Embedded Lending Part-3: All you want to know about Merchant Cash Advance
How Fintech Companies can solve for Working Capital and Cash Flow needs of Small Businesses
As Embedded Lending picks-up steam, more and more companies would focus on creating innovative products that could be offered to their Anchor Partners and embedded using Technology. Since Technology, Data and Cash Flows find a beautiful intersection in Embedded Lending, one product that stands out is the Cash Advance (or Merchant Cash Advance) product
Cash Advance has been around for years now and is one of the most common use cases of Cash Flow based Lending. Simply put,
Cash Advance, as the name suggests, is an advance loan provided to a borrower (mostly a small business) based on their historical cash flows and on predictability of their future cash flows (which can be used to collect this advance)
It is almost the parallel of Salary Advance which many employers provide to their employees and deduct from the future payroll/salaries. Cash Advances are mostly provided by platforms or marketplaces where the borrowing entity is known to sell/provide a product or service on an ongoing basis
There are various variants of a Cash Advance product, some with fixed monthly obligations or EMIs, while others providing flexibility of repayment. There are some products which are a bit more sophisticated, where the lending entity is able to adjust the collections of the cash advance basis the volatility in cash flows. However, in most Cash Advance Products, following are the key components:
a. Tenure — This defines the time period in which the lending entity (the marketplace, platform or their embedded lender) will collect the cash advance from the borrower (a small business/SME in most cases)
b. Fixed Fee/Processing Charges — This is the one-time processing charge of the Cash Advance which is being added to the overall payout made by the borrower (or deducted upfront from the Cash Advance, depending on the lending entity)
c. Factor Rate/Interest Rate — This is the recurring fee that the lending entity charges and is added to the principal payments of the Cash Advance
d. Frequency of Cash Advance Collections by the Lending Entity — This is typically aligned to the frequency of payout/settlement by the Anchor Marketplace/Platform, being daily or weekly, as the case maybe
e. Deduction % — This is the most important piece in the Cash Advance product and defines the experience of the borrowing SME. This is the amount or proportion of deduction the lending entity applies on each of the payouts made by the Anchor to the borrowing SME to collect their dues
We can understand this use case better through an example. Suppose a seller on an E-Commerce marketplace is selling products worth $10,000 every month. Basis this data, the marketplace’s embedded lender provides the seller with two Cash Advance offers:
Offer-1: Cash Advance of $9,000 for 3 months, with a Factor of 1.10 and a Fixed Fee of 2%
Offer-2: Cash Advance of $12,000 for 6 months, with a Factor of 1.20 and a Fixed Fee of 3%
Now, Factor of 1.10 in Offer-1 implies that the seller would have to pay 1.10X of the Cash Advance amount, i.e., $9,900. Add to this, the Fixed Fee of 2%, which is 2% of $9,000 or $180. Hence, the total amount to be repaid becomes $9,900 + $180 = $10,080. Now two scenarios are possible:
a. Fixed Amount Collections (not flexible/non-cash-flow linked): The Embedded Lender collects the amount in fixed payouts. Hence, this amount is paid back in 3 months or 13 weeks. So, the monthly deduction would be $3,360 or weekly deduction would be $775
b. Fixed Proportion Collections (flexible/cash-flow linked): The Embedded Lender collects the amount in proportion to Cash Flows. Since, expected Cash Flows in 3 months would be $30,000, the Embedded Lender would apply a $10,080/$30,000 or 33.6% deduction in every payout to this seller
Interesting to note that the APR for Offer-1 here is 71% and for Offer-2 here is 75%. The borrower must be careful in doing these calculations before deciding on the offer (based on deduction percentage, amount required for their current needs or APR). At the same time, it is the responsibility of the Anchor Marketplace/Platform and the Embedded Lender to ensure the following:
a. Superior Customer Experience — Cash Advance is a simple lending product and because of the relationship of the Borrowing SME with the Anchor, the application process can be simplified to a few clicks and the customer experience can be the key
b. Proper Disclosures — While Cash Advance helps solve the liquidity/working capital problem of an SME, it normally is costlier than other Credit Products. It is the responsibility of the Anchor to disclose the Pricing/Fees and ensure that the same is clearly communicated to the borrowing SME
c. Transparency in Deductions — Cash Advance product involves weekly/daily deductions from the borrowing SME’s daily/weekly settlements/payouts by the Anchor or the Embedded Lender and thus should ensure transparency in the deduction calculations with the borrower
With Cash Flows based Underwriting, superior Technology-led digital onboarding and real-time approvals, and seamless collections through payout deductions, Cash Advance is one of the flagship products in Anchor-led models and an integral part of Embedded Lending use cases
