A LOAN AGAIN
When small businesses in need of quick cash end up with a pile of high-interest debt
Natalie Bobak didn’t anticipate how much money would be going out the door as she struggled to get her bacon-themed restaurant called Porked off the ground.
She busted her budget more times than she imagined she would in the first few months trying to keep up with all the expenses. There was rent and overhead on the building in Lincoln Place, equipment to buy, employees to pay, and she always had to keep a fresh supply of the food.
“If you are trying to build a brand like I’m doing, it has to be perfect,” Ms. Bobak said. “It can’t be flying by the seat of our pants — ever.”
Within four months of opening her restaurant in October 2017, she hit a cash flow crunch. She needed a few thousand dollars for operating expenses. She couldn’t wait months for a traditional bank to approve her loan application. She didn’t even have weeks to spare.
Like many small business owners that find themselves in a bind, she turned to an alternative form of business financing called merchant capital.
“They look at your sales. You send them your bank statements and they come up with a loan amount,” Ms. Bobak said.
Later she would regret that decision.
A newer form of funding
The merchant advance industry is a relatively new form of funding for small businesses. It has thrived in light of the challenges that many small ventures experience when seeking traditional bank loans. Merchant advances are fast and easy, even if they can be expensive.
So many new firms have entered the marketplace that some industry observers see the warning signs of a bubble. According to MoneyThumb.com, as of May there were more than 1,000 merchant vendors across the U.S. and merchant cash advances provide $5 billion to $10 billion each year to small businesses.
The industry is also evolving. It used to be only businesses that accepted credit cards were eligible for a merchant advance. Now business that use ACH have become eligible as well. ACH payments are electronic payments made through the Automated Clearing House network. Funds move from one bank account to another with the help of an intermediary.
Merchant loans go by several different names — merchant cash advance, merchant capital, merchant financing or simply cash advance.
The type of small businesses that rely heaviest on merchant cash advances are restaurants and retail stores, which have significant ups and downs in their cash flow; and salons and auto repair shops, which usually service a heavy volume of credit card payments.
Credit card payments play an important role in the merchant cash advance business.
The merchant advance companies provide small business owners with cash to run their business. In return, the business owners allow the merchant lender to tap into the company’s bank accounts and daily credit card revenues.
Data in play
Kabbage, an Atlanta-based merchant lender that started doing business in 2011, is one of the largest players in the industry. The company said it has provided over $8 billion in capital to more than 200,000 businesses in all 50 states.
Laura Goldberg, chief revenue officer for Kabbage, said the company provides credit lines for up to $250,000. She said the company is able to make fast lending decisions due to its data-driven platform that looks at real-time business data.
If the company sells products online, she said Kabbage can link to Amazon, eBay and Facebook
accounts and pull data to make a credit decision.
“Interest rates are determined uniquely for each customer,” Ms. Goldberg said. “We allow our customers to compare familiar annual rates, but since we offer access to short-term loans with monthly fees, we also provide exact dollar amounts each loan will cost. We call it total cost of capital.”
She added, “It’s a monthly fee-based loan, and fees vary based on the customer.”
She said the monthly fee ranges from 1.5% to 10% each month.
The company believes the rates it charges small businesses are fair. “Our customers come back and take more loans,” she said.
Regulators on the lookout
Some advise that businesses should be careful when seeking funding through a merchant advance, something that can be challenging when the need for quick cash hits.
Bankruptcy attorney Matthew Herron, owner of Herron Business Law in Shadyside, said lending arrangements offered by some companies often sound like a traditional loan, but they are not. Interest rates on cash advances can sometimes exceed 400%, he said.
“Legally, they don’t classify this as a loan,” said Mr. Herron, who is Ms. Bobak’s attorney. “That’s how they can get around usury laws where they can charge unrealistic interest rates. They call it a merchant cash advance. They call it a receivables purchase. They call it merchant funding.
“But in reality it is a very high-interest loan,” he said. “The problem here is they don’t tell you when you get these loans is most businesses can’t survive it.”
Some federal and state regulators are taking a look at the industry’s growth and how some members operate.
In May, the Federal Trade Commission launched an investigation into the merchant cash advance industry based on potentially unfair contract terms imposed on small business borrowers. The district attorney of New York has launched a criminal investigation into the industry while the New York State attorney general’s office is in the midst of a civil probe.
Revenue committed to debt repayment
Pete Tolman, owner of Iron Born Pizza, said he was turned down by two banks at the end of 2018 when he was seeking capital to expand his Detroit-style pizza business to the Strip District. Bank officials wanted three years of sales data. He had one year.
“I can imagine what a big bank thinks when when they see a 32-year-old kid walk in who owns a pizza shop,” Mr. Tolman said. “All kinds of red flags should go off. As charming as I am and as good as my profit and cash balance looks, that’s not necessarily what they look for.”
He ended up borrowing $150,000 from Kabbage. He needed about $95,000 for a liquor license. The rest helped him to maintain the staff and restaurant in Millvale and to do construction work on the new store.
Mr. Tolman said at the height of his borrowing, his payments hit about $15,000 to $20,000 minimum monthly.
By contrast, a $100,000 business loan at 5.25% amortized over five years would have monthly payments of $1,898.60.
Mr. Tolman said he saw the merchant advance as a quick way to get a large influx of cash. But it got to a point where every dollar of revenue was committed to principal and interest debt repayment.
His situation changed over the summer when he was able to refinance $100,000 of the debt at a lower interest rate with a local fintech company called Honeycomb Credit and get help from the city’s Urban Redevelopment Authority.
Mr. Tolman’s current loan payments on $100,000 in debt with Oakland-based Honeycomb Credit are around $2,500 a month. He still owes $50,000 to Kabbage, but he can manage the payments now that his cash flow is freed up.
Refinancing debt
Honeycomb Credit has been around for almost three years, but the company has changed its business model.
Initially, it provided loans for small business to expand. Now it raises money through crowdfunding to provide loans for small businesses to refinance high-interest debt.
“What we found are a lot of businesses are taking on credit card debt or short-term loans to fund their expansion and then a couple of months or years down the road they are getting hit with cash flow problems,” said George Cook, CEO of Honeycomb Credit. “We saw that situation was suffocating a lot of businesses.”
Honeycomb seems somewhat like a GoFundMe. But instead of everyday people donating money to a small business, they can invest whatever amount they are comfortable with in a locally owned small business.
The investment is structured as a traditional three- to five-year fully amortizing loan that the small business makes repayments on and those repayments are returned to the people who have invested in them. Honeycomb does not guarantee the loans.
“We are the marketplace,” Mr. Cook said.
“What we are doing when a business is looking for a project is we do some due diligence. We will try to make sure there is no fraud. We try to make sure the business has a sound business plan. If the small business is successful in raising the funds it needs, Honeycomb is paid a fee between 6% and 8% of what’s raised.”
The interest rate it charges small businesses ranges between 6% and 14%.
With the Honeycomb loan, Iron Born Pizza’s interest rate came out to around 11.25%, which was a far cry from the the estimated 40% to 50% interest rate that Mr. Cook said Iron Born had been paying for the money it borrowed from Kabbage.
A bankruptcy filing
Ms. Bobak hasn’t been so lucky. When she needed funds for her Porked restaurant, she found a merchant capital lender willing to deposit $5,000 into her bank account within 48 hours. Her crisis was solved for the time being.
But one merchant capital loan turned into another. Soon she was dealing with five different merchant capital lenders. She would use one loan that had a better payment structure to pay off another one.
Four of the companies were on a monthly or weekly payment schedule. She had to repay one daily. The company had access to her point-of-sale system and it would pull money out of her accounts.
“They were withdrawing money from my deposits from my credit card machines,” Ms. Bobak said. “They were also attacking money from my DoorDash, PostMates and GrubHub [door delivery service] accounts. They just take it.”
The initial $5,000 loan mushroomed to around $50,000 worth of high interest debt. Ms. Bobak recently filed for bankruptcy.
The courts have stopped the merchant lenders from raiding her company accounts and she can focus on rebuilding the financial health of her business.