Marketplace Lending Defined
For purposes of clarity, the author defines “Marketplace Lending” broadly as any lending transaction in which three or more of the following characteristics are present: 1) the lender’s primary source of repayment is the drafting of periodic payments from the borrower’s bank account; 2) claims of funding within 24 hours; 3) marketed over the Internet by brokers; and 4) marketed by aggressive tele-marketers. The author will refer to these transactions as “loans” or “term loans” (even though the industry shuns use of those term for reasons described later), the provider of the funds as the “lender,” and the recipient of the funds as the “borrower.” Marketplace lending products are marketed under a variety of descriptive and sometimes misleading terms such as “merchant cash advances,” “advances,” “cash advances,” “purchases of future sales,” “credit card factoring,” and “factoring future sales.”
History of the Marketplace Lending Industry
The marketplace lending industry sprung up practically overnight during the modest economic recovery following the great recession Banks largely abandoned lending to small businesses. The marketplace lending industry expanded rapidly, fueled by entrepreneurial lenders, financial technology companies, Wall Street backers, networks of enterprising brokers, and the reach of the Internet and social media.
There was and remains strong demand for loan products for small businesses. Marketplace lending industry participants recognize that merchants, particularly small, single-location merchants that are cash- and credit-constrained, lack access to traditional, lower-cost credit sources such as banks and factoring companies.
How Does a Marketplace Loan Take Shape?
Typically, a borrower is contacted by a broker who is paid a commission by the marketplace lender. Alternately, a merchant in need of cash may search the Internet for such terms as “small business loan” or “cash advance loan” or “merchant cash advance.” An application is typically completed online and the borrower is then contacted by the lender. The borrower must provide copies of bank and credit card statements proving it has been in business for periods of time ranging from a minimum of 6 to 24 months. Unlike traditional consumer and commercial loans, criteria that usually disqualify borrowers from qualifying for traditional lending products do not disqualify borrowers from qualifying for marketplace lending products. Borrowers with low credit scores, criminal convictions, past bankruptcies, losses, insolvent balance sheets, foreclosures, judgments, UCC liens, and tax liens may qualify for a loan from a marketplace lender.
To “secure” repayment of their loans, borrowers must give the marketplace lender a contractual right to draft regular payments from their bank account until the loan, interest, fees, late payments, and other costs are repaid in full. Generally speaking, the marketplace lender’s interest (sometimes referred to as “fees” in the loan documents) is earned and collected up front out of the proceeds of the loan.
The amount of the loan, its term, and the amount and frequency of the payments are determined by the information the lender collects from past bank statements. Payments may be expressed as a flat amount or as a percentage of past cash deposits. Once these parameters are established, the lender debits the borrower’s payment daily, weekly, or monthly as required in the loan documents.
Traditionally, marketplace lenders restricted their activities to lending to merchants such as retailers, bars, and restaurants. The term “merchant cash advance” popularly and accurately described the nature of these transactions: Merchants lacking access to traditional sources of financing found marketplace lending products a fast and easy way to expand their businesses or handle emergency cash needs. Expressed in terms of an annual percentage, when all costs are considered, these types of loans could end up costing well over 100% and in some cases over 300% a year. A practice known as “stacking,” which takes place when a borrower takes on two or more marketplace loans at a time, became a common practice a few years ago as competition among marketplace lenders heated up. Because of the often astronomical costs associated with marketplace loans, stacking often results in the business failure of the borrower or principal loss by one or more lender.
Confusion Between Marketplace Loans and Factoring
Some confusion exists among consumers, small businesses, and regulators about the differences between marketplace loans and factoring. To assist the reader in understanding the differences between the two products, a better understanding of factoring is the best place to start.
Factoring, also known as invoice discounting, is a $ 2 trillion* a year global industry in which thousands of factoring companies participate. For at least the past 100 years, most money-center banks had, and many still maintain, factoring divisions and subsidiaries. Factoring has a broad appeal among millions of businesses worldwide, including multi-national companies, as source of working capital financing that is both reliable and a good value for the client. Factoring companies generally provide other value-added services in addition to simply advancing funds to their clients.
The modern factoring industry traces its roots over 200 years when European craftsmen and merchants shipped goods overseas to American buyers, extending them credit and relying on agents in the new country to vouch for American buyers’ ability to pay for those goods after they were received.
Factors, as they became known, were early facilitators of modern-day international trade by acting as credit advisors to sellers of goods. Sometimes, factors took on the credit risk themselves, guaranteeing to the seller that if the buyer didn’t pay up, the factor would pay the seller.
The factoring industry evolved by adding a funding component, where the factor would not only guarantee payment to the seller of goods, but also advance funds to the seller, take title to the goods while the goods were on the water, and collect directly from the buyer after the buyer took possession.
With the exception of obvious advances in technology, the premise of factoring remains very much the same today as it did over 200 years ago. With few variations, a factoring company purchases (at a small discount, with or without recourse to the seller) an existing obligation that arises when a buyer of goods or services actually receives those goods or services. That obligation is generally evidenced by an invoice issued by the seller, which records on its ledger an “account receivable” (an accounting term categorized as a current asset). When the buyer receives goods or services, it records on its books an “account payable” (an accounting term categorized as a current liability).
Like any other asset, an account receivable may be bought or sold at a market value established by buyer and seller. Generally, accounts receivable are sold at a small discount to face value.
Many marketplace lenders, which as the author pointed out earlier, simply make term loans. They do not buy or factor existing accounts receivable at all. Nonetheless, many marketplace lenders use confusion terminology to mask the true nature of the transaction. Their loan documents often use terms such as “the factor rate” or their loan documents themselves may even be titled “factoring agreements.”
The factoring industry’s largest trade association has distanced itself from the marketplace lending industry. Recently marketplace lenders were barred membership, highlighting the stark differences between the products the two industries market.
Why Create Marketplace Confusion?
Marketplace lending is an efficient and flexible source of easy financing. Lenders avoid referring to their products as loans and they similarly avoid using the term “interest” because the interest rates that lenders may charge on loans are regulated. Almost without exception, the interest rates charged by marketplace lenders exceed regulatory caps by four or five times or more. Penalties for traditional lenders that exceed regulatory caps on interest rates are very costly.
In order to deflect and delay inevitable regulatory scrutiny of their industry, marketplace lenders attempt to confuse regulators and borrowers by referring to their loans as factoring products. However, as explained above, marketplace lenders are not purchasers of receivables at all. They are cash flow lenders that make loans, even if their documents are often worded in such a way as to imply the marketplace lender is “buying future receivables.”
The concept of a buyer paying for something in advance of receiving it is not new; however, in most cases, there is an established value at the time of purchase—even if delivery is delayed.
The problem with the marketplace lender’s claim that it is buying a future stream of receivables from a cash-constrained small business is that nobody, including the small business owner or the lender, can place a realistic value on future sales that have not yet occurred.
Borrowers who turn to a marketplace lending environment are generally unstable and their ability to project future sales or generate future accounts receivable is highly unpredictable. Understandably, a lender that makes loans to high-risk borrowers, many of which are insolvent, must charge exorbitant interest to offset the huge credit losses they expect to take. Transparency about fees and interest is the source of much of the controversy involving marketplace lending. Marketplace lenders cannot make money at legal rates of interest, because they’re lending into a credit-challenged pool of borrowers. They cannot call the fees they charge “interest,” because doing so may violate state or federal caps that lenders are allowed to charge.
About the author: Tony Furman is president and co-founder of the Interstate Capital Group of Companies (“ICC”). ICC is a factoring company established in 1993. Mr. Furman is a former commercial lender and has served on the advisory boards of banks and industry trade associations representing specialty finance companies.
At Interstate Capital, our factoring professionals are experts in invoice factoring and help people turn their accounts payable into working capital to use right away. By simply factoring their invoices with Interstate Capital, thousands of businesses have increased their cash flow and achieved new levels of success since 1993.
Contact Interstate Capital for a FREE factoring assessment today.