First 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; bankruptcies tied to these offerings are on the rise. Read the second story here.
WASHINGTON — The good news for Miami entrepreneurs Mariana Cortez and husband Sebastian Ghiragossian was that Whole Foods wanted to sell their popular vegan cupcakes in local stores – a highly-sought measure of success for any small-scale food producer.
Then an electrical problem threw a needed expansion of their Bunnie Cakes bakery six months behind schedule and wrecked the project’s budget. The couple turned to two online companies that promised them all the cash they needed in a matter of days.
That speed came at a cost. They received $133,000 and were on the hook for paying back a total of $193,000 – roughly one-and-a-half times what they had taken out. And the companies providing the funding, Can Capital and Yellowstone Capital, were given direct access to Bunnie Cakes’ bank account; they sucked out a portion of the bakery’s receipts each day until the full amount was repaid – in a matter of months, not years.
Yellowstone and Can are among the most prominent providers of online loans and so-called merchant cash advances that are increasingly popular with small businesses.
Unfortunately, a growing number of small business owners who have turned to these largely unregulated suppliers of capital have also filed for bankruptcy in the past five years, particularly in Florida.
Call them payday loans for your corner grocer.
“These things have the same functional problems as payday loans, except they’re worse,” said Mike Calhoun, president of the Center for Responsible Lending, a consumer advocacy group. “There’s very manipulative pricing.”
Why sign up for this costly type of financing? For one thing, despite the old bromide that small business is the backbone of the U.S. economy, many of those who run or are trying to start such an effort find it exceedingly difficult to get a traditional bank loan.
Community and regional banks approved just under 50 percent of their small business loan applications, while the rate was a much lower 25 percent at big banks, according to an April survey by online lending marketplace Biz2Credit.
Those aren’t great odds, and leave a lot of small businesses – over four hundred thousand of which are started each year, the U.S. Census Bureau estimates – looking elsewhere for financing.
Enter merchant cash advances and other online options.
The contracts typically carry the equivalent of what most would consider a hefty interest rate. The effective annual rate on Bunnie Cakes’ biggest contract was roughly 60 percent, an amount that would be considered usurious for similar consumer products in 38 states and Washington D.C., according to the National Consumer Law Center. And experts say it’s not uncommon to see rates for these products that reach into the triple digits.
For Bunnie Cakes, the high costs and daily withdrawals associated with their agreements made it hard to stay afloat.
“That almost put us into bankruptcy,” Ghiragossian said. “It was horrible.”
Individuals who take out payday loans are getting no bargain. But at least those loans are regulated by the federal Consumer Financial Protection Bureau and most states. Five states and Washington D.C. outright ban them, according to the National Conference on State Legislatures.
Small business financing attracts far less scrutiny.
“Small business borrowers are not afforded protections that consumer borrowers rely on,” said Karen Mills, the former head of the Small Business Administration and a senior fellow at the Harvard Business School.
Merchant cash advance providers, in particular, slip through the regulatory framework, which has led industry observers to label this kind of financing the “Wild, Wild West.”
“And many of them do prove to be bad actors,” Mills said.
Little attention has been paid at the federal level. But California, where the state Senate passed a bill last week to ensure uniform disclosure of the costs of these less conventional offerings, could be on its way to being the first state in the nation to impose rules on the providers.
The high cost of the quick capital infusions can prove to be a death knell for small businesses already struggling to pay their bills.
“There were nights when we couldn’t even sleep,” Ghiragossian said. “I remember that and it gives me chills.”
Business owners watching payments disappearing from their accounts often wind up in a ditch. A McClatchy analysis found more than 700 personal and business bankruptcies in the past 10 years associated with major merchant cash advance companies, as identified by industry trade publication deBanked.
And that tally may undercount how many businesses actually have gone under. Because merchant cash advances aren’t technically loans, their providers don’t necessarily appear as creditors in a bankruptcy filing. And many smaller businesses don’t even go through the trouble of filing for bankruptcy if they fail.
“It will just be a sale and the proceeds will be distributed to creditors informally,” said Craig Goldblatt, a D.C.-based bankruptcy lawyer at WilmerHale.
The number of bankruptcies has increased each year and there were nearly four times as many in 2017 -- 193 -- as five years earlier.
One feature that likely contributes to the failures: Merchant cash advance providers and other nonbank lenders don’t have to ensure that small business borrowers can afford to repay the funds. That sets these instruments apart from most other types financing, including home mortgages.
Experts say some of the blame rests with the borrowers themselves.
“There are small businesses looking for credit who probably shouldn’t be given credit,” Mills said.
But when a customer does run aground, these cash providers often are out less than other lenders, because they are repaid directly from the daily receipts of the business, even in its final days.
No state has seen more small businesses fail in connection with this kind of financing, even adjusted for population, than Florida, which accounted for nearly one in five of the bankruptcies reviewed by McClatchy. The Sunshine State saw nearly 40 associated with merchant cash advance companies in 2017 alone.
Miguel Pena’s Miami home health care company closed in 2015, but he continued to be pursued by the merchant cash companies and online lenders whose high fees had been part of what drove him out of his business. He was forced to file for bankruptcy both personally and on behalf of the company in 2016.
“It was the worst experience in my life,” he said.
Some entrepreneurs have appreciated the cash these companies provide.
Ainsley and Johnny Tsokos don’t regret the cash advances they took out to pay for unexpected costs as they transformed a former beauty salon into Cream Parlor, their ice cream shop and cafe in Miami’s Upper Eastside neighborhood.
“The value is that you can make your dreams come true,” Johnny Tsokos said. “I would not be here talking to you if we had not had those opportunities.”
Industry experts say that the popularity of these products that provide financing in exchange for a percentage of sales -- as well as other nonbank alternatives -- took off around a decade ago, when the recession brought a decline in small business lending from traditional banks.
“Even now, bank lending hasn’t fully recovered,” said Ann Marie Wiersch, a senior policy analyst at the Federal Reserve Bank of Cleveland.
She co-authored a 2013 report that pointed to tighter lending standards, decreased borrower demand and long-term consolidation in the banking industry as some of the factors creating a tight market for bank loans to small businesses.
Mills has done research that shows that small businesses have an especially hard time getting traditional loans under $250,000, which come with many of the same costs for banks as larger loans, but less potential for profit.
“If banks were doing their jobs, companies like us probably wouldn’t need to exist,” said Jason Fleming, vice president of direct sales at Mulligan Funding, a San Diego-based online funder that mainly offers short-term small business loans.
Some of the slack is taken up by groups known as community development financial institutions, which are banks, credit unions and other groups that offer capital to small businesses owned by minorities or based in economically distressed areas.
After they had paid off their advances, the owners of Cream Parlor turned to one of these groups, a local nonprofit called the Miami Bayside Foundation, for both loans and financial advice.
“They really got in the trenches with us,” Tsokos said. “We are very grateful to these guys.”
But the funding for those nonprofits, which comes in part from grants and tax credits from the U.S. Treasury Department, only goes so far.
“Last year we had 40,000 people reach out for capital,” said Gina Harman, CEO of Accion's U.S. network of four such lenders. “We can’t make 40,000 loans.”
And the growth of the online cash providers isn’t just a question of need, it also has a lot to do with the fact that they offer a faster, more user-friendly experience. And they provide funding big and small to a wider range of borrowers, including many who have less-than-stellar credit ratings.
“You don’t have to xerox a pile of paperwork and go from bank to bank,” said Mills. “You can now go online and get offers of credit with the touch of button, and you can get the money in your bank account within days or minutes.”
The providers are scattered around the country, though most heavily concentrated in the New York tri-state area and South Florida. One company was run out of a Long Island office shared with former Trump Organization associate Felix Sater, who had been working on a proposal to develop a Trump Tower in Moscow during the 2016 presidential campaign.
These new offerings still represent a small portion of the overall credit market, but not an insignificant one. In 2016, Treasury estimated that merchant cash advance companies alone offer $3 billion in credit each year, not counting similar online lenders.
Private equity firms and hedge funds have taken note. New York-based Pearl Capital was acquired in 2015 by Capital Z Partners; Strategic Funding Source, also in New York, got a $35 million investment in 2014 from Pine Brook Partners; and Maryland-based RapidAdvance was acquired by Rockbridge Growth Equity – co-founded by Quicken Loans founder Dan Gilbert – in 2013. Some of that enthusiasm has dimmed, however, in response to the disappointing performance of online lender On Deck Capital, which is now trading at roughly $7.00, one-third the amount of its $20 initial public offering in late 2014.
Putting businesses in the grave
A number of factors account for the higher costs associated with merchant cash advances and other online options.
The biggest one: These companies have to pay more than traditional banks to get money to lend out -- often borrowing cash from private equity or hedge funds.
They also tend to take on riskier borrowers than banks, with lower credit scores and shorter business histories.
But another key driver of costs: Often, there’s a middleman.
Brokers can earn commissions of up to 10 or 15 percent on each advance or loan they sell, and are under no obligation to share the best offer available with borrowers.
One trade group that represents a number of merchant cash and online loan providers -- including RapidAdvance, Strategic Funding and BFS Capital – is currently formulating guidelines on best practices for brokers.
“We want to be able to really help small businesses understand what a good broker is and what a bad broker is,” said Stephen Denis, executive director of the Small Business Finance Association.
Many point to brokers as the culprits behind a practice known as stacking, in which borrowers are encouraged to take on multiple advances or loans.
“It creates a spiraling, vicious cycle of debt,” said Jackson Mueller, associate director of the Milken Institute’s Center for Financial Markets.
The reality, though, is that some merchant cash providers themselves don’t believe it's their job to help entrepreneurs succeed, said Levi King, CEO of Nav, a web site that collects financial information from small businesses and provides recommendations on the best loans or credit products available to them.
He recalled a conversation with the CEO of one merchant cash company based in New York, in which the CEO compared his company’s small business borrowers to patients with stage 4 cancer.
“Does our product put them in the grave faster?” King remembered the CEO saying. “Yeah, but that’s a service to them.”