In recent months, both BusinessWeek and Inc.com have featured articles describing the explosion of merchant cash advances as a funding source for small businesses. BusinessWeek reports that the size of the merchant cash advance industry “jumped 50% in 2007, to around $700 million.” The industry even has its own trade association, the North American Merchant Advance Association.
What are merchant cash advances? Traditionally, banks have lent money to small businesses and taken credit card receivables as collateral. As would be expected, the business pays back the loan over time with interest. In many cases, the loan agreement specifies that payments to the bank will be taken directly from the business’s credit card collections. Merchant cash advances are functionally very similar to credit card receivables lending – except that merchant cash providers are quick to point out that their agreements are not loans. According to AdvanceMe, the industry leader, a merchant cash provider “purchase[s] a portion of … future credit and debit sales at a discount.” For example, a merchant cash provider might give a business $100,000 in exchange for $130,000 of future credit card receivables. Then the merchant cash provider collects “a fixed percentage of daily credit [card] sales” until the agreement has been satisfied. Merchant cash providers claim they are supplying much needed liquidity to small businesses that have been squeezed by the credit crunch.
But the merchant cash advance industry is not without its critics. Because merchant cash advances are structured as sales and not loans, merchant cash advances need not comply with state usury law. Merchant cash advances are unquestionably more costly than traditional bank loan financing. Inc.com reports a typical 25% fee, but other press has reported more costly advances.
In addition, merchant cash advance agreements are treated differently from loans in bankruptcy proceedings. Merchant cash providers contend that they can continue to collect from credit card receipts even after a business has filed for bankruptcy (when the automatic stay protects the business from most loan collection efforts). Merchant cash advance agreements are not discharged in bankruptcy.
Of course, some courts may be willing to look beyond the form of the merchant cash advance agreement to find that the agreement is, in substance, a loan. (Courts have long struggled to distinguish leases from loans and have generally tried to look beyond the form of the transaction to the economics of the agreement.) If this happens, usury and/or bankruptcy laws could be applied directly to merchant cash advance agreements.
It is also possible that the rapid growth of the industry will attract legislation. I tend to favor free markets and believe that heavy-handed regulation here would be a mistake. It seems to me that the case for usury laws here is weaker than for the average consumer loan because small businesses should have some financial sophistication. Regardless of what happens, it should be interesting to watch this emerging industry.
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