Banking Sector / Business Analysis
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Rather than jumping in with both feet, you might want to consider just dipping your toes into the water when entering into the cash advance business. Many cash advance companies allow participation in deals on a limited basis. This usually involves entering into an agreement called a Participation Agreement that allows you to fund a portion of the advance. Below I will discuss how you can participate in cash advances and some of the risks of doing so.
How do you participate?
In most cases you will have to be working selling merchant accounts and cash advances and referring them to the cash advance company before the company will allow you to participate in funding advances. However, some companies do not have this requirement and allow just about anyone to participate in making a cash advance.
By letting you participate, the cash advance companies are allowing themselves to fund a larger number of deals which fundamentally can reduce the overall risk of the portfolio. The general rule of thumb in any type of investment is the more you spread out the invested cash the lower the risk of losses. And also, hopefully the cash advance company will get some better merchants that you have originated given that you are personally willing to risk your own money funding the deal.
The Participation Agreement that you enter into is usually fairly straightforward and neutral as to who it favors since you both are sharing risk on the deal. For that reason I find I make very few changes when reviewing these types of agreements. If you want to participate, you can decide what percentage of the deal you want to fund. For instance, you can fund as little as 10% of the advance or as much as 50% of the cash being provided to the merchant. The agreement provides that you get a percentage of the funds paid back by the merchant in the same amount as the percentage you have chosen to fund. There is also a management fee that is taken off the top of typically 3% that slightly reduces your return.
What are the risks?
There are a number of risks in participating in these type of cash advances. Number one on the list is that the merchant decides who it does not want to pay. In most bad deals I see, the default occurs early in the relationship, generally within the first 30 days. The merchant takes cash knowing his business is going under and defaults within weeks of getting funded. This is a very real risk and if you are not participating in a large number of cash advances to spread your risk, one or two bad apples could destroy your expected return on investment.
To that end, many of my clients that are participating in these
advances are larger ISOs whose main business is originating merchant accounts. They tend to make cash advances more as a side business creating an additional small source of income. They usually pick out the merchants that they know are creditworthy and have a personal relationship with as knowing the merchant is key to reducing the risk.
There are other programs in which anyone can just participate in where you do not need to have any relationship with the merchant to invest. Some cash advance companies have websites where they list out the merchants that are available for you to participate in the deal. You can pick and choose as you like but it is up to you to do your due diligence on the merchant. The Participation Agreements make clear that the cash advance company is not making any representation that these are good merchants that will likely pay back the advance. So if you do not do a thorough due diligence you again could end out losing all the money you put in.
This brings up another risk, in that as you are essentially partners on this merchant’s cash advance, you also have the duty to pay the costs associated with collecting from the merchant if it fails to pay up. Collection costs and attorneys fees can get expensive quickly and you may not want to have to put any more money into what you see as a worthless pursuit of the merchant. To that end you need to ensure that you make clear in the Participation Agreement that it is not mandatory that you have to pay collection costs. Of course, as you can imagine, if you do not pay your fair share of the collection costs then you are not going to get any money if any recovery is made from the merchant.
Another issue is what if the merchant sues the cash advance company? In these instances, again the Participation Agreement is going to have provisions that provide that you have to pay your share of the attorney’s fees to defend that case. So again, as you can see, your exposure is not limited to the money you put in to the advance and can be much more.
Of course this brings up the specter of the class action lawsuits in the industry. Here in California there have been a number of class action lawsuits filed alleging cash advances are really disguised loans with usurious interest rates. Conceivably, if your merchant got included in one of these class action lawsuits you could be stuck in a long drawn out and expensive legal mess. This is another matter to address in the Participation Agreement to either get rid of this possibility or limit your exposure to a share of the final settlement.
One last thing to note, there may be an issue of what types of investors are allowed to participate in these cash advances. Some of Participation Agreements I have seen allude to the fact that the person investing must be an “accredited investor” as defined under federal securities law. I’m not an expert in federal securities law but it certainly raises an issue that needs to be investigated before making the leap into allowing people to participate in your cash advance business.
As you can see, participating in merchant cash advance deals is not without its risks. But if you do your due diligence, know your merchant and spread out your cash over a number of deals, you can maximize your chances for a good return without having to set up a cash advance company yourself.