Why Are Merchant Cash Advances So Expensive?
Opinions expressed by Contractor the contributors are theirs.
When I started observing the alternative finance industry in 2008, the press tended to be overwhelmingly negative toward merchant cash advances (MCAs). From New York Times blogs to Bloomberg Businessweek articles, lenders have been lambasted for charging excessively high interest rates. Although I think the perception is changing, it is worth explaining the factors that contribute to the high rates charged.
Let’s break down what an alternative finance provider needs to cover in that 30 to 40 percent factor rate (technically it’s a discount rate, which is the present cash value versus the future payment , rather than an interest rate), in order to take advantage of . As counterintuitive as it may seem, it’s not a given that backers make money off the cuff, and they could easily lose their shirts. They simply hedge their level of risk and even advance money at a rate of 50%, because that Forbes article explains, some lenders actually manage to lose money.
Related: Case Study: How a Merchant Cash Advance Worked in a Snap
In my opinion, there are a handful of components that add up to the 30-40% factor levels on MCAs. For the following illustration, assume a rate of 40%.
1. Commission: acquisition cost
The cost of customer acquisition alone accounts for about a quarter of that 40%. This is the commission paid to the independent service organization that brings the merchant to the backer. This represents 10 points of the 40, or 25%, of the funder’s total factoring rate. If the funder sells directly to merchants, given today’s exorbitant marketing costs, acquisition may take a larger chunk of the 40% – more like 12-15 points (the average acquisition cost of industry for a $30,000 advance is $2,600).
A large part of underwriting is for operations – overheads, personnel, etc. , it’s more like 5 to 10 percent. In the best case scenario, this equates to 7 or 8% of the gross profit margin of the funder.
3. Cost of capital
For small independent lenders, the cost of raising enough capital to deliver ACMs can be huge – up to half the factor rate, or 20%, of the total advance. As funders can take advantage of experience, historical data, infrastructure and technology, this number can drop as low as 8-15%.
Then there is the wildcard that the trade itself can under-execute when the trader takes longer to redeem than the originally agreed term. Let’s say the repayment of a six month advance increases to nine or ten months – what happens? First, the merchant, initially priced for a six-month repayment cycle based on underwriting assumptions and risk factors, significantly increases the risk level of the funder. It also exhausts the available facilities of the MCA company. The sums that would have been reimbursed and transferred to another advance are no longer available to the funder, who nevertheless pays the cost of this capital even if it is underperforming. And the default potential increases as the lead gets further away. All of this risk needs to be factored into the factor rate.
Related: Getting a Merchant Cash Advance Is Easy, But Reimbursing Can Be Expensive
Depending on how the financing from the alternative lender is arranged, the company may have a call for capital from the primary lender – and then it must bring in capital to draw that amount from the line. Depending on the covenants of the lender’s facility, the MCA company may then be required to constitute a reserve, which must be in cash. And if defaults increase, they could eventually render the business insolvent.
4. Bad Debts
Most of the 40% factor rate could potentially be bad debt: ACMs that default. The write-off rate can cost the funder 8-20% over the entire portfolio, depending on how the company has managed the overall risk. The defect can manifest itself in several ways. For example, there is outright fraud. It could also come from an entire industry sector that is performing poorly, funding programs that have not been well designed or that are not properly priced.
The bottom line is that alternative funders are lucky to get by after all of this. To earn their return and minimize their risk of default, they need to have the right mix: pricing risk, factor rates, lead times, lead time, schedules, systems and collections. It’s like dancing on the tip of the needle.
Related: Choosing a Lender? Beware of these expensive traps.