Small business growth can benefit from efficient access to capital, yet there are numerous challenges making it difficult for small business to secure such capital. Owners are often time and resource constrained, and the traditional borrowing process is time consuming and burdensome. Access to more traditional loans is also challenging in part because it is inherently difficult to assess the creditworthiness of small businesses. Small businesses are a diverse group spanning many different industries, stages of development, geographies, financial profiles and operating histories, historically making it difficult to assess creditworthiness in a uniform manner.
The cash advance is a new form of alternative financing for small business that is short term, similar to the personal payday loan. The average term of a cash advance loan is 3-12 months; its average yield is 40.4 percent APR and the average loan size is $50K – $300K, therefore making it a loan product built to fit most small companies.
Small businesses whose lending needs are not met by bank loans have historically resorted to a fragmented landscape of products that include merchant cash advances, credit cards, receivables factoring, equipment leases and home equity lines, each of which comes with its own challenges and limitations. Merchant cash advances are expensive and limited to certain industries. Credit cards are pervasive but cannot be used for certain types of expenses and face limitations on size. Equipment leasing has a cumbersome application process and is only appropriate for specific use cases. Factoring is useful for funding working capital, but requires commercial invoices as collateral. Home equity lines have strict collateral requirements, are unappealing to business owners on a personal level, and are challenging for businesses with multiple owners. Given the pros and cons of these options, cash advance loans can look like an attractive alternative to the small business owner, but before pursuing that route it is important to understand the ins and outs.
How do cash advance lenders work?
The cash advance lender (companies such as Kabbage and OnDeck) gets deals from a broker. The prospect i.e. the small business owner will fill out a short online application, and will typically send in copies of bank statements from the last three months. The cash advance loan is not underwritten based on cash flow or collateral, but instead it is based on the average daily balance of the business or borrower’s bank account. When approved, the cash advance lender will provide a loan of a multiple of the daily average bank balance.
How much does it cost?
The original APR quote tends to fall in the mid-teens, but this can significantly jump after closing costs and documentation fees are added. Also, the fees are front loaded, meaning if you want to prepay the loan you will still have to pay all the fees and interest. In total, will be looking at an APR rate as high as forty percent, give or take.
Consider the Pros and Cons
One of the biggest benefits of financing business through cash advance lenders is they are fast. Securing funding requires minimal information. Usually it entails completing a short online application and loans can be funded in as quickly as 1 to 3 business days.
Cash advance loans are unsecured, which means most cash advance lenders do not file financing statements (UCC1) against the borrower. This is good and bad. Since there is no public filing stating the assets of the borrower are pledged to a lender, a new lender can come in and loan on the same collateral. Thus, the cash advance lenders can “stack” loans. This means a borrower could have as many as 3 to 6 cash advance loans and if sales are weak, the payments could essentially bleed the company to death.
If the borrower also has a secured lender in place (i.e., a bank or factoring line of credit) and the cash advance lender does file a financing statement then the borrower is possibly in default with their secured lender. This scenario could cause disruptions to the borrower’s line of credit.
Also, cash advance repayments are typically made through an automatic clearing house debiting the borrower’s bank account. If an issue arises, it can be difficult to talk to someone or establish a lending relationship, as the set-up and transaction has all been established online. The other risk is these loans are frequently sold. Cash advance lenders can bundle loans and sell them in the secondary market. Thus, a borrower will be dealing with a large intuitional investor if there are any issues.
Small businesses are still largely underserved in the lending market and cash advances provide financing options that traditional institutions cannot. While there are a variety of other financing options serving the small business market, there is still a need for greater resources. According to the Federal Deposit Insurance Corporation there were $180 billion in business loan originations under $250,000 in the U.S. in the fourth quarter of 2014 across 22.1 million loans. For some small businesses a cash advance can be a good short-term fix, but before pursuing any option small business owners need to consider the long-term effects before favoring one form of financing over the other.
