Square's not offering plain vanilla small business loans. With Square Capital, the San Francisco-based company is offering a more controversial product, called a merchant cash advance. In a merchant cash advance, the financier buys a portion of your future revenues--but at a discount. Technically, it's not a loan, and you're paying fees as opposed to interest. A Square spokesperson declined to comment on the specifics of the program.
Merchant cash advances have been around for a while, but they got a lot more attention after the financial crisis, when more companies started offering them. With banks reluctant to loan to small companies, merchant cash advances--along with other tools such as invoice financing and factoring--became one of the few ways small companies could get working capital.
Interest rates for merchant cash advances can be astronomical, sometimes reaching triple digits. The financing is somewhat risky, the time period of the cash advances tends to be very short, and the transactions aren't governed by usury laws.
Square's offering highlights just how tricky it is to evaluate merchant cash advances. Say you need $7,300. In an example cited by The Information, Square would require you to pay back the $7,300 plus a $1,022 fee. Yes, that $1,022 works out to 14 percent. But it's not a 14 percent annual rate, because there appears to be no fixed time period in which the loan needs to be repaid. Instead, in the example, every time you receive a credit card payment from a customer, Square will take 10 percent of it. If it takes you a year to pay back Square, then yes, you've paid a 14 percent annual interest rate.
Alternativley, say that right after you get the cash advance, your business takes off. Square is still taking 10 percent of each transaction, but now you manage to pay the loan off in only two months. That sounds great, right? But because you paid the whole thing in two months, your equivalent annual percentage rate is now more than 84 percent. That sounds horrible.
Defending the markup
At OnDeck Capital, another company that offers short-term cash to business owners, CEO Noah Breslow says that annual percentage rates average 56 percent. He says that business owners don't look at interest rates--they care about the bite each payment takes out of their cash flow. Plus, the amount his company charges is part of what allows it to make small loans in the first place.
OnDeck has built technology that helps it make loan decisions in just a few hours. Amounts under $35,000 can be approved in just a few minutes. That's something business owners care about, says Breslow, and it costs money to develop and implement those tools. Breslow says that as loan volume grows, rates will naturally come down.
Marco Lucioni, CEO of California microlender Opportunity Fund, agrees that rates are headed down. But he says it has nothing to do with loan volume. Instead, he says, it's about competition between lenders, which is increasing rapidly. Opportunity Fund has built an online lending engine too, but it doesn't make on-the-spot lending decisions. It takes about a week to get a loan (in the case of Opportunity Fund, the transaction is technically a loan), and Lucioni wants one of his lending officers to visit each business. As a nonprofit, Opportunity Fund built its technology with grant money, not venture capital. It's not under pressure to bring home tenfold returns.
Opportunity Fund is charging between 15 and 20 percent for loans through its platform. Compared to its competitors, that's low. Lucioni doesn't think he'll be that much of an outlier forever. Eventually, as the industry matures and it becomes easier for businesses to comparison shop for short-term money, he says rates will come down.
"Between 25 percent and 35 percent, including fees, is where it eventually comes in," Lucioni says. "That's doable in any state in the country. Those are rates any regulator will be able to stomach. It will take a while to get there." He declines to comment on what the range might be for a fair price on such a loan at this time. Cleverly, that's a debate Square is managing to stay out of, too--at least for now.