It seems like every month in our column we begin by lamenting the shrinking ISO residual base as things continue to get savage with no end in sight on the average merchant discount rate. Equipment sales and leasing are not what they were even three years ago, and big acquirers are beefing up their own internal sales forces while giving third party ISO offices the cold shoulder.
    Regular readers know that we are constantly extolling the virtues of the ISO increasing the number of arrows for their quiver to make money with a diverse product mix. This month will be no different as we will explore the opportunities and pitfalls of cash advance factoring for both the ISO and the merchant. For those that are not familiar with the term “factoring”, factors are those individuals or companies that look at an individual company’s accounts receivable, and advance funds based on the likelihood of collecting the accounts receivable from a company payable to the company that received funds based on these accounts receivable.
    The factoring company, as part of its due diligence review for a company that is looking to receive these factored funds, usually reviews a company’s books and checks various pieces of information. For example, they will check the various companies that the company does business with, for how long they have done business together, and the typical aging cycle of the payments from one company to the other along with other important details such as a principle’s credit history. In addition, federal and state agencies will be queried to see if there are any liens or encumbrances upon a principal or the place of business, as well as the company’s standing with their current landlord; some will also check criminal backgrounds.
    If the company that is looking to receive factored funds is approved by the underwriting decision makers at the factoring company, the factoring company will then extend an offer to advance funds for these expected future receivables at a discount to the face value of the receivables; for example, the factoring company may offer 95 cents on the dollar for a company’s expected 45 day cycle of receivables. The companies that normally write checks directly to the company that received the factored funds will then be advised that they should cut checks directly to the factoring company. Factoring has been going on in one form or another in this country for hundreds of years.
    The concept has been stretched somewhat for the world of merchant bankcard now. The factoring company will analyze a merchant’s processing statements, for a period of time, typically 6 months. Then the factoring company will “buy” these expected future receivables (typically 75% of an average Visa and MasterCard settled monthly volume) at a steep discount, advancing the funds to the merchant, and collecting a daily remittance from the merchant over time (ranging from 6-15%). The balance of the merchant’s funds less the taken percentage is sent to the merchant’s operating account over the course of 4-12 months depending on the cash advance program.
    We’ll look at the inner workings of this again in a moment, but first it may be of interest to provide a little background of some companies that have been doing this factoring for a while and the evolution of their business models.
    A little more than 20 years ago, there was a company named Transmedia that started out on the West coast doing something rather unique at the time-they advanced money to restaurants at a ratio of 2:1 food and beverage dollars for the funds they provided the restaurateur. For example, the restaurant received 10,000 dollars and repaid the cash advance with 20,000 dollars in food and beverage credits. The pitch to the restaurants was that the food and beverage only cost them typically 35% of the total check so they were way ahead of the game. Usually Transmedia also sold the restaurateur advertising in newspapers and magazines, using the funds that were allocated to the restaurant to pay for the ad space. As a big buyer of media, Transmedia earned revenue on these advertising placements as well.
    Transmedia members bought a yearly membership for $45 and received a gray Transmedia card which looked like a credit card with the Transmedia logo on it. The card entitled the cardholder to receive a 25% discount for their food and beverage purchases with a few restrictions with regard to party size and time of the week. The Transmedia card was tied to a cardholder’s particular credit card and when they received their credit card statement it would show a discounted expenditure at the end of the month. This worked very well for many years until too many people knew about the program and the use of the card began to carry a negative connotation to it as a discount card when taking out guests for dining.
    Transmedia then merged with another company, Dining a La Card, which had a similar formula for success but they had a different technology set up which linked an individual’s “registered” credit card to the discounting program so that someone could pay for a meal and receive a discount unbeknownst to others sitting at the table. These companies evolved into iDine, and now, the recently renamed Rewards Network with an excess of 10,000 restaurants and 3.5 million registered active cardholders participating in the program. Along the way over the past 15 years, other competitors such as In Good Taste and their card portfolio (New York Times card, Boston Globe card, Washington Post card) have cropped up doing exactly the same formula- advancing cash to merchants in a 2:1 ratio, pushing media purchases and extending discounts to cardholders that patronize restaurants that are in their various networks.
    As you would expect, some of these companies that advanced the funds to the merchants invariably had to be in control of the merchant acquiring for the merchant, and these companies became huge sales organizations in their own right. Most of the time the merchant’s transactions are redirected to the factoring company’s settlement account and the factoring company would then settle a new reduced amount to the merchant until such time as they paid off their advance.
    So the first lesson here is cash advance deals drive traffic to ISO portfolios because to get the funds the merchants must switch acquirers to the factor’s acquiring platform. This switch to another platform usually does not require a new lower transaction rate-merchants that need capital will be happy to pay the same or even slightly higher rates to their new acquirers. Cash advance can drive merchants to a portfolio but that isn’t the real exciting piece of the puzzle.
    The aforementioned companies did not typically recruit ISO offices; rather, they had their own internal salaried sales forces. The reason is that advertising content was a critical component to the sale and most companies needed a trained ad professional as much as they needed a bankcard professional which was not seen as important as the former. Things have started to change over the past few years however.
    New well capitalized companies have been dangling the fruit of percentage points versus basis points in front of the eyes of the ISO. Much like the traditional large ticket equipment lease (e.g 36 or 48 months), where upon a broker may take a buy rate and mark it up a few percentage points, the cash advance model lends itself well to the aggressive mark up. For example, a $10,000 cash advance may be repaid back to the tune of 13,750 over the course of 6 months by the merchant to the factoring company. What could have been seen as usury conveniently hides under the guise of factoring. All the companies that perform this service never use the word “Loan,” rather they use the terminology cash advance.
    Many out there will say, “Who in their right mind would take capital at the rate equivalent of 75% or more per year?” The answer seems to be very similar across merchant profiles and SIC codes, and is prevalent among restaurants. Many of these merchants have, shall we say, sketchy reporting habits, and at the end of the year, after paying themselves a nice salary and expensing various things that maybe should be left in the company as profit, show a loss.
    These same merchants visit their local bank and, while the bank likes their deposits and check writing, can’t seem to get past the fact that every year the merchant shows a loss and now wants a 40 thousand dollar line of credit or loan. This is a typical merchant that looks for these costly advanced funds; they may have a decent enough business but because of how they conduct it on the yearly financial reporting side, they can’t utilize their assets in their business to leverage up a line or a loan at prime. Many merchants rationalize this new high cost of money due to the fact that they look at the cost of money being only variable goods cost and negating other operating costs, as well as the fact that their accountants will write off the difference between the funded amount and the payback as a “promotional” cost incurred by the merchant.
    Cash Advance products are not for everyone, and they can be both dangerous and addictive to the merchants. Dangerous in that if a business needs a cash infusion to get over a tough period, the payback that they become saddled with can be long and expensive as compared to traditional bank generated lines of credit or loan products. The cash advance products are also very addictive as merchants become reliant on these cash infusions over the course of time and come to manage their business-based on large deposits made to their operating accounts a few times a year. We mention a few times a year because as merchants pay back their cash advances, most of the companies that do cash advance will allow a merchant to “re-up” their original line amount once they have repaid 60% or more of the original amount. The cash advance companies will pay down the old line and extend a new line to the merchants. It is not uncommon to see merchants on a cash advance platform for 3-5 years with multiple “re-ups” in a year.
    This translates into enormous potential residuals for ISO’s. Typically, the cash advance companies allow for a small application fee or origination fee that the ISO can collect on the original paperwork, which ranges from $75 to $250. At the time of funding, the ISO usually receives a gross percentage based upon the original funding amount. Upon successful payback from the merchant to the cash advance company, some of these companies pay the ISO another couple of points, based on this successful pay back. Some cash advance companies will pay both on the front end as well as the back end, when this amount is repaid, however, many just perform this cycle once for the ISO and reduce the total amount paid out in commissions by half for the subsequent refinancing.
    The argument for the reduction in commission payments is that over the course of time, the more often and the longer the merchant goes to the well, the more likely they will end up defaulting on their cash advance, much like the extended stays people tend to have at a craps table in Las Vegas. We at POS have seen this first hand.
    In a deal that we were involved in two years ago, we introduced cash advance to a high profile NYC restaurateur and chef. He had six seemingly successful, high flying locations that had great New York Times reviews and was expanding rapidly. After successfully receiving and remitting funds for three cycles and paying them off, the cash advance company began to relax their underwriting standards and gave higher cash to credit card ratios to the merchant. When the merchant fell from grace it was a catastrophe as each individual corporation (all individual sub chapter S corps) ended up defaulting at similar times, with the cash advance company talking a hit of 75-90 thousand dollars per location.
    Even though the cash advance company filed Uniform Commercial Code forms on the furniture, fixture and equipment, and received a personal guarantee from the merchant, things moved a little too quickly for them to lay claim to anything when the whole deal unraveled. There were other creditors in line including the landlord, the state for unpaid withholding tax, and by the time the auction on the properties came and went, the fixtures were carted off by buyers at pennies on the dollar. The personal bankruptcy filing by the merchant left the cash advance company with nothing but a write off.
    Another lesson here for the ISO is, if you do a cash advance program, make sure you don’t have any liability in case of default. Your job is to bring the deal and make sure it is properly executed; let the cash advance company do their part of due diligence and underwriting. This being said, the ISO contract will also have clauses that are very onerous towards the ISO in the event of fraud. This means that paperwork and merchant signatures should be handled by trusted people and double checked before submission. If a deal goes south and there is any impropriety from the ISO offices, you can bet that the cash advance company will look to the ISO to help offset the loss in the event of misrepresentation.
    It’s also important for the ISO to make sure that the agreement on the bankcard side of things is decent (most cash advance companies do a 50/50 revenue share). Even though the cash advance companies usually view the bankcard residuals as pocket change, it’s still critical to make sure that if you do deals and the merchants don’t renew cash advances that you’ll still receive your share of the revenue. This is not an area to be overly fixated on traditional buy rate costs, but rather long term vesting of the residuals.
    We have been deploying cash advance products as part of our product mix for approximately four years with mixed results. Although very lucrative, the underwriting can be arduous and frustrating. The ISO should expect that more than 60% of the applications they submit will be rejected (this is why a small application fee should be collected because there will be time lost). Many times a merchant is not exactly forthcoming in their overall financial health. As part of the questions that ISO offices should ask cash advance clients in the pre screening, questions about tax liens or other unpaid government obligations need to be addressed. Many merchants are desperate to keep their doors open and look to a cash advance to bail them out of a tax lien or Marshall’s notice. Underwriters never consider funding a merchant with a tax lien, unless the underlying business is so strong that they can pay off the tax lien for the merchant and still have some funding dollars available to them.
    Again, even though the underwriting process can be frustrating to the ISO that is used to a rubber stamp approval based on retail swipe business, the amount of money earned on a single cash advance deal can be equal to three or more similar sized bankcard applications.
    For example, if the average cash advance deal is 20 thousand dollars and the ISO earns 4% on average, this is equivalent to $800 dollars. This funded amount may have been generated by a merchant that was doing 25 thousand per month in Visa and MasterCard transactions with 95% of the transactions being swiped transactions. If we assume that the ISO is earning 10 basis points, this merchant is providing 25 dollars per month in bankcard residuals; if you add another $5 in monthly earnings from statement fees the deal may earn an ISO $30 a month.
    This cash advance scenario is providing an up front payout to the ISO of almost two and a half years of monthly residual checks, plus given the assumption that the ISO is hopefully receiving traditional bankcard revenues from the cash advance company’s processor makes the whole environment very compelling.
    Cash Advance is not an easy sale, however there are some offices that have been leading with this product exclusively and have been doing really well. Other offices just have it as a value-added service for their growing portfolios so they don’t lose a merchant to another processor. We have found that ISO offices that simply dabble in the product usually can’t place a deal because it requires a higher multiple of submitted deals to approvals from an underwriter. This all being said, it seems that as ISO offices continue to get squeezed from all sides on residuals, terminal leasing and traditional attrition, the cash advance product could provide a financial windfall to those that successfully incorporate it into their sales kit.