“Never attribute to malice that which is adequately explained by stupidity.” - Hanlon’s Razor (1980)

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“How did you go bankrupt?” Bill asked. “Two ways,” Mike said. “Gradually and then suddenly.” – Hemingway (1926)

 

Did you ever wonder what happened to the rest of those small businesses destined for distress and bankruptcy in the Covid/post-Covid era? Those businesses that took cash from the $905 billion Paycheck Protection Program (PPP) and Economic Injury Disaster Loan (EIDL) program that had to run out eventually. Around that time the Fed increased the federal funds rate up to 5.50%, shooting floating rate loans up to 9.35% and SBA rates to double-digits most assuredly leading borrowers to declining debt coverage availability. Around that same time the Subchapter V bankruptcy program was released at a perfect time to help with the inevitable onslaught of small business bankruptcies to a level which, only now, years later, has begun to exceed pre-pandemic levels.

 

Yeah! All those small businesses that somehow found a way to stay afloat.

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There is plenty of factual and anecdotal evidence for where many of these small businesses continued to find much-needed cash, but there is one increasingly prevalent source that has evolved into a coffin nail…the Merchant Cash Advance.

 

Put a Tarp Down First

 

Merchant Cash Advances, commonly known as MCAs, are an alternative form of business financing that provides a lump sum of cash in exchange for future sales revenue. While technically not a “loan,” or at least they don’t think so, MCAs are typically serviced through automatic daily or weekly drafts directly from the recipient’s bank account. They are generally easy to qualify for, especially if the business has a constant stream of sales, includes a fixed factor rate, repayment could be a fixed fee or include a holdback rate as a fixed percentage of sales, and the recipient can receive the funds in as little as 24-48 hours.

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Sounds great, right? A capital source for cash-strapped small businesses. But desperate times that lead to desperate measures are inevitably followed by desperate consequences. Here is how a typical MCA works.

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Little Suzy’s Cupcake shop has experienced sales declines since competition moved to town. Instead of adjusting to the new reality, Little Suzy’s was too late to realize bloated fixed payroll costs had eaten away cash reserves. Suzy went to her conventional lenders who unfortunately couldn’t help. But Suzy recalled seeing an online ad from sCapital, and after only 4 simple steps and no credit check, Suzy could have $100,000 in 24 hours to cover an upcoming payroll and more. And besides, despite the sales declines Little Suzy’s still generates an average of $135,000 in revenue per month, so there is plenty of cash inflow available for the repayment.

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After a few keystrokes, sCapital comes through with the requested $100,000 at a factor rate of 1.28x (typical range is 1.2x-1.5x) for a total repayment of $128,000 with a holdback rate of 15% (typical range is 10%-20%) of daily sales. What is even easier is that sCapital will draft a daily payment directly out of the bank account, so Suzy does not have to cut checks. Little Suzy’s reported average daily revenue of $4,500 is verified, so with the holdback rate, her average daily payment is $675. So long as sales hold, the debt will be paid off in 190 days (typical range is 3-18 months).

 

Annualized this translates into a total interest rate yield of…53.9%.

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Since Suzy obtained the funding under her own duress, she likely did not read the fine print. Because MCAs are not classified as loans, they are not subject to government-regulated lending practices or usury laws, and APR disclosure requirements can vary. Unlike other MCAs, fortunately, Little Suzy’s agreement doesn't have a contractual minimum payment, and the holdback is based on sales. However, if the business suffers any weeks of poor performance, it may quickly run out of cash for future operating expenses. Because MCAs generally do not modify their terms, what was an immediate fix could become the impetus to put Little Suzy’s out of business.

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MCA and “Your Bank” Should Never Be Spoken in the Same Sentence

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Lenders and advisors are generally familiar with the First Law of Holes - when you are in one...stop digging. But for cash-strapped small businesses, when you see an MCA start looking around for a rope, either to wrestle up a ladder…or a noose. There is likely an atomic-sized hole in the financials and a shovel lying around nearby.

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While it is not strictly enforced, MCAs will commonly file a UCC-1 lien despite a company’s having other secured debt. But does it matter? As the phrase suggests, possession is nine-tenths of the law, and liens on cash, including bank accounts, can only be perfected by possession. By capturing cash directly from the borrower’s bank account, an MCA, or often more than one (aka, MCA Stacking), “primes” all other lenders in the capital structure. And because many lenders, notably SBA, only require annual financials, it is not uncommon for an MCA to be discovered only after it is too late - after the borrower has missed multiple loan payments. To a desperate small business, knowingly or unknowingly busting covenants and ignoring loan agreement provisions is part of the calculus, but something to be dealt with later if it is ever discovered.

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Legally, the bankruptcy courts are scrutinizing MCA agreements to determine if they are purchases of future receivables, or loans subject to usury laws. They are examining reconciliation provisions, the presence of finite terms, and recourse during bankruptcy, all of which indicate MCAs are loans. But until it is settled, what is helpful is that if the MCA lender even shows up in court, claims can be challenged in bankruptcy proceedings, and because many are unsecured, they may be subject to a cramdown leading to a reduction or discharge.

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And fortunately, the automatic payment drafting stops when a debtor-in-possession (DIP) account is opened…hint hint.

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Moby Dick in a Fishbowl

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It has been estimated that since 1998, when the first MCA was deployed to a Gymboree franchise, the US merchant cash advance market has grown to $22.45 billion with projections showing up to 8.9% CAGR. This could be an impressive $44.5 billion market by 2031, which should be no surprise considering the up to 90% approval rating.

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There is a clear benefit to having the immediate access to capital that MCAs provide, but it's not uncommon for small businesses taking MCA debt to already be in distress. Hence the limited access to capital in the first place. MCAs know this, which paints them as potential predatory lenders. But any business that takes the cash does so of their own volition and is contractually obligated to pay the money back. No doubt many small businesses have gotten through MCA debt intact, but for others, perhaps Iron Mike Tyson said it best, “Everybody has a plan until they get punched in the face.”