January 2014 – Issue 1

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The funding gap

The story of the rise of merchant cash advance might also be told as the failure of the small business banking markets.

In the words of many investment banking insiders and industry analysts, many small businesses in the United States are essentially “unbanked.”

That is because, for years, and certainly since the 2008 credit crisis, many, if not most U.S. banks have backed away from lending money to the small business community.

Insiders say that today the banks are ignoring merchants who, from a credit perspective, should be attractive to financial institutions who have traditionally lent money to them.

Even the most credit-worthy small businesses that are able to get funding are facing unfavorable terms.

Many businesses must put up collateral dollar-for-dollar, or pay exorbitant fixed costs — meaning if someone wants to borrow $5,000, but then has to pay $5,000 in fees and fixed costs, then the deal just doesn’t work. In this environment, only businesses seeking the largest loans can make them work profitably.

That is why so many businesses are now turning to merchant cash advances to fill in that gap.

“They are serving an important and large need,” Cox said. “Big banks are set up to serve big businesses best, but little businesses have a real need for capital.”

Most small businesses just fly under the radar of the commercial banks.

“A lot of the businesses that get involved in taking merchant cash advances have 500 and 550 FICOs. There is no way they are getting a loan from the bank,” said Tom McGovern, vice president for New York-based investment banking firm Cypress Associates.

Having a low FICO score is typical of small businesses that take on debt and mortgage their personal assets to get their companies off the ground, meaning that the companies that need funding most are now the least likely to be served by the banks.

“When I talk to bank CEOs, the rule is bigger is better,” McGovern said.

Large commercial banks are typically raising capital to raise their lending limits ultimately to make larger loans, not smaller loans.

“The result is that you have this unbanked sector that will stay unbanked. And this is the environment that merchant cash advance is serving, and that is why you see the growth over the last two years, and banks don’t seem to be coming back,” McGovern said. “I could even see that increasing.”

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