Even finance whizzes say it's impossible to compare online small business loan options

The Lotus Method fitness studios in the San Francisco area cater to pregnant women and new moms.
The Lotus Method fitness studios in the San Francisco area cater to pregnant women and new moms. Courtesy of The Lotus Method

Second of two stories on unregulated online financing options for small businesses: They're quick and available even to those with imperfect credit ratings. But some say their high costs make them akin to payday loans, and bankruptcies tied to these offerings are on the rise. Read the first story here.

WASHINGTON — With more than a decade of experience working in finance, Wesley Kennedy is savvier about money than the average small businessperson.

He figured his expertise would land him and his wife funding at favorable terms when they needed quick cash to help them expand The Lotus Method fitness studios they run in the San Francisco area, which cater to pregnant women and new mothers.

But when he turned to nontraditional, online companies for the financing, he was surprised by what he saw. Unlike banks, these companies require direct access to a business’s bank account or credit card payment system. Every day, they drain out a set amount – or sometimes a percentage of sales – until they’re paid an agreed-upon sum for having provided the money in the first place.

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And when he tried to compare offers from different companies, his frustration level hit the ceiling.

“They do everything in their power to make sure that you can’t compare A to B,” he said, with fees, costs and other terms presented in a myriad of ways from company to company.

That would change under a bill making its way through the California statehouse that would require the online firms offering loans and merchant cash advances (which are similar to online loans but have no fixed repayment terms) to disclose up front the annualized cost of the financing they provide and all the fees attached to their products; those frequently aren’t spelled out for business owners.

If it passes, the California measure would be the first in the country to impact this largely unregulated realm of credit that small businesses sometimes are forced to rely on.

“Especially in the market for short-term financing, you see loans and cash advances with high fees and charges that are often not clear to the consumer,” said the bill’s sponsor, Democratic state Sen. Steve Glazer of Orinda, Calif. “That’s why this bill proposes a simple, consistent disclosure for all small business financing in California.”

While many of the companies that would be affected — firms like Yellowstone Capital, Everest Business Funding and Platinum Rapid Funding Group — aren’t household names, the bill also would reach some of the best-known technology companies in the country.

Amazon, PayPal and Square each issued roughly $1 billion in online loans or cash advances in 2017 to businesses that use their services to process payments or sell products. The sums have been climbing steadily; PayPal even acquired a Delaware-based online provider of loans and merchant cash advances last year, Swift Financial, to continue growing in this space.

Providers big and small of this type of cash would be subject to the California measure — and for the most part, have worked against the legislation.

The bill has found some support in the online lending industry, though.

One of its biggest boosters is Levi King, the CEO of Nav, a website that collects financial information from small businesses and provides recommendations on the best loans or credit products available to them.

“It’s all about transparency and sales practices and metrics you can compare against,” said King, who started several small businesses himself before entering the online lending industry.

And some alternative lenders and merchant cash providers dropped their opposition to the bill, after Glazer tweaked its annual cost calculation requirement.

“What we’ve tried to do in California is work with the legislature to come up with a bill that will help industry but will also help small business owners better understand the products they’re getting into,” said Stephen Denis, executive director of the Small Business Financial Association, one of the trade groups representing companies in the industry.

[Have you taken out any merchant cash advances or online business loans? Tell us about your experience here.]

Struggling for bank loans

What the bill does not do is regulate the cost of such financial offerings.

Consumer advocates see that as a problem, and believe that the California legislation – or any attempt to regulate the industry – should cap how much these alternative lenders can charge, or require them to ensure that businesses can actually afford to repay the money they receive, as banks must do when making loans.

“Something that protects the borrower from getting trapped in debt, because disclosure doesn’t,” said Dory Rand, president of the Woodstock Institute, a consumer advocacy nonprofit for based in Illinois.

Not surprisingly, King, whose company makes money off referrals to online loan firms, said he does not support a cap on costs, despite maintaining that his “vision is to materially decrease the death rate of small businesses in the United States.

“There’s times it makes complete sense to borrow money at 300 percent,” he said.

That’s in part because so many small businesses struggle to get loans from traditional banks.

“In the most robust times for credit about half of small businesses aren’t getting a loan,” said Karen Mills, the former head of the Small Business Administration.

She’s done research that shows it’s particularly hard for small businesses to obtain bank loans of less than $250,000.

“The banks are the ones that are to blame for this,” said Kennedy, who was eventually able to negotiate terms he could live with for The Lotus Method's online loans.

He acknowledges that online providers charge “ridiculous fees.” But “if you remove them from the ecosystem, there are a lot of people who aren’t going to get the capital that they need,” he said.

That includes the owners of Los Angeles bakery Southern Girl Desserts.

Catarah Coleman, co-founder of Southern Girls Desserts in Los Angeles, was in tears the day before her wedding over the money she owed to online loan and merchant cash advance providers.

Catarah Coleman and Shoneji Robison picked a seemingly auspicious time to expand: They found a large corner space in a popular mall in Los Angeles in 2012 — and the next year, saw a rush of new customers when they won the Food Network’s Cupcake Wars.

But they maxed out their credit cards and cashed in their retirement accounts to pay for the construction, and still struggled with payroll each month.

When banks turned down their loan applications, a friend from church suggested they go the online route.

The pair wound up taking out loans and advances one on top of the other. The high costs and fast repayment schedules started to mount.

Coleman found herself panicking about repaying the bills, even at what should have been the happiest of times.

“I’m at my wedding the day before in tears, like, “How am I going to do this?” Coleman said.

An earlier stab at constraints

The California bill is not the first attempt to regulate online lenders and merchant cash advance companies.

Illinois lawmakers introduced similar legislation in 2016 that, in addition, would have required companies to determine a borrower’s ability to repay before offering a loan or advance, and to be licensed by the state.

That bill was largely the brainchild of Kurt Summers, the city of Chicago’s treasurer, who said he first became aware of the issues surrounding small business capital after he visited each of Chicago’s 77 neighborhoods early in his term.

“Story after story, we heard lack of disclosure [by] the capital providers,” Summers said.

The bill drew quick and furious opposition from both the nontraditional companies and conventional banks. Summers said he called it “the Illinois lobbyist act of 2016.”

The measure never made it to a floor vote.

The California bill was inspired partly by the Illinois effort, but also by a model framework for voluntary disclosure developed by a trade group for several large nonbank lenders like OnDeck Capital and Kabbage. The model, called the SMART Box, envisions disclosure of all the costs and fees associated with cash advances and loans, as well as the equivalent of an annualized rate of interest and the cost per month.

The model is barely used, though.

And the group’s CEO, Scott Stewart, says its members are against the bill, wary of state-driven regulation.

“We think a patchwork of different regulations is not helpful for small business borrowers,” Stewart said.

Passing the buck

In the absence of regulation, some of the issues surrounding this type of financing — particularly merchant cash advances — have been litigated in the courts.

Many of the lawsuits have alleged that the advances are really loans by another name and, as such, subject to usury laws.

But the merchant cash companies' argument that they're actually purchasing a slice of future business revenue, so the money they provide is an investment, has won out more often than not, according to McClatchy’s review of dozens of cases across the country. That includes a much-watched decision in March by a New York State Supreme Court judge in Manhattan confirming that a merchant cash agreement was not a loan and, thus, not subject to usury laws.

One notable exception: A New York State Supreme Court judge in Westchester County ruled against merchant cash company Pearl Capital in October 2016, finding that the terms of the advance -- and testimony from Pearl Capital -- didn’t properly establish the advance as an investment, rather than a loan. And Justice David Everett assailed Pearl’s agreement with the borrower for being “illegible, with excessively small print.”

In 2011, Can Capital settled with plaintiffs in a class action suit in California for $23.4 million. Again, the suit alleged that the company's cash advances (under the name AdvanceMe) were really usurious loans.

The online options have received little attention in Congress. After launching an investigation in 2017, Rep. Emmanuel Cleaver, D-Mo., who sits on the House Financial Services Committee, said he wants to ensure that the algorithms used to approve, and set terms for, online loans and advances aren’t biased based on race, gender or other factors. He hasn’t focused on disclosure or capping the costs of these online offerings.

Mills, the former SBA head, and former Sen. Olympia Snowe, a Republican from Maine who used to chair the Senate Committee on Small Business, are preparing recommendations for Congress on improving small business lending; those will include requiring greater disclosure.

Small business lending is on the radar of some federal regulators.

“When small businesses take on high-cost payday-style loans, they can face financial ruin,” newly appointed Federal Trade Commissioner Rohit Chopra told McClatchy in a statement.“The FTC is the only federal agency with the authority to crack down on these high-cost small business loans offered by online outfits.”

But the FTC’s Republican chairman has shown little interest in this area, and has appointed a lawyer who represented payday lenders to lead the agency’s consumer protection unit.

Most observers expect that any meaningful controls on merchant cash advances and other non-bank small business loans will come first at the state, not federal, level.

“If you actually care about having a functioning marketplace for your small businesses you cannot afford to pass the buck to the federal government,” said Summers, the Chicago treasurer.

In California, companies opposed to Glazer’s bill have hired some of the state’s top lobbyists, including Mercury Public Affairs, Platinum Advisors and California Strategies & Advocacy.

Kate Fisher, a lawyer for an industry group that represents some of the biggest merchant cash advance companies, threatened in a May 9 hearing that members of the Commercial Finance Coalition might stop doing business in California if the bill passes.

That drew a fiery response from Glazer.

“If the worry is that somehow by more honestly disclosing the cost of your capital, small business people are going to run away and not borrow the money...then good riddance, get out of here,” he said. “I don’t want them in California, I don’t want them lending to our good people.”

On May 31, the bill received the minimum number of votes it needed to pass the Senate and will be considered this summer by the Assembly.

In Los Angeles, Southern Girls Desserts founder Catarah Coleman said the legislation is needed – and doesn’t believe it would kill the industry.

Lousy disclosure, she said, can lead owners of small businesses to make costly mistakes when they need capital — mistakes that can kill their bakeries, fitness studios, stationery stores, restaurants or whatever enterprises they pour their talents into.

“People still bungee jump knowing they could die,” said Coleman. “But they know they could die.”