment phenomenon. Hopefully they didn’t file for a patent on that too. Then there might really be trouble.

Whether or not your inventions or technology is patentable or conflicts with a Kabbage held patent would best be determined by consulting with an attorney. Let this be a reminder or notice though that the battle taking place in alternative lending is happening on many levels. As the industry matures, patents could become an Ace in the hole.

Lending Club Threatens The Status Quo

March 20, 2014
Article by:

3 billion pound gorillaIn late 2013, consumer peer-to-peer lender Lending Club announced their plans to start offering small business loans. That caused a stir in the merchant cash advance world for a few weeks, but the hype died down. The general consensus was that there would be little to no overlap between the applicants each target.

To this day, I continue to doubt that the overlap will be anything less than substantial. Nik Milanovic of Funding Circle would probably disagree with me. The main argument has been that Lending Club will only target small business owners with good credit, which assumes that businesses with anything less are the only users of merchant cash advances. Not to give anyone’s figures away, but I have seen data to suggest that a large segment of merchant cash advance users have FICO scores in excess of 660. Somewhere along the line we convinced ourselves that merchant cash advances were for businesses with really bad credit. That was never the purpose it was intended for, though it’s true that many applicants have low scores.

Historically, merchant cash advances were for businesses that posed a cash flow risk to banks. Split-processing eliminated that risk by withholding a percentage of card sales automatically through the payment company processing the business’s transactions. Funders today that rely on bank debits for repayment don’t have that safeguard, but they make up for the risk they take by doing something banks don’t do, require payments to be made daily instead of monthly. This allows businesses to manage their cash flow throughout the month and enables the funder to compound their earnings daily. It’s a phenomenon I wrote about in the March/April issue of DailyFunder (Razzle Dazzle Debits & Splits: Daily is the Secret Sauce)

According to the Wall Street Journal, Lending Club will require a minimum of 2 years in business and participation will initially only be open to institutional investors.

Lending Club’s website states that they will recoup funds on a monthly basis via ACH and that interest rates range from 5.9% APR to 29.9% APR + an origination fee. Terms range from 1 to 5 years and there are no early payment penalties.

TechCrunch openly pegs CAN Capital and OnDeck Capital as chief rivals for Lending Club in the space. CAN has enjoyed frontrunner status in the industry since 1998 and while they have been tested in the last 2 years, they haven’t come up against something like this.

In the same Wall Street Journal story, Lending Club’s CEO, Renaud Laplanche lays out who his competitors are with his quote, “The rates provide an alternative to short-term lenders and cash-advance companies that sometimes charge more than the equivalent of 50% annually.”

But will the impact be felt right away? In Laplanche’s interview with Fortune, he claims that it’s very likely they’ll focus on the 750+ FICO segment first, where institutional investors will be comfortable. But make no mistake about it, that will change quick, especially with a probable IPO in the next 8 months.

Is Lending Club really all that big? To draw a comparison, RapidAdvance got a $100 million enterprise valuation when they got bought out by Rockbridge Growth Equity about 6 months ago. Lending Club on the other hand was valued at around $2.3 billion at that time. It took OnDeck Capital 7 years to fund $1 Billion in loans. Lending Club is funding a billion dollars in loans every 3 and a half months. Granted, they’ve all been consumer loans, but let’s not kid ourselves about their capabilities.

Lending Club is funding more consumer loans than the entire merchant cash advance industry is doing combined. Thanks to the peer-to-peer model, they have infinity capital at their disposal. We can pretend that no one with good credit ever applied for a merchant cash advance or we can acknowledge the 3 billion pound gorilla in the room.

Lending Club and other peer-to-peer lenders that follow them will disrupt the alternative business lending status quo.

Previous articles on this subject:
Will Peer-to-Peer Lending Burn the Alternative Lending Market?

Lending Club Business Loans are Here

Peer-to-Peer Lending will Meet MCA Financing

Merchant Cash Advance Term Used Before Congress

Merchant Cash Advance and Crowdlending

Are Loan Underwriting Algorithms Limited?

March 15, 2014
Article by:

As news of OnDeck Capital’s $1 billion milestone spread yesterday,

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:

The video has since been taken down

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.”

Declined loanI 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.

Is There Cause for Alarm?

March 8, 2014
Article by:

CNN 3/7/14

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 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.

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, 2014
Article by:

We’ve seen copies of this notice posted on a few websites now:

square capital

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
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the divideIt 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, 2014
Article by:

If 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.

ebitda3. 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.

merchant cash advance growthPoint #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

Will Peer-to-Peer Lending Burn the Alternative Business Lending Market?

January 12, 2014
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For months I’ve been saying that peer-to-peer lenders will be companies to look out for, the latest being on December 29th. Lending Club fully intends to make the leap from consumer lending to business lending which may possibly pit them against the world of merchant cash advance.

In this video, a Bloomberg reporter asks OnDeck Capital’s CEO if his company will get burned by peer-to-peer lending.

If you watched the whole thing, you might also hear the insinuation that OnDeck’s product is similar to factoring since Breslow explains his loan program much like a merchant cash advance account rep would. “You simply pay x cents on the dollar”

I think there is room for both Lending Club and OnDeck. It’s the little funders of the world that will eventually feel a squeeze.

2014 Starts off With a Case of Red bull

January 10, 2014
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business lending red bullWoah, slow down there fellas. Let us digest one thing at a time. We’re not even 2 weeks into the new year and already we’ve learned that:

CAN Capital raised another $33 Million (but that they didn’t need it?)

Merchant Cash Advance was the the feature story on the front page of the Wall Street Journal. Seriously…

Bloggers are learning about this industry for the first time. They’re having a bit of trouble getting it right.

PayPal, which just recently kicked off its own merchant cash advance program (or as they call it, their Working Capital Program) has already issued 4,000 advances.

Regulators are freaking out over the use of social media information in loan approvals.

DailyFunder will begin mailing out the first alternative business lending magazine a week from today. It’s free so sign up!