Growing Up, But Not Giving In
As our (not so little anymore) company continues our inevitable progression to “grow up” from a start-up with passion and big ideas to fully-streamlined institution capible of staying power, we are doing something I never thought we’d do: we are no longer offering cash advances.
Now, don’t get the wrong idea; this is in no way a move of desperation or even something that will have much impact on our originations or revenue through our current channels. Conversely, business is booming and we are reaping the benefits we sowed when we made a (difficult) decision early-on to bootstrap as much as possible in order to remain independent and investing in the platform instead of chasing growth. We remained one of the few players not be subject to the whims of a private equity firm pinning for a sale in an overheated market, but instead controlled our growth and controlled our destiny. In hindsight, our choice is looked obvious, but when you live your life to “compete”, it’s hard to remain on the sidelines. But we did, and are positioned so much better for it. While our competitors loosened credit to capture volume, we tighten our credit box and focused on new ways to de-risk our portfolio via various security strategies; the result is an industry with increasing loss rates, while our portfolio continues too outperform and has left us optimally positioned without the baggage of a toxic portfolio and more robust platform.
But we also didnt follow the market in another key way: while we did shift most of our book to loans, we didn’t follow our peers in dumping the stigmatized product of the cash advanec. But don’t let me get carried away: this won’t be headline news in the WSJ. Cash advances represent a small fraction of our business (under 10% of our portfolio) and much of the market wouldn’t even notice this change. But as a long standing advocate of the importance of the cash advance structure […when offered like a true cash advance….. See my next post!], this transition to a loan-only platform is both indicative of our maturation as a business but also, in my view at least, the coming to age of an industry frequently viewed as “lawless”. As the industry continues to embrace the idea of best practices and common-sense Federal regulation, best actors are choosing to “opt in” to oversight that comes with a loan product and cash advances are increasily symbolic of the “old way” in a nacent market; a rejection of mercurial roots and its a reputation as the “wild wild west”. Seven years ago, cash advances were the industries primary product; today, we were one of the last “best actors” that stubbornly fought the stigma to hold onto a product that I firmly believe can be a great alternative[…when offered like a true cash advance (see a theme here?…..]. But, stubbornness, my friends, is not a virtue and passion in leadership can so easily blur the bigger picture.
I do see the magnitude of the challenge we were facing to fight the growing “stigma” of the cash advance product and I’d be lying if I didnt feel a tinge of failure, temporarily at least, by eliminating the product. It also brings forwared a wide array of conflicting emotions: excitement, frustration, exhaustion, sadness…. that has finally led to on overarching feeling of “relief” and complete comfort in the knowedlge this is the right decision for Breakout Capital, and this was the right time to make it. As we fought to be an innovator in the industry, my steadfast insistence on “saving” the cash advance limited our reach to “clean up” the market and even stigmatized us to some as a company that truly employs best practices. But it’s also emblematic of the changing of the guard and growth of an industry, as “newer” companies such as Breakout Capital continue to steal marketshare from long-standing competitors and the industry rejects its untethered roots and embraces the need for basic controls, best practices, and common sense Federal oversight.
Those of you that know me know I have been a long-standing cheerleader of a merchant cash advance…. when offered properly: it is great for seasonal or lumpy businesses that leverage a variable payment to tie to cash flow trends. For new or higher risk businesses, selling receivables or a future revenue stream can save you a ton of hassle if your business goes under. Why? Because, since you bought future receivables, if those “receivables” aren’t there, you DO NOT owe anything and no personal guarantee can be enforced. I loved the fact that full alignment should exist as the cash advance company receives more in good times, and less in bad. And, so importantly the cash advance ushered in a new era of alternative small business financing solutions to a whole new set of previously “unbankable” businesses.
As a non-credit solution, a traditional cash advance is based on cash flow and the impact of FICO was minimized; in lending, you have two primary forces that dictate whether a borrower will pay: ability to pay (suffient cash generated by the business) and willingness to pay (the choice a business owner may make to stop paying a loan despite sufficient resources). Cash advances were supposed to reduce the “willingness” component and dilute the importance of credit scores, but as credit card spits turned to ACH debits (without lockboxes), the willingness component was reintroduced, thereby raising questions about the hisotrical models that used credit card splits and whether they could be a proper indicator of loss performance on a credit product — and as this industry continues to be impacted by more and more exogenous and truly unquantifiable factors such as stacking or the proliferation of the debt settlement business, is it safe to say that the original cash advance models that discounted FICO are now obselete, or at the very least, less accurate? For converted lenders, I believe FICO is undervalued in scoring models. But for the higher risk cash advance companies, the model changed from true customer risk assessments to one where excessive pricing enabled higher risk cash advance companies to price on a pool basis and augment already out-sized returns with predatory practices such as Double Dipping. That is not the market I want to be in. That is not how we compete, how we price, or how we lend. And after I spent years defending the product as a great solution the right type of business […when offered like a true cash advance…..], but the stigma, fair or not, proved a veil too thick for to pierce.
As a company, we pride ourselves on best practices and our ethics and it is somewhat ironic that we were one of the last first position companies to eliminate the product. Why? I knew we were offering a “true, unsecured, non-credit alternative”, and I truly believed the market would see past the product name. But I was wrong. Keeping a cash advance product did very little to boost our origination volume or revenue, but it did restrict meaningful opportunities to leverage our reputation as a best actor and add select widely respected partners that have taken an absolute view on the product; why? Because the precense of a cash advance in our product offering diluted our reputation as a best actor in the eyes of select partners who, and more are adopting this view, that the easist way to segment the “bad actors” was to broadly color the product as a universally predatory product.
To me, that stance, whether right or wrong, is at a minimum unfortunate as I do believe the cash advance structure should exist. And for a while, I viewed our inability to validate our cash advance product as failure and stubbornly grasped the final pieces of a dying product. But the more I really thought about it, I started to view it both as an opportunity not only remove that “shadow” or “black eye” that hindered growth our business, but more importantly, as a way to more openly address the problems in the product and come up with a better way to offer a product I do believe in, but in the way it was supposed to be offered. So we do expect to re-introduce a similar product with the borrower-friendly benefits of a cash advance, but, much like Square, offered as a loan and subject to lending laws like the rest of our products. And that’s exciting.
Let’s examine the great things about cash advances, and see where the market has gone wrong:
- A cash advance is not credit, and with the original cash advance structure (a credit card split), the impact of FICO on risk assessment was viably lessened, thereby increasing accessibility of capital.
Today: Cash advances are toeing the “non-credit” line too closely; a daily pay loan and a cash advance are so close in structure, the primary difference is simply contractual protection. Most advances are consistent amounts and typically collected daily ACH draws that can be cut off at anytime by a borrower. This reintroduces the “willingness” component of repayment risk and also reinforces FICO as a leading indicator of default.
2. There should be no term on a cash advance since the revenue holdback (the % of revenue the cash advance firm captured from the business) changes regularly; instead of an interest rate, the cash advance company draws or holdbacks a specific % of credit card sales or business receipts. If the business is booming, cash advance is paid more quickly and if it is slow season, a cash advance is paid more slowly (and the draws are smaller). It’s one of the most important and beneficial (from a merchant’s perspective) elements of the product structure.
Today: I’ll admit it. The introduction of an ACH product has made a core element of a cash advance — the “true ups” or fixed holdback percentages have been replaced by a fixed payment amount that should be “trued up” regularly to ensure the proper amount is pulled from the business each day or week — a cumbersome process that is increasingly ignored for ACH products. As a first position lender only, we can speak from (too much!) experience of being stacked, so we are familiar with how many firms in the high risk (AKA stacking) market deal with business dips or has cash flow issues; simple, right? Not in our experience; when we are stacked and a borrower requests a modification on our loan, we have yet to see a high risk “true up” on an ACH advance be anything more than a negotiation and modification, like a loan, based on how much the borrower can afford to pay instead of the holdback % as intended (again, I state this from our experience only and am in no way saying every cash advance is done this way — but it is unfortunately a common trend that we continue to see).
3. There is no recourse if you take a cash advance and your business fails organically. Personal Guarantees, if included, would only guarantee against “bad acts” or contractual defaults (e.g. change processors so advance company can’t collect).
Today: Outside of the true holdback of a credit card split, this has potentially changed the most and really has added a truly deceptive element to the product. Since cash advances only allow for “contractual default” (remember, it’s not credit, and if the receivables or receipts don’t materialize, no receipts or revenue should mean there is nothing to collect; but that isn’t the case (at least from our experience), many cash advance companies have made it so it is very difficult to fail organically but not also contractually default. If you ask around, you will be hard pressed to find many examples of companies that let organic defaults “walk”, but that’s how the product shoudl work. And in our limited cash advance experience, we have at least twice been offered to pay by a business owner that failed organically while on our cash advance, but we refused to accept any payment. They followed the spirit of the contract, and thier business failed; losing your business is hard enough, but one of the beaties of the cash advance is that you can walk away and not be burdened by debt. But we were in the minority, and it’s a shame. allow the company to get a default judgement, and/or enforce the personal guarantee of performance.
And it is getting more egregious and more egregious. Business issues, such as a missed ACH payment or two, is a commonly used mechanism to prove contractual default. And folks are getting more and more creative.
4. Confessions of Judgement, which are used by the bulk of the “high risk” cash advance companies today, weren’t used before. We can argue about the ethics of having someone confess judgement to a debt due before even taking the loan all day (hint: we won’t do it, except on charge-offs if a payment plan is executed), but since cash advances aren’t credit, what debt is the borrower confessing?
Today: I’ll be honest, COJs (Confessions of Judgement) are not only a strange tool to use since a cash advance is not-credit, and therefore is no “debt” to even confess (if enforced, and they aren’t always) are not only, in my view, predatory as frequently leveraged, are a direct violation on the non-credit element of the product.
5. Cash advances aren’t credit so it can be hard to compare to traditional products and APR is impossible to calcuate.
Today: If you uphold a cash advance has no term or interest rate, it is impossible to calculate APR. In an industry (cash advances) with little to no guidelines on how the product is sold, the defense of “there is no APR for a non-credit product”, despite its truth (assuming its done like a proper cash advance), can be a way to allow unsavory brokers or cash advance firms to shield rate. For example, in the “high risk cash advance” space, a product that carries an effective term of three months at a “factor rate” of 1.45x is a common product. Add a typical fee, the customer just received a product with an effectiveAPR of over 400% but had no idea. And if that product is Double Dipped? It can increase to over 600% effective APR but packaged to the customer to sound cheaper than it actually is. This problem is real, and the stigma is legitimate. And that is why we endorsed the SMART Box as a product comparison tool for all products, including cash advances.
6. So what’s next? I can name only a few firms left that offer a “good” cash advance, with true variable ACH or credit card splits. Are the rest just claiming this structure to skirt usury rates?
Today: That’s one of the most pressing questions that impacts so many small businesses across America. These products are high cost (despite their positioning) and with the short terms, high renewal rates, and Double Dipping on nearly every product, predatory practices, unnavoidable debt traps, and an unwillingness to disclose the true cost are killing businesses and they are raising the cost of capital for all firms in the space. This product has earned it’s stigma.
When we have a merchant that we find out has stacked us with a cash advance, the risk profile, even if everything else stayed the same, just increased and potentially meaningfully. And since, as a first position lender that goes out to two years consistently, this is an exogeneous factor that our credit model has to consider — how likely is thiscustomer to stack — that has absolutely nothing potentially to do with the risk of the business. We have created products that attempt to properly price these risks up front, but gradually remove these risk factors that are unknown on a deal by deal basis (this alslo includes the new wave of debt settlement companies). But our strategy isntcommon and i do think the cost of capital for every borrower needs to consider these risks up front (and mitigate on the back end) to avoid a carrying a toxic book of assets.
Despite your role as a reader in the “fintech” ecosystem, you probably think the title of this piece is wrong. We quit. We gave into the pressure to walk away. And even I believed that…. but as I thikn about it, I do belivee that by stepping back, removing that stigma from our book, walking away, at least temporarily, we are better positioned to shed light, educate merchants, and fix this part of the space help bring back a product I love. On that front, I’ll just say “stay tuned”.
