RISK/REWARD: MODERN OPTIONS FOR QUICK MONEY

(And Implications for Credit Management Decision)

With the advent of Internet banking and financing, merchants, both business-to-business (commercial or BTB) and retail, have more options than ever when it comes to obtaining quick cash. Two mechanisms are readily available to those for whom a traditional bank loan is not an option. This article will examine Merchant Cash Advances (MCA) and Invoice Factoring (Factoring).

The hardest part of this article is going to be either avoiding the use of words related to “loans” or “lender” in terms of the sources of the funds being obtained. So, going forward, those are the words that will be used, and you, the reader, can decide by the end of the article whether you perceive of the transactions described as a “sale” or a “loan.”

“MCA’s entail the [purported] sale of future receivables for a set dollar amount, repaid with a set percentage of the [merchant’s] daily sales receipts.” (Source: Barbara Lipman & Ann Marie Wiersch, Bd. of Governors of the Fed. Rsrv. Sys., “Uncertain Terms: What Small Business Borrowers Find When Browsing Online Lender Websites”). Factoring also involves a purported sale, this time of a percentage of open invoices for the borrower’s customers.

In the case of MCA’s, repayment occurs when the lender/buyer takes a designated percentage of the funds paid to the merchant’s credit card processor or deposited via ACH into the merchant’s bank account. There are a number of different mechanisms for this repayment, but the key risk for the merchant is usually found in the terms of the sale agreement which usually allows the lender to either access fees or clean sweep the account if the merchant falls behind on repayment. Another distinguishing element of most, if not all, MCA agreements is that the “sale” is secured by detailed blanket UCC-1 filings, personal guarantees, sometimes deeds of trust or assignments of leases not just for the corporate debtor but for all owners/principals, and sometimes spouses. The MCA agreements generally prohibit “stacking,” i.e. selling another percentage of the receivables to a different lender. While no interest rate is set (the discount between the set amount of receivables being purchased and the actual lump sum being loaned, plus accessed fees are meant to cover the cost of the transaction and time value of money), generally, the ultimate cost may result in an APR reaching triple digits.

MCA’s are generally used for large, one-time, purchases by the borrower as the mechanism is not designed to create a cash flow, but instead is a lump sum transaction. By its nature, this method of borrowing/selling is available to both retail and commercial merchants since payment of the sale price involves collection through the credit card processor or the bank of the merchant.

Invoice factoring is closer to a true sale in that the purchaser generally does not require guarantors or other security. They, instead, take an assignment of the entire invoice, bear the risk of collection, and return any overage to the merchant. This opportunity is only available in commercial settings since the repayment is dependent upon an open invoice. The lender assesses the quality of the merchant’s customers in determining the risk of collection. This mechanism is generally used to even out cash flow as the merchant will depend on the overflow coming back from the lender after invoices are collected.

For a supplier’s credit department, due diligence to determine whether a new customer is beholden to either a MCA lender or a factorer is important and can often be detected by checking the new customer’s UCC filings on record with the Secretary of State’s office. Factorers can be harder to detect as they may not file UCC-1s. And, for existing customers, unless the customer self-disclosers, or the supplier is extraordinarily vigilant, you may only learn of the existence of an MCA or factoring when your customer suddenly stops paying or begins bouncing checks.

For a contractor or subcontractor, the word of warning is to fully understand the agreement you are considering and what the ramifications are. For some, these arrangements may provide a bridge over a rough patch and work just as they are intended. For too many, however, such agreements become a death spiral of ever-increasing costs and expenses.

As always, if you have questions, please feel free to contact our office.