Independent Sales Offices (Brokers) have played a vital role in the marketing and sales of Merchant Cash Advances since the industry’s inception. Over the years and during the different stages of the industry’s development, their value has waxed and waned. A survey of the Small Business lending landscape a year passed the effects of COVID-19 has revealed an opportunity for Brokers to extend their role in Small Business finance, cement their presence, and secure their livelihoods; by adding a micro-lending component to their business. We’ll discuss why this opportunity emerged, and offer a test case for how a Broker Lender business might look.
A Merchant Cash Advance (MCA) is a Small Business financial product that allows business owners to sell a specific amount of their future revenue for an upfront discounted amount.
Early on, as the top line performance of the business was heavily weighted in the decision-making process, so long as the business accepted credit cards as a form of payment and their merchant processing was healthy and consistent, borrowers with substandard credit profiles were eligible. The minimal required documentation and quick time to funding were also attractive features.
Funding amounts range between 50% and 125% of the business’ monthly revenue. Terms are typically measured in months, pricing is in the form of a factor rate, and much smaller payments are typically made on a daily or weekly basis.
An eligible small business with $100,000 in monthly revenue qualifies for the sale of $79,200 of future revenue in return for an upfront payment of $60,000. Repayment terms are approximated over 9 months. The discount rate (NPV) here is approximately 75.75%.
The common nomenclature is $60,000 at a 1.32 factor rate over 9 months.
The expected repayment is about $420 per day for 189 business days (assuming 21 business days per month).
Note – a factor rate is simply the inverse of the discount rate, i.e., 1/75.75% = 1.32
This product was primarily sold through brokerage offices; over the years, many lenders have themselves built out salesrooms. The reasoning and the economics behind Lenders going direct is sound, regardless, the added competition has not gone unnoticed.
The initial popularized version of the Merchant Cash Advance arrived in the mid-2000s, born from earlier restaurant rewards’ programs.
The attractive feature of the product to the merchant was ease of access, and aligned interest in the repayment method. The amount of repayment was a fixed percentage of the Small Business owners’ credit card receipts, somewhere between 10% and 20%. When times were good the merchant paid back the advance quicker, while during leaner months, repayment amounts would decrease. The fluctuating payments without a fixed payback period reinforced the fact that the product was indeed a purchase of future receivables, and not a loan.
The striking features to the lender were;
Repayments were made at the merchants’ credit card terminal, meaning the Lender would receive their daily payments directly from the credit card processing company, with the remaining amount being deposited into the merchants’ bank account.
The early results were promising. As the repayment method reduced default risk, Lenders could focus their underwriting primarily on monthly credit card processing to determine the amount of receivables they’d be willing to purchase. There is a case to be made to resurrecting this repayment method, known as Split Funding.
The marketing message was that MCAs were for folks that weren’t eligible for a bank loan.
Variations in performance analysis (bank statements with or instead of merchant processing statements), additional weight being given to credit quality, term extension, rates compression, and collection methods that enabled non-credit card receiving Small Businesses to apply (ACH from the merchants’ bank account) were taking place. However, the understanding of a company’s top line performance was still paramount, because at this stage, the young industry's main focus was to determine if this was a desirable and needed product.
The growth over the following decade was resoundingly affirmative.
As with any industry that is emerging and showing promise of good returns, more participants are attracted to it. In the MCA industry, the lion’s share of the early money was private, the true trailblazers. Within just a few years, however, larger and more analytical money began to pour in, and with it, the scrutiny associated with due diligence, and the associated compliance and covenants requirements. The industry was new, and there were subtle differences in the products and pricing and repayments and terms in comparison to a conventional loan. But in the absence of term sheets and agreements that reflected these nuances, conventional documents between funding sources and lenders were used, inadvertently handcuffing MCA Lenders that relied on the receipt of daily payments to refill the kitty to continue funding. We can address this topic in depth at another time.
A number of things happened almost immediately:
The first 2 decreased revenues, and the second 2 increased overhead. Along with the increased number of applications being underwritten to fund a deal, economic gains per unit shifted dramatically.
Growth became the mantra, with the hopes that economies of scale would follow. For some it initially did; and even if a transaction was break even the first time around, the gains on subsequent fundings (Renewals) made up for it.
Managing Renewals became an integral part of the business. Most Lenders built internal sales teams to work with these merchants, even though they were paying full commissions to the Brokers that had originally brought in the deal. It was just too important a source of revenue not to be managed internally.
However, among the detrimental unintended consequences of larger funding amounts over longer terms was the business owners’ need for additional capital before they were eligible for more money.
Borrowers are typically eligible for a Renewal once their balance is such that after retiring their existing balance with the new funding, they receive at least 50% of the proceeds.
For example, the small business above with the $79,200 repayment amount would need to pay down to a $30,000 balance to once again receive a $60,000 offer. To get there, the merchant would need to pay $49,200; at $420 per day, that’d be about 118 business days, about 5 and half months. Merchants were mostly able to manage that amount of funding over that period, and mostly waited until they were eligible for a renewal; Lenders offered incentives for merchants the subsequent times around.
More money over a longer term stretched the business owner. Although they spent the additional money they received in about the same amount of time, and were making roughly the same payments, they now had to wait almost twice as long before becoming eligible:
$100,000 at 1.42 over 15 months = $142,000; 315 daily payments of $450
To get to a $50,000 balance, they now needed to pay $92,000; about 205 business days, or more than 9 and a half months before becoming eligible.
Small business owners found themselves in a bind, they’d run out of cash within 5 or 6 months, but wouldn’t be eligible for additional funding for another 4 or 5 months. A cottage industry called Stacking, based on this deficiency was born. Stacking occurs when a merchant takes additional funding from a different lender, and is now obligated to make two or more daily payments. Unless subsequent offers are calculated with some precision, oftentimes, this leads to pressure on cashflow, causing merchants difficulty in meeting their daily obligations.
Slowly but steadily, the industry began to diverge; the Lenders that sought the best paper, to fund larger deals for longer terms, and those that sought lower quality paper or merchants that were already funded elsewhere to fund smaller deals over shorter terms.
The COVID-19 pandemic exposed fragilities within Merchant Cash Advance, which were exacerbated by the stay-at-home mandates that were in effect (borrowers couldn’t repay), and the government-sponsored relief programs (small businesses had no need to borrow).
We’re mostly past that, and the industry has been close to full speed (albeit more conservatively) for nearly a year now, and although the players have changed some, there seems to be as many participants now as there were pre 2020, and applications are once again growing.
The divergence has widened, with the more established Lenders increasing their eligibility requirements; applicants with higher credit, longer times in business, higher minimum revenues, offering approvals only to those that qualify for higher funding amounts. Their reasoning is that the amount of paperwork and time it takes to underwrite a file, and the number of files they need to underwrite to fund a deal has made funding smaller dollar amount deals unprofitable.
This echoes almost exactly what was said of the banks less than 2 decades ago.
The result of this has taken a toll on Brokers, increasing their acquisition and operating costs, and thus lowering their chances of long-term success. Additionally, this has left some Small Businesses with fewer options.
For the following discussion, when historical data is needed, we’ll refer to a dataset of 750,000 Merchant Cash Advance and Small Business Loan applications of which 140,000 were approved for terms between 3 and 12 months; and 60,000 were funded to just over 40,000 unique small businesses. Except for default rates, and unless stated otherwise, results are normalized per 1,000 records.
Between leads’ providers, digital and conventional marketing strategies, and the mining of their own data, Brokers have maintained an edge in their access to Small Business owners. Established Lenders have created an opportunity for Brokers to leverage this advantage and extend their role.
To maximize this opportunity, our thesis is that Brokers, with a small but significant debt facility ($500k) can offer small-dollar amount, short-term fundings (up to $10k for up to 6 months) to a sizable population of small businesses; and then working with their current and new Lenders to provide follow-up funding to a subset of these borrowers.
In this manner;
As a Lender, with a focus on low and medium risk small businesses, we’ll assume an average funding amount of $7,500 over 5 months at a 1.22 factor rate, with an expected average default rate of 5.63%. This offer was chosen for a number of reasons;
$788/7,275 = 10.83% per 5 months *(12/5) = 26% per year
As a broker, we’ll assume an average funding amount of $60,000 over 9 months at a 1.32 factor rate. This offer was chosen for several reasons;
The Economics are simple, 4% in, 1% to the salesroom, 3% to the house.
It’s important to keep in mind that the goal is for brokerage income and origination fees (both paid upfront) to exceed operating and capital expenses, with funding-related income to exceed funding-related expenses. This will help as you raise equity and/or debt.
The goal here is marketing, operations and sales efficiency, and the strategy to achieve this is by;
The size of a receivables purchase can be directly tied to the amount of the small business’ monthly revenue. For short-term funding, a range between 8% and 16% of monthly revenue is typically used, varying based on industry, credit quality, term, and other factors.
Extending our earlier example, it is expected that the small business generating $100,000 per month will pay back $79,200/9 months = $8,800 per month, or $8,800/$100,000 = 8.8% of its monthly revenue for debt service.
The following table shows the Monthly Revenue, Frequency of occurrence, and the % Revenue allocated for debt service for both the internally funded deals and the brokered-out deals.
We’ve broken down average monthly revenue into 4 buckets:
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It’s the 2nd ($25k to $75k) and 3rd buckets ($75k to $125k) that are our target audience; 537 per 1,000 applications received. As you can see in the table above, for buckets 2 and 3, the range in % Revenue used to service debt is 1.46% to 7.32% for in-house funding. For brokered deals, in bucket 3, the range is from 7.04% to 11.73%.
Applicants that are smaller than this present a higher risk to lend to directly, would require higher pricing, and would need to be supported by an active Collections department. Also, there are few and diminishing outlets for brokering files this size.
Applicants that are larger than this may not see a benefit to receiving the initial $10,000 offer, and the brokering of deals this size, although lucrative, is disproportionately time consuming and paperwork intensive. We posit that the larger Lenders would be inclined to pay a referral fee for such leads. However, we have not included any referral revenues in the economic model that follows.
The access, dissemination, and organization of underwriting data has historically been a cumbersome, time-consuming and error-prone exercise. Increased access to this data thru the use of APIs has solved for this and has enabled its automation. By further extending this into the population of credit scorecards that drive decision and pricing engines will enable the delivery of these small-dollar loans accurately, efficiently and profitably.
To standardize and streamline the underwriting process, the use of credit models and underwriting algorithms have gained wide acceptance. For transaction up to $10,000, we recommend the use of a credit scorecard that incorporates the following dataset.
If you notice, there is no mention of personal or business credit; analysis of deal performance at this size shows negligible correlation to credit quality.
Based on the sources and quantities purchased, the cost to acquire this dataset runs about $12.50 per applicant.
Once scored, decisioning and pricing can be completed and presented to the borrower. If accepted, online checkout, funding and servicing follow.
Digital applications, online checkout, underwriting models and conventional credit scorecards are currently widely in use. Online decisioning, pricing, origination, servicing and management platforms with varying degrees of automation are becoming more readily available.
Ideally, these self-service transactions should take about 10 minutes from application to funding .
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As you can see, growth is gradual and steady, with 4 times as many in-house deals as there are those that are brokered. Also note, due to the short-term nature of the in-house deals, 4.5 months on average, renewals exceed new business after just 18 months. Less marketing, less commission, and fewer net dollars out associated with renewals' business have a material effect on unit economics.
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As you can see, brokered business volume is twice that of in-house origination. Risk-free generated income is key to keeping investment costs down.
With just a little more effort, this company can break $100m in year 5.
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As you can see, the business turns cashflow positive in month 9, and as such, is thereafter self-sufficient; this includes all Operating & Capital Expenses and Lending Expenses.
Building this business from scratch will require about $500,000 in Debt and $180,000 in Equity. The equity portion varies of course for existing Brokers that are already cashflow positive. See the tables that follow.
Note 1 - Drawn down thru Month 8
Note 2 - Interest only Months 1 thru 12, Principal and Interest Months 13 to 36
Note 3 - Assuming an interest rate of 12%
Note 1 - Drawn down thru Month 10
Note 2 - Repayments after debt balance paid, Months 37 to 48
Note 3 - Assuming an interest rate of 12%
Note 1 - This is needed early on to pay interest on the debt
Note 2 - Drawn down thru Month 8
Note 3 - Repayments after debt balance paid, Months 37 to 48
Note 4 - Assuming an interest rate of 12%
As you can see, by Month 8, Receivables Outstanding exceed Total Debt & Investment.
As discussed above, by Month 9, the business turns cashflow positive, and the business is self-sufficient. As can be seen here, Breakeven occurs during Month 18.
An opportunity for MCA Brokers to extend their business has emerged; to that of a Broker Lender. With the right plans and systems in place, Broker Lenders will be able to leverage their vast knowledge of the Small Business landscape to provide a fast, friendly and fairly priced product to a wide audience of business owners.
The model we have presented here is significant enough to attract entrants and investors, while small enough to be run by a team in the single-digits. As can be seen, managed properly, this business can generate substantial returns on investment.
We anticipate that Broker Lenders will be a welcome addition to the industry, by filling a void while enhancing their Brokerage relationships. By filtering applicants up front, Broker Lenders will be able to direct applicants to the right Lenders, creating efficiency gains throughout the supply chain. Additionally, new fintech products for Small Businesses are being developed and deployed regularly; having a substantial book of in-house clients will add enterprise value to the Lender Broker business and open many other opportunities.
Sherif Hassan is the principal of Syh Strategies, a financial and technology services advisory firm based in New York City. Among the services they provide in Lending are business strategy, portfolio analysis, credit modeling, product and pricing optimization, and operations architecture for lenders and brokers of all sizes and at all stages of development. He can be contacted at sherif@syhstrategies.com.
