24 Feb Merchant Cash Advances: A Solution Not Worth the Cost

By Michael McAdams, President, Pasadena Private Lending

Let’s say you’re a hard-working entrepreneur who has had a few bad months for whatever the reasons (it happens to the best business owners). But you also have been trying for three years to acquire a competitor that has made life difficult since you started your business. They are selling because the founder has some medical issues and has no one to take over the business. So you can get it cheap because, at least, his legacy will be preserved by a respected competitor in the industry.

You were depending on the last few months’ profits for the down payment, not to mention justification to your lender for a line increase for the rest of the money to close the deal. But now things are not so clear as to where the cash will come from for this “once in a lifetime opportunity.”

What to do?

Then you get an email or text or even a direct mail advertisement offering “quick business cash!” The highlights of the offer include:

• No credit check
• 24-hour funding
• One signature standard documentation
• $100,000 to $1,000,000 funding
• Flexible payments
• Structured as “revenue-based financing”

While you remember the adage, “if it seems too good to be true…it is,” you call their 800 number, tell your story, and the nice person asks you about your business, how long you have been running it, the kinds of customers you have and how they pay you and when. You send them some business bank account info for the last three months and in 30 minutes they call back with “you’re approved for $750,000.” You ask to see the documents and ask what the costs are. The helpful phone person answers, “We will send you the docs to sign and they will explain the costs… but we charge you nothing at closing! What is your email address?”

You soon get their email and start to read a document that sounds like a combination of a multi-language cookbook and Tokyo subway guide. Phrases you have never heard before like “Deposit Account Control Agreements,” “Factor Rate,” “Holdback Percentage,” “Retrieval Rate,” “ACH/Split Withholding,” and “Confession of Judgement” as well as other terms scattered around the document used primarily in the business euphemistically referred to as revenue-based finance or merchant cash advance (MCA) funding. And, you also see in the document that there is a “Total Payback Amount.” Stay tuned for that one.

So, do you sign up?

Before you decide, here is what you would really be getting into:

• Weekly and even daily ACH (pre-arranged, automated account debits) from your main operating bank account. On the $750,000 example above, you will typically have sold $1,000,000 of future revenues, which will be collected by ACH to the tune of $10,000 per day for the next 100 bank days. This sum is removed consistently first thing each bank day without fail.
• That means you start every day $10,000 in the red compared to your normal budgeted cash flow you might have intended to use to buy inventory, pay wages, or invest in your business.
• They also get their payment first. Period. And, oh, the cash is gone before you can set aside cash to pay any senior lenders, equipment lessees, or landlords.
• These programs may also say they are not debt but an advance on future revenues in order to “wire around” strict indebtedness provisions of some creditor agreements. However, they try to write an MCA agreement that resemble debt to void typical protections against usury lending. Naturally, banks and private lenders like PPL increasingly restrict borrowers from incurring any payment responsibilities that sell future revenues not pre-approved by the lender. Nevertheless, failure to receive pre-approval will likely become a serious event of default under prior credit arrangements.
• Again, while not technically debt, the MCA cash provider may try to file UCC liens that may or may not be valid in the eyes of future lien holders but will be another major concern to any existing senior lenders or other parties to whom you own money or have pledged to make payments like preferred shareholders. This can normally be another event of default under existing lending arrangements.
• Amendments to your deal with MCA providers are solely up to them and are difficult to get. Minor slowdowns in cash sweeps for short periods of time are possible but can come with further stepups and catchups on missed payments, exacerbating future cash issues.
• Now the big reveal: Think 50-90% cost of MCA financing! But the way they display their costs can be very misleading: the total payback amount seems somewhat acceptable when cash is immediate cash and a necessity. Here is an example: They might say they will take $250K out of an even million and advance you $750K which seems like 25% interest, no? (And cheaper than a credit card!?) But $250K on a $750K loan is actually 33%, which if paid over five months is more like an 80% APR, not 25%! Then there are late and extension fees that add up further if you miss payments or seek any delays.
• And if 80% interest is not scary enough (and in violation of consumer usury laws, although, admittedly not small businesses, as yet), considers the final nail in the coffin. This “MCA-too-good-to-be-true-free-money” can materially reduce your businesses value. Remember that you technically sold revenues at a discount; you did not incur debt that pays interest (that gets added back to the magic “EBITDA”). Continuing with the same example, assume you are a business that last year did $4MM in revenues growing at 20% per year and generated $1MM in EBITDA. Most brokers would tell you that your business could be sold at 6x EBITDA, or $6MM. By doing the MCA, your revenues dropped to $3.75MM and your EBITDA dropped to $750K. Now business brokers and possible lenders and future buyers will see a reduction in EBITDA, lower revenues and a business in potential distress also reducing the multiple applied to the lower earnings. In this example, your enterprise value drops by 50% from $6MM to $3MM. Of course, if you buy that competitor and synergies and market share increases go well, it might be worth it. But the costs and risks are very, very high.

In sum, the MCA finance provider can reduce the value of your business or literally put you out of business because you needed a short-term infusion if that cash doesn’t pay off at or more than your expected returns. Is the investment… and more importantly, that type of capital… worth the bet?

So, why do such predatory lenders do this and how do they get away with it?

Entrepreneurs need to think through what is or isn’t the “once-in-a-lifetime” opportunity when they see it. That is not for anyone else to judge. But how it is financed is what we think about every day. And why we offer this article for your consideration.

In the end, America is a place where innovation is rewarded and where addressing market needs has made many people rich. One could even say that the legitimate pharma industry grew in time and with guidelines in place out of “snake oil” and traveling medicine shows. And as small businesspeople sometimes do get between a rock and a hard place, these predatory business lenders are filling that need. But demand and supply are out of balance just as laws and regulators have not yet caught up. In the meantime, “smart” financial people realized the need and build in the high expected losses of lending basically unsecured to businesses (that, by definition) have issues into their financing offers. They reason that by financing at sky-high costs and playing the odds that most will pay long enough to get their principal back plus some return on capital (remember, it is not interest if it is not debt), they will make money. And they do. Some are virtual cash machines that use AI to send automated emails, letters, texts, and phone messages to thousands of small businesses every day.

And, to point out how pervasive the MCA marketing machine is, even we at Pasadena Private Lending got a flyer in the mail!

But if a company does find itself between a rock and a hard place, what are legitimate options?

• Communicate with your existing lender. Of course, as we have said in Insights many times before, keeping an open line of discussion with lenders all the time is best so that surprises are minimized; even bad news delivered with candor and honesty is better than a surprise to any lender. And you might be surprised how much they can be flexible if they know you are cooperating and the business remains sound for the long run.
• Pledge additional personal or business collateral that is not currently pledged to your lender or get a second lien on any real estate you might control.
• Friends and family can often help even if it means admitting the need for temporary help. And if that is too personal, your accountants and lawyers often have access to friendly sources of temporary capital.
• Looking to a traditional asset-based lender that lends on a strict formula based on the value of your company assets, if you are a more traditional company. They can be more expensive than a normal loan and require a lot more administrative work for your accounting and finance people. But they can sometimes get you more money in tough situations.
• While factoring of receivables is a valid and time-rested source of finance for many specialized industries, the cost of factoring is not often fully appreciated but tends to be 2x loan rates (and of course, a fraction of MCA costs.)
• While SBA loans can be ideal solutions in some cases, in truth, the government just does not typically work fast enough to help in any rush situation, so it is not worth your efforts to fill out their forms if it is truly a rush.

As always, we wish our readers well and hope our thoughts and experiences are helpful to you as you thoughtfully and successfully grow your businesses. Should you have any questions, we invite you to contact us.