All small to medium-sized businesses have cash flow as a vital aspect that needs to be considered at all times. Good revenues accrued on paper but a poor cash flow can easily choke out a business. Cash is vital to keep business operations running, which can include paying suppliers or manging internal expenses like salaries. One may need urgent cash too in order to plan for seasonal growth or to cater to sudden spurt in demands. Therefore, businesses look out for different aids to manage the working capital needs effectively.
Traditionally, banks are always wary of providing credit to small businesses. Their books many a times reel with bad debts and higher provisions towards corporate advances. In absence of proper collateral, the small and medium sized businesses continue to have a huge gap towards access to capital. Additionally, most of small businesses do not have formal data points to enable Banks or other credit institutions to do underwriting.
In the recent few years, merchant cash advance (MCA) has been one of the growing areas in the alternative lending segments. Technically speaking, they are not loans extended by banks. MCA is a credit product offered by fintech players in the POS and payment gateway segments along with other financial institutions.
MCA provides entrepreneurs the choice of obtaining a discounted advance by pledging a part of their future POS and payments gateway sales on a regular basis. Therefore, he has the ability to collateralize his future cash flows and revenues in absence of traditional assets to pledge. This acts as a great solution for small businesses to meet their short-term financing needs in a seamless way. It also incentivizes merchants to adopt to digital payments as an alternate to cash-only payments. The value which MCA offers to merchants is that it has easy access, fast processing of application, high approval rate and absence of traditional collaterals. One of the biggest differentiators is that the collections are based on the revenue, i.e. payments are remitted from the bank account when the cash flows in. However, the APR (annualized percentage rate) for the merchant will increase if his POS sales are weak, thereby increasing his cost for the business.
How does a typical MCA work?
With a merchant cash advance, repayments are made through remittances from your bank account. It can be structured in two ways – one can get an upfront sum of cash in exchange for a part of the future credit and debit card sales, or one can get upfront cash that is repaid by remitting fixed daily or weekly debits from the merchant bank account. The merchant cash advance provider determines a factor rate based on the risk profile of the merchant. Higher the factor rate, the higher the fees the merchant pays. E.g. if the factor rate is 1.2 and the advance amount is $60,000, then the merchant has to pay back a total of $72,000. The MCA provider will automatically deduct a percentage of the POS sales as agreed upon in a fixed interval until the full amount of $72,000 is repaid. Higher the POS sales in a month, faster the merchant pays back. On other hand, if POS sales growth is low, longer the merchant will take to repay, thereby increasing the APR. In case of fixed withdrawals, payment does not fluctuate with sales. This means that the merchant will pay the same amount regardless of whether his sales are up or down.
Figure 1. Simple illustration flow of how MCA works
MCA has emerged as one of new lending model introduced post emergence of Fintechs. Many players in the payments segment (POS and Payments gateways) are venturing into becoming MCA providers. They either do it on their own books or tie up with other fintechs/financial institutions to source the capital. Payments is a volume-based business which works on thin margins. High transaction volumes are required to earn good revenues, thereby making transaction business non-lucrative beyond a point for growing revenues and profitability. Higher IRR (internal rate of return) is obtained in the lending business and that is the primary driving factor for fintech players in payments space to diversify their business into lending models like MCA.
One of the known used cases in the segment is Square, an US based financial services firm in the payments and merchant aggregation space. It provides working capital financing to the merchants on its platform via merchant cash advance. Based on card sales through square, the merchant can choose loan size and get customized offer to suit his needs. In return, square takes repayment from the merchant as a proportion of its daily card sales. The repayment is slower during times of weak sales, while it is much faster during peak sale cycles.
With need for credit quite evident in the current global scenario, many small businesses will have requirement of financing to re-start or support their cash-strapped businesses. With banks also being conservative about direct lending, alternate lending sources will have huge scope in the post-covid19 era. Rise of digital payments has already forced many merchants to shift to POS and PG based payments. This driver will continue to act even in the post covid world. With potential for POS based sales to rise further in the future, the demand for merchant cash advance will most likely continue to grow. There will be a huge opportunity for fintechs to cater to this need.