A New Age for Growth Capital

Strategies

By John Stewart

Thanks to new players, new tech, and new data sources, access to funding has never been so plentiful for small but growing merchants.

The payments industry often celebrates small merchants as the breeding ground of transaction growth. After all, as they start up, they offer new places for consumers to buy things, and as they grow they generate more buying activity.

That’s all to the good. But often overlooked is how these businesses start and grow in the first place. Where, in other words, does the fuel come from for this transaction growth?

Historically, expansion capital came from banks. But as banks retreated from the small-business market, that function fell increasingly to the same companies—acquirers and their representatives—that were selling card-processing services. Merchants could “sell” a portion of future credit card receipts in return for an immediate injection of cash.

That’s still the case. These so-called merchant cash advances, or MCAs, are still the dominant form of credit in what is now an approximately $5.25 billion market for alternative financing for small merchants.

But just in the past few years new players have busted into this market, bringing with them new methods and new technologies that are radically reshaping the business and heightening competitive pressure on everything from rates to how long it takes to get loan approvals.

In the process, small merchants—those Wal-Marts of the future—confront as never before a feast of alternative funding not only from independent sales organizations and other acquiring agents, but also from a raft of new players like Square Inc. and PayPal Inc. and from new online lenders like Kabbage Inc., On Deck Capital Inc., and Funding Circle Ltd.

Banks’ Retreat

The virtual implosion of traditional bank lending since the 2008 financial crisis has had much to do with this invasion of new players. “Small-business lending is broken. It’s very inefficient,” said Noah Breslow, chief executive of New York City-based On Deck during a talk last month at the Money20/20 conference in Las Vegas.

Small-business loans now account for 24% of all bank lending, down from 35% just before the crisis, according to On Deck, which was founded just two years before the worldwide financial collapse. That retreat by banks has left an enormous opportunity for alternative funders. While the market is growing about 20% annually, according to Omaha, Neb.-based consultancy The Strawhecker Group, that $5.25 billion total is a sliver of the overall $274 billion market opportunity estimated by On Deck.

Square is only the latest transaction processor to see that opportunity, and it’s not likely to be the last as the wave of lenders, investors, and processors pours in. At least for the time being, “I do foresee it continuing,” says Mark Cerminaro, chief revenue officer at Rapid Advance, Bethesda, Md., a 9-year-old provider of merchant cash advances that added short-term loans in the wake of the financial crisis.

As usually happens when competition heats up, pricing has been compressed. Take the venerable cash advance. With this product, a merchant agrees to hand over a slice of credit card receipts over time—say, six months—in return for an upfront injection of cash to add on to a building, pay employees, or meet some other immediate need.

The receipts handed over, of course, add up to the original advance plus some vigorish. So a $10,000 cash advance, repaid with card income, might cost the merchant as much as $13,300. According to David Goldin, president and chief executive of New York City-based funder AmeriMerchant LLC, that multiple, which five years ago ranged from 1.35 to 1.4, has come down to a range of 1.3 to 1.33. “It’s definitely more competitive now,” he says. “There’s a lot of new companies out there that think it’s easy.”

Secret Sauce

But, of course, it’s not easy. Challenges abound. Distribution costs can eat up profits if not carefully managed. So can bad risks, which become especially dangerous if the economy takes a dive. MCAs, after all, are a bit of a high-wire act without a net. There is no recourse when a merchant fails.

“Most new companies coming into the market don’t know how significant the losses can be in a down market,” says Barry Davis, who follows the business as a senior management consultant at The Strawhecker Group.

To deflect some of the competitive heat, many traditional cash-advance firms have added term-loan products in recent years. These products open a wider market, since not all businesses accept credit cards, and may lay off some of the credit risk of MCAs. “They’re trying to attract better-profile merchants,” says Janinne Dall’Orto, an analyst at First Annapolis Consulting, Annapolis, Md.

These loans, which typically carry a year-long term, are also called daily remittance loans because merchants agree to repay them with daily payments automatically transferred from their account to the lender’s account via the automated clearing house. The key with these loans is that they’re meant to help a growing business grow faster. “We are not a funder of last resort,” says Cerminaro.

But the gaping opportunity in merchant lending has also brought in a new sort of player, one that depends on automated data analytics to pinpoint good risks. Square, for example, entered the market in May with its Square Capital line and within six months had advanced $75 million to 15,000 businesses that use Square to process card transactions.

That direct access to transaction data represents a big advantage for companies like Square and PayPal, which has a competing product called PayPal Working Capital. Without recourse to any external data, they can monitor cash flow, identify growing businesses, and pitch cash to merchants for specific uses—more chairs for a hair salon, for example.

The processing relationship also makes a difference to the merchant when it’s seeking funds. “Square is in a unique position because we’re already processing the business’s payments,” says a Square spokesperson. “It feels very logical for them to get small-business financing from Square.”

Atlanta-based Kabbage Inc., meanwhile, got started three years ago extending lines of credit to Internet merchants. In February, it began lending to brick-and-mortar merchants, and expects to begin white-labeling its technology to banks. Overall, it has extended $500 million in capital to small businesses.

Its secret sauce is a proprietary algorithm that crunches data not from loan applications or landlord interviews but from the online marketplaces that serve small merchants—eBay Inc. and Amazon.com Inc. for example. Relying on such so-called alternative data (Kabbage still gets a FICO score, but this carries only about a 5% weight in the risk calculation), the algorithm churns out a yes or no.

‘Market Correction’

This one-two punch of data and technology hasn’t been lost on some of the larger cash-advance players. New York City-based CAN Capital Inc., which operates through two units, CAN Capital Merchant Services Inc. for cash advances and CAN Capital Asset Servicing Inc. for loans, is deploying technology to control distribution costs.

Distribution is the bane of cash advances. The product has typically relied on legions of ISOs, middlemen who have to be compensated and also trained in the products they’re selling. “It’s a high-cost model,” says James Mendelsohn, chief marketing officer at CAN Capital.

So CAN is looking to take out some of that cost by integrating its product line with third-party business-management software, such as the Yodlee Small Business Portal. The new service, CAN Connect, can take an application in 10 minutes and render a quick approval.

Meanwhile, the flood of new entrants, combined with the squeeze on pricing, has some players predicting a nasty shakeout. “We’re due for a market correction,” warns AmeriMerchant’s Goldin. The survivors are likely to be firms with deep roots in an established book of business, he figures.

But don’t discount some of the newcomers. In an age of ever more potent computing, it could be dangerous betting against the power of data.

Growth in the Kabbage Patch

In short order, competition in the business of funding small merchants has ratcheted up to new highs, with new, online and technology-based entrants flooding the market.

One of the most recent, and successful, of these new entrants is Atlanta-based Kabbage Inc., which this year will hit the $500 million mark in total loans extended to both e-commerce and brick-and-mortar merchants.

Some $390 million of that lending, or nearly 80% of the total, has flowed out just in 2014 alone. “2014 has been an astounding year for us,” says Victoria Treyger, Kabbage’s chief marketing officer.

Much of this momentum has come since the 3-year-old company in February began extending lines of credit to physical merchants. Until then, Kabbage had funded online sellers exclusively. To add the new class of client, it doubled its maximum credit line to $100,000. Physical merchants “tend to be larger, they tend to have five, seven, or 10 locations, more employees, and so have broader needs for Kabbage funds,” Treyger says.

Now, physical sellers are Kabbage’s fastest-growing market segment.

But the company’s move into this arena, combined with its rapid expansion, has brought Kabbage—known for its lightning-quick approvals and one-to-three-day funding—into direct competition with marketers of traditional merchant cash advances (MCAs).

This market, which has historically been driven by independent sales organizations selling MCAs on top of processing services, has already seen rivalry heat up with the entrance of new players.

And it’s not likely to stop with startups or near-startups like Kabbage and Square. “You’ll see more companies getting into the cash-advance space because of the improvement of the economy and demand from merchants,” notes Janinne Dall’Orto, who follows the business as an analyst at First Annapolis Consulting, Annapolis, Md.

Strictly speaking, Kabbage doesn’t extend cash advances, which are typically funds merchants receive against expected credit card receipts. Instead, it sets up a line of credit that merchants can tap at any time. Its typical line, Treyger says, ranges from $20,000 to $25,000, or up to five times more than the average merchant cash advance from Square.

Kabbage started out with online businesses because it could set up links with online data sources serving those merchants, companies like Intuit Inc., eBay Inc., and Amazon.com Inc. Through an application programming interface, Kabbage receives a data flow from such sources and churns it through a proprietary algorithm to arrive at a funding decision. These data can include, for example, UPS shipping information.

The decision comes quickly. Where banks and traditional cash-advance firms might take weeks to gather underwriting data and pore over applications, “a company like Kabbage is able to get information on companies in six or seven minutes,” says Barry Davis, a senior management consultant at The Strawhecker Group, Omaha, Neb.

Indeed, the typical time between a merchant arriving at the Kabbage site and receiving an approval is under 10 minutes. “The process is 100% automated,” says Treyger. “It’s as simple as booking your Thanksgiving flight on Expedia.”

If a merchant has a PayPal account, he can receive funds immediately. Checking accounts, which are more typical of physical merchants, can be funded in one to three days. Once funded, the accounts can be accessed on a mobile device through the Kabbage app.

The company holds two patents, one on the automated approval and the other on its underwriting algorithm.

Next up, says Treyger, is a closer working relationship with banks, including a deal the company is set to announce with a “large financial institution.” These arrangements, which will involve Kabbage’s links to sources of alternative underwriting data, will include licensing and white-labeling opportunities.

“We’ve seen much interest from banks. They get it,” Treyger says. “Being able to act on alternative data is the way things are going.”

As for small businesses that have used merchant cash advances in the past, Treyger has no doubt her company is having an impact. Says she: “We think they’re switching over to Kabbage.”