Small and mid-sized businesses of all industries require cash flow to survive. Over the years a variety of tools have emerged to help these businesses get access to the working capital needed to expand, renovate or take their organization to the next level.

A Merchant Cash Advance

    (“MCA”) is one such tool that continues to grow in popularity to help these businesses better manage and grow their businesses. But, like any other powerful tool, if used incorrectly, it can do more harm than good. In an industry that is self-regulated, MCA providers must ensure they are serving the cash-flow needs of the merchants in a responsible way that will still ensure profitability for all parties?

What is a Merchant Cash Advance?

    A Merchant Cash Advance (or MCA) involves the purchase of a portion of a business’ future card sales at a discount. The purchase price paid by the MCA provider is a lump sum of cash delivered to the business for its use as working capital. A common and popular way for the MCA provider to collect its purchased receivables is through “batch-splitting” and/or closely related variations through Automated Clearing House(“ACH”) transactions. In batch-splitting, the merchant directs its processor to forward an agreed upon, set percentage of the merchant’s daily net (post-charge backs, reserves and other processor-related charges) settlement dollars from card sales (or “batch”) to the MCA provider’s account and to forward the remainder of the net settlement amount to the merchant’s account. In the ACH variation, debits in amounts equal to the agreed upon percentage of covered card sales are instituted by the processor from the merchant’s bank account (i.e., demand deposit account) through ACH transactions.
    An MCA is not a loan – it is a purchase of a specified amount of card sales that have yet to occur. A merchant contracts for an MCA because, among other reasons, it has no fixed term. Rather, the MCA provider is entitled to receive a set percentage of its merchant client’s daily net settlement batch. This means that the dollar amount received by the MCA provider on a given processing day is based on the merchant’s card sales volume.
    For example, if the merchant and MCA provider agree upon an 8% retrieval percentage, the provider will receive $8.00 with respect to a day on which the merchant had $100.00 in net card sales. With respect to a day on which the merchant had only $50.00 of net card sales, the MCA provider is entitled to receive only $4.00. Because of its structure, an MCA involves no “late payments” or associated charges or penalties and is better aligned with the merchant’s cash flow than traditional “fixed payment” style arrangements, in which the payment of a fixed dollar amount is due regardless of the merchant’s sales volumes.

Growing Pains

    As this industry matures, it is exhibiting many of the traits demonstrated during the development of other innovations in the financial services industry. Early providers found a market niche and went about doing business. As their business models and practices gained acceptance, multiple providers entered the market offering more money, lower rates and extending the market into less predictable customer profiles. Although, as explained below, an MCA is not a loan or a financing, the MCA industry has the potential to follow this pattern and develop similar problems in the small and medium-size business market.
    However, the same aspects of an MCA (viz., the provider is only entitled to a set percentage of net card sales and the total amount of purchased future receivables is fixed) also make it a risky product for the MCA provider to deliver. If the merchant’s future card sales are lower than the MCA provider projected, the provider’s collection of the receivables it purchased will take longer than projected – a timing difference that may result in loss of income for the provider. Moreover, the MCA provider will bear the loss if the merchant fails to generate future card sales sufficient to deliver the total amount of receivables sold to the provider. For these reasons, responsible MCA providers are careful to set the terms of their transactions based on the particular profiles of their merchant clients. Any miscalculation in the merchant’s profile, or unforeseen event (e.g., Hurricane Katrina), can change the collection curve on the MCA transaction – often dramatically.
    MCA providers usually require less paperwork than traditional capital sources and can often go from application to completed funding in a week or less. Those MCA providers do not require personal collateral to secure the merchant’s obligations. Some MCA providers require the merchant to provide certain covenants (e.g., to not switch or split their processing without the provider’s consent) and owners to provide guarantees of performance of those covenants.

Best Practices for a Self-Regulated Industry: Do Not Harm the Merchant Customer

    What are best practices that will enable growth that is both fair and robust, benefiting all participants – from merchants, to processors and acquirers, to salespeople and MCA providers? Best Practices should provide market participants, banks and associations with the benchmarks to distinguish between reputable and disreputable MCA providers using a common taxonomy. This ability to choose amongst providers is certain to become more and more important as the industry grows and attracts greater scrutiny from the press and regulatory entities.

Know Your Customer & Fix the Retrieval Percentage

    Responsible funding means knowing your customer and using commercially reasonable efforts to ensure that your funding does not harm the merchant’s business. Every business has a maximum percentage of its gross revenues that it can afford to pay each month against any financial obligation (the “Safe Retrieval Percentage”). If the merchant has to pay more than that percentage, it risks going out of business. There is a strong correlation between the traditional margins associated with a particular type of business and the Safe Retrieval Percentage.
    One of the most severe breaches of this Best Practice is increasing the retrieval percentage without express consent of the merchant customer. Within the industry, there is talk that that certain MCA providers change the retrieval percentage in the event the provider is collecting its purchased future receivables more slowly than it anticipated (i.e., when the merchant’s card sales volumes are lower than the provider projected).
    As described above, alignment between the business’s card-related cash flow and the MCA provider’s collection of its purchased receivables is the very essence of an MCA. If MCA providers increase the retrieval percentage precisely when the client’s business has slowed, they endanger the business’s viability. The MCA product is priced to account for the unknowable timing of revenues, which is precisely the risk MCA providers must assume.

Provide Clear Disclosure of Fees

    Fees, rates and automatic deductions and renewals are not necessarily evil. Unexpected fees, rate changes, and contract renewals are. Contracts need to clearly specify these items, with bold print. Salespeople must adequately disclose and explain contracts to their customers.

Establish Customer Service Standards and Issue Resolution Mechanisms

    Merchant customers should be able to get assistance and answers when needed. Some MCA providers operate without any infrastructure in place to serve their client base, diminishing the overall professionalism of the industry. A Best Practice rule should require MCA providers to establish:

• Staffed customer service desks, enabling merchant customers to receive answers to their questions and problems within commercially reasonable times;
• Issue resolution policies, with appropriate escalation procedures;
• Quality control measures to ensure that the correct amounts are being deducted from the merchant’s net settlement batches;
• Agreements and processes with processors, and their acquirers to ensure that mistakes are corrected quickly.

Do Not Harm the Industry: Represent the Product Accurately

    If the MCA is structured as a purchase and sale transaction, then the product should be described accurately in a way that avoids confusion. A true sale transaction cannot have an interest rate or a principal balance and cannot involve repayment, late payment fees, payment guarantees, or any other indicia of a loan. These features must be absent from both the transaction itself as well as any marketing collateral or sales efforts. Mixing the features of a “true” MCA purchase and sale with the features of a traditional loan confuses merchant customers and invites regulatory scrutiny.

Distinguish the MCA Sale

    Just as the Card Associations and regulatory agencies have closely scrutinized and discouraged tying the sale of merchant processing to the sale of other products and services, the merchant community is best served by being able to similarly distinguish the relative merits of an MCA separate from related products or services.

Summary

    Merchants should want to work with MCA providers who abide by these Best Practices for obvious reasons. They will receive money that helps their businesses and build ongoing, professional relationships with providers that can save them time and frustration. ISOs benefit because MCA providers that embody these Best Practices have satisfied, happier merchant customers who will take advantage of more fundings over their lifetimes. The industry benefits because it builds a reputation within the regulatory community that it has the ability to self-regulate, advocate responsible funding practices and minimize unscrupulous behaviors without the need for government intervention.
    For more information, please visit www.mcabestpractices.com.

Glenn Goldman is the CEO of Capital Access Network, Inc. Capital Access Network, based in Scarsdale, New York. Capital Access is a provider of financial solutions to small and mid-sized businesses. He can be reached at GG@AdvanceMe.com. For more information visit www.CapitalAccessNetwork.com.