Thanks, But No Thanks

Why to avoid taking out a merchant cash advance.

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In a tight credit market, businesses sometimes take funding wherever they can find it. But money that seems easy now may prove extremely difficult later. That's especially true with a fast-growing and risky new product for businesses, the merchant cash advance, or MCA.

A merchant cash advance -- also known as credit and receivables financing -- is essentially the business equivalent of a payday loan. A business owner is advanced a cash sum -- usually less than $150,000, often within a week and without the amount of paperwork required by banks. The merchant agrees to pay back the principal plus a fee, which is typically at least 25 percent of the total amount advanced but sometimes much more. The MCA provider collects the money by taking a portion of the business's credit card sales until the debt is paid.

Ideally, MCA providers offer companies with few financing options a quick, easy way to find funds in a cash-flow emergency. Some entrepreneurs like the arrangement because it allows them to repay less when sales are slow and more if revenue picks up. But it's a pricey form of financing. Most business owners complete repayment within six months, so paying a 25 percent fee is equivalent to taking out a loan with an annual interest rate of 50 percent or more.

A decade ago, there was one main MCA provider, AdvanceMe, then based in Kennesaw, Georgia, and it advanced less than $10 million a year. Now there are 50 such providers, says Marc Abbey, managing partner of First Annapolis, a consulting firm that has worked with MCA providers. Providers are now advancing about $700 million a year, and they have been marketing heavily, says Paul Martaus, president of Martaus & Associates, a research and consulting firm that focuses on the industry. AdvanceMe, now a wholly owned subsidiary of Capital Access Network, is still the biggest player in the industry and says it will probably advance about $1 billion to business owners over the next three years.

As the industry has grown, so has the controversy surrounding it. "The word unscrupulous comes up a lot in the business," Martaus says. Some providers advance as much money as possible, regardless of their customers' capacity for debt. Some have even changed their billing practices without notifying business owners. Last year, Karen Zebulon discovered that First Fund, the MCA provider she used for Gumbo, her Brooklyn clothing and gift store, had started taking money directly from her business checking account instead of deducting 25 percent of her credit card sales. Michael White, director of risk and recovery for First Fund, says the company's contract with Zebulon allowed such a change and that he reduced the withdrawals when Zebulon complained. But for Zebulon, it was too little, too late; she has since switched to AdvanceMe. "What First Fund did felt unethical," Zebulon says.

Traditional banks are regulated by several state and federal agencies, but MCA providers are not, partly because legally they are buying receivables, not making loans. That technicality also allows them to escape state usury laws; about a dozen states, including California and Texas, prohibit unlicensed lenders (and sometimes licensed ones) from charging businesses exorbitant interest rates.

Anat Levy, an attorney with Anat Levy & Associates in Beverly Hills, says usury laws should apply to MCA providers, too. In 2004, she filed a class action against Rewards Network (AMEX:IRN) on behalf of about 3,000 California restaurant owners. In court documents, the plaintiffs claimed the company broke California's usury law by charging effective interest rates as high as 419 percent. (Unlicensed lenders in the state aren't allowed to charge more than 10 percent.) Rewards Network, formerly known as both iDine and Transmedia, argued that its product isn't a loan. Indeed, the company says it's not even in the cash advance business, though it does provide funding to business owners, who repay it through receipts, with a fee that can reach 100 percent. But its process is more complicated than that of typical cash advance providers. Consumers register their credit cards with Rewards Network to get discounts at participating restaurants. Rewards Network advances cash to those restaurants, which pay it back by sending Rewards Network a portion -- typically 75 percent -- of the proceeds from meals bought by registered cardholders. In theory, if no such cardholders ever dined at the restaurant, the owner would never have to repay the advance, says Rewards Network CFO Chris Locke. He adds that Rewards Network brings new diners into participating restaurants. (In some cases restaurants don't take cash advances; they sign up because of the marketing advantages of the program, and they pay Rewards Network a smaller piece of each customer's bill.) The company contended in court that because it provided more than just money, its fees shouldn't be considered interest.

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