Merchant Cash and Factoring: Can we all just get along?
Revenue-based advances known as merchant cash advance or “MCA” is a business that has exploded onto the scene in recent years. Like any new kid on the block, the welcome from the establishment has not always been warm and friendly. Nowhere is the tension greater than between MCA’s and the factoring industry. Factors have a number of reasons to be upset, including:
- Competition for broker leads. MCA’s pay big commissions up front, as opposed to factoring’s revenue stream.
- Hidden UCC’s. MCA’s are frequently using a “masking” service whereby a third party service company files the UCC in their name, disguising the identity of the true lender.
- “Stacking”, the practice of lending from a secondary secured position without bothering to notify the senior lender.
- Lack of self-regulation. Both factoring and MCA are unregulated financial services industries, but while factoring has developed self-regulation standards, MCA is still the “wild west” with a mix of players and practices that are not always ethical.
- MCA’s used to confine themselves to credit card advances and consumer based businesses. Increasingly, they are invading factorings turf: B2B accounts receivable based businesses, with repayments based on bank ACH debits.
- Unresolved legal issues. Though frequently lending from a subordinate position based on UCC filing date priority, MCA collection methods step on senior toes. I know of factoring companies who have received strongly worded demands from MCA’s based on creative and untested legal theories.
Overall, factors see MCA’s as a nuisance, a distraction, and unwanted competition. Some MCA companies have earned a reputation for being predatory, offering cash at exorbitant rates to desperate companies unlikely to reap any benefit from the high fee/aggressive repayment structure.
There is some irony in factors looking down their noses at the MCA’s. It wasn’t long ago that factoring was considered the shady side of the street, the lender of last resort. But factoring has done much to repair its image, notably with simplified contracts and value-added services like credit and collection management.
Can MCA emulate the factoring model and gain respectability?
Are there productive ways that factors and MCA’s can work together that actually benefit a borrower?
Some background: Non-interest non-lenders
Even more adamantly than in factoring, MCA’s will tell you they are not lenders, they are merely buying a future revenue stream. In this sense, they are stealing a page from the factoring playbook. Factors don’t “lend” against receivables, they “buy” the receivable at a discount. This allows the factor to charge a fee and therefore avoid interest rates which may be frowned upon by certain courts as usurious. The factoring contract could well be called a “Purchase Agreement” rather than a finance or loan agreement. Likewise, MCA’s advance against a percentage of future revenues for a designated period of time. The aggregate payments exceed the advance, generating profit potential. It’s interest, but it’s not interest.
The MCA’s “percentage of future revenue” worked well when the popular structure was based on credit card swipes, administered by a designated third party servicer. It the restaurant did $5000 on a night, the MCA received $500. If they had a slow night of only $2000, the MCA got a smaller $200 share. But all that’s changed. MCA’s are more likely to go with a bank debit arrangement, because not all businesses get significant sales revenue from card swipes. Taking “a percentage of sales revenue” from a bank account is problematic, however, for a number of reasons. That’s why most MCA’s put a “fixed payment addendum” into their agreements, translating (roughly) the estimated percentage of sales into a fixed dollar amount. Legally speaking, this is a bit touch-and-go.
The bank-based ACH model also leaves the MCA vulnerable to “stacking”, the practice of funding secondary or tertiary merchant advances behind the first. While the first MCA may have established a prudent, 10% of revenue daily ACH payback over a reasonable period of time, more aggressive (and less scrupulous) secondary lenders may structure a higher daily payment amount with an aggressive short term payback. With multiple lenders competing for daily bank balances, the situation can get nasty.
Factoring to the Rescue
A factor/MCA lending alliance could be structured in such a way as to resemble to more stable MCA credit card model. There are never any NSF notices with a credit card processor, because the processor sends a percentage of daily swipes. The credit card processor is not the bank, but he is the source of the funding that goes into the bank. The MCA is much better off dealing with revenue at the source.
And this is precisely what factors do. In most factoring arrangements, ALL sales run through the factor, in the form of unpaid invoicing to commercial customers. The factor decides how much to advance, and wires that advance to the bank account. What if the MCA could negotiate an agreement with the factor similar to the credit card processor: a fixed percentage of the factor disbursement directed to the MCA? Such an arrangement protects the MCA from secondary stacking because he is no longer competing for bank deposits, he’s getting funds before they hit the bank. The borrower benefits because he can plan his cash flow around a very predictable structure, meaning there is less chance of bouncing checks due to aggressive ACH debiting.
The factor? The factor benefits because the MCA is willing to do that “out-of-formula” advance that he’d prefer to avoid. Factoring clients are frequently asking for over-advances when they are short on payroll, or “PO financing” when they lack vendor credit. A quick call to a friendly MCA solves the problem. And the structure puts the factor in control of the funding process for both lenders.
An Evolving Market
The MCA market is changing fast. Not all of the changes will be painless, and not everyone will survive, but it’s likely that the mature market will have addressed many of the problems we see today, and the industry will become stable and self-regulating, just like its “big brother”, factoring. Cooperative models like this one may be a step in the right direction. In the meantime, there is opportunity for both sides to thrive and co-exist, provided they are willing to respect each other’s agreements. Who knows? It may not be long before we hear of MCA’s actually asking for an intercreditor agreement. Now about those masked UCC filings….