There are over 32 million businesses registered in the United States. However, few small business owners have access to low-cost, reliable small business funding. And because small businesses need funding, small business owners turn to alternative funding sources to access what they need. And in turn, small business funders jump at the opportunity to fund those who need it.
However, the SEC and our firm estimate that default rates are as high or more than 50% on alternative loans and merchant cash advances. So, in this article we explore several (maybe harsh) ways that may explain why so many small business owners default on their fundings.
By Thomas Tramaglini, Chief Operations Officer
The Center for MCA Research
Out of the gate, it is a pretty simple concept. Business needs funding. Only funding available is through a merchant cash advance (MCA). Small business owner applies for funding and gets funding in a day or two.
Then, the fun (or no fun) begins.
Most small business owners who take on MCAs will have daily payments, high rates to pay back, and very short terms. Those attributes make it hard to pay back their commitments. Then, the small business owner may take on more funding or may default on their commitment. For many there is no clear off-ramp, as small business owners face legal action, UCC actions, harassment, loss of credibility in their business, and more.
Sound familiar?
The team at Beacon sees it every day. Small business owners who get in deep as fast as can be.
Dealing with negative outcomes of predatory lending in small businesses can be challenging, as often the damage has already been done. This article discusses various reasons why small business owners default and explores the implications of such situations.
The science behind alternative lending with merchant cash advances is just awful.
Perhaps the biggest reason for why small business owners default is because the funder should never have funded the small business owner.
How does the funding science work?
Small business owners submit their bank statements to an alternative lender(s). Usually three months is required for funding, as well as an application. So called underwriters (who are not really underwriters) analyze things like the number of deposits a small business owner makes, daily balances, expenditures, negative days, and pretty much anything they feel is important in funding.
Yet, it is pretty clear that the people who are funding deals are just hedging bets to fund the business owner and get paid back fast.
Banks have a very low default rate. Why? Because they use data which is over time and based on the profit that a small business has shown on their taxes and financials. Among other data used to fund businesses, banks use something called Debt Service Coverage Ratio (DSCR). DSCR is a statistic driven from the profit a business has over time. The number is usually 15% and banks will approve loans that fall within the 15% profit margin.
And while banks make it hard to borrow, they have a low default rate and relatively low risk. On the other hand, using 3 months of business data using bank statements is an awful way to hedge whether or not someone will be able to pay back what they owe. Bank statements yield little in what is really needed to gauge payback ability or even what a business may not be able to pay back. Bank statements do not include things like debt payments, commitments to contracts, or factors that might drive financial trends (such as the economy, interest rates, etc.).
Many MCA companies and small business funders have no idea what they are doing.
There is no certification or license to run a MCA company. Many MCA companies are in many cases a few people who have pooled their own monies and investors monies to distribute funds. Many MCA companies have no idea what they are doing, what to look at with financials, taxes, profit and loss, debt schedules, and more.
A strong demonstration of this is when MCA companies decide to give people 5, 6, 7, or more advances. In those cases, it is very hard to believe that anything other that roulette is being played with small business owners so MCA companies get rich fast. In some cases, small business owners are so over-leveraged that they cannot even pay their personal bills and in no way can repay a cash advance. But they are funded.
We are not saying that those who lend money need to be educated at Harvard, many in the industry are uneducated, poorly trained, and lack the basic knowledge to run fiduciaries which support small businesses. And what these funders peddle causes people and businesses to suffer in many ways.
In our opinion, its financial malpractice.
Many small business owners have no idea what they are getting into.
In the same way that many funders do not know what they are doing, many small business owners have no idea what they are committing to. So, when a small business owner signs on for a cash advance with a 50%+ fee payback in 120 days, with daily payments and massive origination fees, the outcome can be really ugly. When small business owners take on funding they should fully understand the commitment they are making, what can happen if they fail, and how it can influence their business. When 1 in 2 small business owners fail, there is no way that many understand what is going to happen to them until it is too late.
Small business owners are unclear of what alternative loans and merchant cash advances are and how they work.
Merchant cash advances are not loans. They are purchases of future receivables which alternative lenders hedge on so they can make money fast. However, many small business owners believe that there are safety measures intertwined into their lending, including the future ability to consolidate debt, which is rarely the case. Small business owners expect that if they have issues paying back their commitment that they will be supported. Some funders are proactive and work with small business owners. Most do not and once default occurs, all hell breaks loose.
Dishonesty rules the alternative lending world and small businesses pay the price.
Without regulation, few safeguards are in place that protect small businesses from the dishonesty that exists. Our firm daily sees things like fake bank statements, false contracts, lies about funding, untrue promises for consolidation, and more. There is NO accountability for anyone who preys and hurts small business owners. And it is because of the dishonesty that alternative lenders and brokers take advantage of business owners, until their finances are sucked dry.
Brokers
By far, broker are some of the most predatory vermin that take advantage of small business owners. We know that there are some honest brokers out there, but in all most are not honest and do not care about both the advance companies or the business owners. They do things like add fees beyond what is allowed, do not disclose important things about funding, they lie, cheat, change bank statements, sell your information, plagiarize, harass, and more.
Undoubtedly, brokers are one major reason for why small business owners fail to pay back their advances and suffer.
Alternative Lenders
Like brokers, while there are some outstanding alternative lenders, many are horrible. Many rip off small business owners, prey on the weaknesses of the business owners, and when a small business owner starts to have trouble, the lender swoops in and does whatever they can to destroy the small business owner. Overall, they have the ability provide terms which are tolerable and would decrease the default rates. However, they do not. They do not because they want to make money, FAST and that is it.
To our firm, when you could support small business owners and make money, few predatory lenders have any interest in making this industry reliable, supportive, or ethical.
It is get rich fast world and that is pretty much it.
So What?
The team at Beacon Client Solutions regularly works with clients who have been taken advantage of by MCA companies. Specifically, those business owners who have been burned.
Dr. Thomas Tramaglini is the Director of Operations and Negotiation for Beacon Client Solutions, a company that supports small businesses on a host of fronts, especially MCA debt. Thomas has been a small business owner for many years, as well as held leadership positions in several organizations and companies. Thomas holds a B.A. in History, as well as Masters and Doctorates in Organizational Leadership from Rutgers University, The State University of New Jersey.
Disclaimer: Beacon Client Solutions is not an accountancy, or a law firm. We are business consultants. While Beacon works with outstanding attorneys and accountants, we cannot and do not provide legal or tax advice. All of our work is connected to those who are legally certified to give such advice. Beacon does have a longstanding body of work in MCA resolution and understands what small business owners deal with, specific to MCA. Beacon Client Solutions serves clients in all 50 states, Puerto Rico, Mexico, and Canada.
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