Business Cash Advance in 2011-2012; Fool's Gold or Is the Gold Rush Back?

It is no surprise that in these uncertain economic times, small business owners face challenges when it comes to raising capital, whether for growth, expansion or just to help with cash flow. Yet these business owners need access to capital to enable their businesses to grow and to help bolster our economy. However, despite what we read about the federal government's TARP program and the pressure on financial institutions to lend, the vast majority of small business owners cannot borrow money.

Approximately ten years ago, a cottage industry, known as the Business Cash Advance industry (BCA), was established. BCA provides an alternative type of financing for small business owners who cannot obtain traditional financing. BCA is similar to traditional accounts receivable factoring with one glaring exception: while traditional factors finance a merchant's existing receivables, cash advance companies advance funds against future receivables and anticipate that those future receivables will be generated by the merchant. There are substantial risks to the BCA companies: a BCA is not a loan, there are no personal guarantees, collateral, late fees or predictable payments. Instead, the BCA companies receive a fixed agreed upon percentage of a merchant's future credit card transactions until the BCA company has received the total amount of future receivables that it has purchased.

Because of the risks that a BCA funder is subject to, traditional business cash advance factor rates are high, often in the range of 1.25 over a projected six or seven month term, meaning that if a BCA company advances $10,000 on day one, it is expecting to collect $12,500 over a six or seven month period. That sounds like an excellent return for the BCA Company, assuming that the merchant accepting the advance stays in business and generates subsequent credit card receivables within the anticipated timeframe.

Now, put yourself in the shoes of the merchant. Is the $10,000 fool's gold or is it an indication that the gold rush is back? Is it a good idea for a small business owner to sell $12,500 of future credit card receipts over an extended period for $10,000 on day one? Sounds expensive, but let's consider the options. With traditional providers of business working capital having basically closed their doors to American small business owners, where is the business owner to turn? Bank business loans, to the extent available, take months to close, require extensive documentation, personal guarantees, collateral, and are accompanied by late fees and penalties. Many small business owners in this economy have challenging personal credit and limited funds in the bank. Yet many of these business owners have opportunities to grow their businesses, improving the lives of the business owners and their families.

Let's consider an example. There is a pizzeria that has been in business for four years. The owner has a small, yet profitable business, selling $800,000 of pizza annually, earning an annual net profit of $80,000, or ten percent (Pizzeria 1). Two blocks down the road is another pizzeria, but this one is struggling, losing money because of a high cost of goods (Pizzeria 2), despite doing $500,000 in annual sales. As a result, the owner of Pizzeria 2 is looking to sell his business for $75,000, along with an assignment of his lease, which has five years remaining.

The owner of Pizzeria 1 is looking to expand. Assuming that he can generate the same net profit at Pizzeria 2 that he does at Pizzeria 1 (10% of gross sales, though the profit could be greater given economies of scale), he concludes that operating Pizzeria 2 could generate an additional net annual profit of $50,000. Yet despite his profitability at Pizzeria 1, he does not have the free cash flow to write a check for $75,000. He has a 650 credit score and an average daily bank balance of less than $250, so he will not qualify for an SBA or bank loan. In the world of traditional finance, the owner of Pizzeria 1 will hit a dead end, despite having a real opportunity to acquire Pizzeria 2.

What the owner of Pizzeria 1 does have is $50,000 of monthly credit card sales. A Business Cash Advance funding company, such as Merchant Cash and Capital, will likely allow him to leverage that $50,000 in credit card sales allowing him to sell a future amount of those sales for the $75,000 he will need to purchase Pizzeria 2.

Is the owner of Pizzeria making a wise decision? Is the $75,000 he has obtained from his BCA funder fool's gold? Or is it an example of the rebirth of the gold rush? Well, let's consider the economics of the transaction using the assumptions identified earlier in this article. In order to acquire the $75,000 needed to purchase Pizzeria 2, the owner of Pizzeria 1 will need to sell $93,750 of future credit card receivables ($75,000 x 1.25 factor rate). So the cost of the funds from the BCA Company will be $93,750 to the business owner. So, for a one-time cost of $93,750, the business owner will be buying a business that will generate annual profit of $50,000 (10% of $500,000 in annual sales) for each of the five years remaining on Pizzeria 2's lease. So for a short term cost of funds of $93,750, the new owner of Pizzeria 2 will generate a gross profit of $250,000 ($50,000 x 5 years remaining on the lease). This is hardly a case of a fool looking for gold. And while it may not be an example of the return of the gold rush, it does demonstrate that in certain circumstances, the BCA industry provides an important and accepted form of small business finance.

Although a recent Wall Street Journal online article supports the conclusion that the Business Cash Advance industry is growing and accepted, in order for a merchant to make a proper decision for his business, he must consider alternative options. One can only assume that in today's economy, a traditional bank loan will be out of the reach. In addition, a bank loan will take far more time to close than a business cash advance, require more paperwork, personal guarantees and collateral. The merchant will also have to pay the bank's legal fees and run the risk of penalties and late fees in the event scheduled payments are missed. None of these requirements apply to a cash advance.

Well, with a bank being eliminated as a capital source, where else can the small business owner look to? There are always friends and family. But it is a rare business owner that wants to be in debt to his friends and family and even rarer to want to take them in as partners having a say in how the business is operated. Some merchants look to professional investors or venture capitalists for funding. But it is difficult to imagine a professional investor providing capital for such a small transaction, and dealing with venture capitalists requires difficult discussions with respect to equity and control. These are not issues which the owner of Pizzeria 1 is going to have experience dealing with. And why should the owner of Pizzeria 1 want a partner, as a venture capitalist would demand? After all, our owner has already demonstrated an ability to make money.

So with other capital sources unavailable to our merchant, let's return to the Business Cash Advance (BCA) industry and look at its evolution. The owner of Pizzeria 1 has a credit score of 650 and positive bank balances. Business Cash Advance industry data will indicate that business owners with higher personal credit and positive bank balances are considered "Premium" merchants. As a result, this merchant may be able to qualify for so-called "Gold" or "Diamond" BCA programs, which are generally longer programs with lower factor rates. Should this be the case, the owner of Pizzeria 1 will have a lower cost of funds, enabling his return on the acquisition of Pizzeria 2 to increase.

It is difficult to equate the rise of the Business Cash Advance industry to the gold rush of the 1800's. But as this article demonstrates, business owners' utilization of merchant cash advances to grow their businesses is hardly an example of fool's gold.

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