When I first came to take a look at the alternative financing business, the press tended to be extremely negative about merchant cash advances. From blogs to articles, lenders were derided for charging extremely excessive interest rates. While the impression is changing, it’s worth explaining the factors that make contributions to the high interest rates charged.
Let’s take a look at what an alternative lender needs to cover within that 30-40% factor rate, this factor rate is also called discount rate, which is present value cash versus future expenses, except the interest rate, so as to come out ahead.
Even though it may sound contrary to common sense, it is not a given factor that lenders are making profits quickly and continuously. They are certainly overlaying their level of risk, and even advancing cash at a 50% rate, some lenders manage to lose their money. There are so many components that add up to the 30-40% factor rates on merchant cash advance. For the following instance, let’s count on a 40% rate.
- Value Of Acquisition
The cost and value of acquisition of the customer is quarter of that 40%. This is the fee paid to the independent service company that brings in the merchant to the lender. That is 10 points of the 40, or 25%, of the lender’s total factoring rate. In case the cash advance lender is selling directly to merchants, given present excessive marketing expenses, acquisition can take a large bite out of that 40% – more like 12 to 15 points.
- Underwriting Cost
A large part of the underwriting is in operations – overhead, employees, and so on. For a lender with advanced underwriting technology, this part can be as low as 3-6%; however for a lower tech, more employees-intensive business, it is more like 5-10%.
- Cost Of Capital
For smaller independent funders, what it costs to acquire sufficient cash to offer merchant cash advances can be immense – as much as half of the factor rate, or 20%, of the total advance. As the funders are able to get experience from, infrastructure and technology and historical records this number can go as low as 8-15%.
Then there is a twist of fate that the deal itself can under perform while the merchant takes longer to repay as compared to the originally agreed-upon term. Let’s say the repayment on a six-month advance goes out to 9-10 months – what goes on? Primarily, the merchant, basically cost for a six-monthly repayment cycle based on the underwriting assumptions and risk factors, considerably expands the funder’s risk.
The cash that would have been repaid and cycled into another advance are not available to the funder, who is despite the fact that paying for the value of that funding even as it is under performing. And the chances for default will increase the further the advance goes out. You also need to know that all this risk has to be charged into the factor rate.
Based on how the alternative lending is structured, the small business might get a capital call from the lender – and then they have to put up capital to take that amount off the line. Based on the covenants for the funder’s facility, the merchant cash advance lender may additionally need to set up a reserve, which should be in cash. And in case the defaults rise, they could ultimately leave the corporation bankrupt.
- Bad Debt Cost
The largest chunk of the 40% factor rate ought to possibly be bad debt: merchant cash advances that default. The write-off charges can cost the funder a whopping 8-20% off the entire portfolio, based on how properly the business has managed the overall risk. There are many ways that default can visible itself.
The end result is that alternative lenders are auspicious to come out ahead after all of this. To decrease their default risk, they should get the entire mix right: pricing risk, factor rates, turnaround times, term of the advance, packages, systems and collections.