Tuesday, July 24, 2007

Never Use The Four Letter Word

When you were child, you were probably taught to never use certain four letter words. In the merchant cash advance space, there is one word letter word that you never should be using when presenting this product to a merchant, "L-O-A-N."

Any person selling a true merchant cash advance product that is a factoring product, meaning you are purchasing a merchant's future credit card receivables at a discount, you need to understand the difference between a loan and a factoring product such as a merchant cash advance. (Note: there may be some "loan" products offered by companies to merchants that this article may not apply to, so I would check with your merchant cash advance provider whether or not they are offering a loan product or a factoring product. Almost every product I know of in the merchant cash advance industry with the exception of one or two is NOT a loan product). There are various state usury laws (usury is typically defined as the the maximum interest rate allowed by law) that a loan product must comply with.

The first distinction between a loan product and a merchant cash advance is there is no fixed time period with a merchant cash advance. For example, if you walk into a bank, every loan product they offer has a fixed time period - eg. a 30 year mortage, a 5 year auto loan, a 5 year SBA loan, etc. With a merchant cash advance, a merchant is simply agreeing to sell a percentage of their future credit card receivables at a discount and allowing a merchant cash advance provider to collect those payments by taking a set percentage of a merchant's future credit card processing sales. For example, lets say you purchased $20,000 worth of future credit card processing receipts for $16,000 from ten different merchants on the exact same day. And in this example, the agreement called for the merchant to collect 20% of the merchant's future Visa/Mastercard sales until $20,000 was collected and the advance was paid off. Each of the ten different merchants will pay off the advance in ten different time periods - one merchant may take seven months, another nine months, another twelve months, etc. Again, unlike a loan, there is no fixed time period with a merchant cash advance.

Another distinction between a loan and a merchant cash advance is there is no fixed monthly payment. A loan requires a fixed monthly payment amount (or in the case of some mortgages, a fixed bi-weekly amount). With a merchant cash advance, there is no fixed monthly payment as we are taking a percentage of a merchant's future credit card sales. For example, if a merchant's cash advance contract calls for 20% of their future Visa / Mastercard sales and they process $10,000 worth of these sales in Month 1 after taking the advance and $5,000 worth of future Visa / Mastercard sales in Month 2, then the amount they will pay back the merchant cash advance provider will be $2,000 Month 1 (20% of $10,000) and $1,000 Month 2 (20% of $5,000). As you can see, unlike a loan, there is no fixed monthly payment with a merchant cash advance. In addition to a legal difference, there is also a cash flow benefit to the merchant with a merchant cash advance compared to a traditional loan. That is, if their sales slow down, the amount they owe their merchant cash advance provider slows down since it's a percentage of their future sales that determines how much they pay back each month on their advance. With a bank loan, a merchant has to worry about making a fixed monthly payment to the bank regardless of how sales were that month. If they can't, they can default on their bank loan which can include the bank eventually foreclosing on personal assets that the borrower may have had to pledge.

Another difference between a merchant cash advance and a loan is there is no interest being charged with a merchant cash advance. A loan has an interest rate, while a merchant cash advance does not. A merchant cash advance involves buying future credit card sales at a discount. For example, if you are buying a merchant's future credit card sales for .75 on the $1, then you would purchase $10,000 worth of future sales for $7,500. You are buying these sales at a 25% discount, this is a discount (remember, this is a factoring product), not an interest rate. One of the reasons why there is no interest rate is because as discussed above there is no fixed time period to collect these sales purchased, it can take seven months, twelve months, fifteen months, etc. The time period it will take to pay off the advance is unique for each merchant as it is based on how much credit card sales the merchant actually processes
since they received the advance.

One of the key differences between a loan and merchant cash advance is their is no recourse with a merchant cash advance. One of the key attributes of a loan is there typically is a personal guarantee. A true merchant cash advance should be a purchase transaction and there is no recourse to the owner should they legitimately go out of business. With that said, this is not a free for all for fradulent merchants to take a cash advance and not pay it back. Most merchant cash advance provider contracts will have a fraud guarantee on the merchant personally. Some examples of a fraud guarantee where a merchant can be held personally liable are if a merchant misrepresented the information on their application that the merchant cash advance provider used to approve them, sells their business without paying off their balance on the advance, and/or disrupts the merchant cash advance provider's ability to collect the future credit card sales they purchased (this can be done by changing compatible processors, blocking ACHs, changing bank accounts, etc.)

In conclusion, when selling a true merchant cash advance product, you should be using the correct terminology such as "advance" instead of "loan" and "discount" instead of "interest." If a merchant asks you what is the difference, you should be able to point out the attributes of a merchant cash advance discussed above which are no fixed time period, no fixed monthly payment, no interest rate and no personal recourse.

To properly inform the merchant the type of product you are selling, I recommend putting a notice on your website, marketing materials, etc. that indicate it's a merchant cash advance. Something to the effect of "Note: This is a merchant cash advance factoring product and not a loan product."


terence said...

I enjoyed reading this blog. It was very informative and it really broke down the differences between a loan and cash advance. I've been in the industry for a while and have had the ability to offer cash advance ever since 2005, but I never did because I didn't look at it as a viable product. I never even carried applications for it! I just didn't think that it was something that a merchant would have been interested in.
It surprised me to see what the 2007 forecast was for this market! Looking back now, I wonder how many clients I would have actually had if i'd been marketing this product since 2005. I wonder how many renewals I would have on the books by now...
You've changed my thinking and I will certainly begin to market this product, i'll keep in touch


Jesse said...

Great information here. I am new to the industry and often struggle explaing to merchants (and sometimes myself)the difference. Thanks!

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