hot trend in auxiliary products in the financial services industry and a hotly debated topic among ISOs and merchant level salespeople (MLSs) on GS Online's MLS Forum, is the concept of offering merchants cash advances based on their future credit card sales.

The merchant cash advance industry is growing at an astonishing clip. Some critics say this growth is because traditional banks are not meeting the needs of small businesses that might have few material assets but healthy receivables, mostly pledged through credit card debt.

But understanding this adolescent industry can be something of a quagmire. Merchants want to know how it works and what it will mean for them. Each cash provider offers its own terms, both to merchants and to ISOs and MLSs selling its program to merchants.

The industry is not regulated. There isn't even consensus on what to call the product, except that it is most definitely not a loan.

"This product is unique," said Glenn Goldman, Chief Executive Officer of AdvanceMe Inc. "It's a purchase and sale, not a loan, so we have to use specific language consistent with a purchase and sale, like retrieval rate and discount rate instead of interest rate. It is more like factoring but of a sale that has not yet happened."

A cash advance provider gives merchants the money up front. In exchange, merchants agree to pay back the principal, and usually a rather hefty fee, by giving the company an agreed percentage of their credit card sales until their balance is zero.

Merchants must use the providers' credit card processor because the advance is paid back automatically as a percentage of each batch's proceeds.

"Cash advances are very different from traditional funding programs," said Stephen Sheinbaum, CEO of Merchant Cash & Capital. "In essence, we purchase a percentage of future MasterCard and Visa revenues, and the merchant repays this as a daily percentage of those revenues."

Getting cash from traditional financing institutions can be difficult for some businesses, particularly retail, restaurant, franchisees or seasonal businesses. These merchants most heavily use credit card processing, so cash advance programs offer a number of benefits.

Why Merchants Like It

The cash is usually available more quickly than it is with traditional loans. Marc Gardner, CEO of North American Bancard, said these programs appeal especially to retail and restaurant merchants not only because these types of businesses can rarely get traditional funding but also because of the immediate liquidity.

North American Bancard usually funds within 72 hours of approval. Most cash advance providers advertise that the cash can be available in less than 10 days.

Unlike a loan with a fixed rate of interest, amount due and set due date each month, with credit card advances the money is paid back as credit card receivables come in.

"We ebb and flow with the business, so it is cash flow friendly, especially during seasonally slow periods," Goldman said. "Traditional loans and leases require a set payment every month, whether the business has made a sale or not."

"Because payments are calculated as a percentage of sales, if sales are growing, the amortization could be quicker," said Woochae Chung, Managing Director of American Microloan. "But if the proprietor experiences some interruption or downturn in business, the payments will be lower."

In most cases, business owners put up no personal collateral and make no personal guarantee.

The drawback? The cost of money through these programs is high, considerably higher than it is with traditional loans. Gardner said a 35% premium is common.

How Providers Make Money

According to Chung, financing charges can vary widely, not just from one provider to another, but from one advance to another. "As a thumbnail example, the range of financing on a $10,000 advance could be as low as $700 or as high as $4,000. That's a 60% difference," he said.

There is no fixed interest rate; the effective interest rate varies depending on the business. If the merchant's business is doing well and sales are up, the advance provider collects the money sooner and the interest rate is rather high. If sales are sluggish, the payback period is over a much longer period and the effective interest rate goes down.

For example, a typical cash advance provider may advance merchants $0.74 on a dollar; if merchants are advanced $74,000, they pay back $100,000 from future credit card sales.

If merchants paid back that $100,000 in a year, the cost of the money would roughly equal a 35% annual interest rate. Since there is no time limit on paying back the loan, the effective annual rate decreases as the payments are extended over time, although the cash provider typically forecasts a fairly short period for payback, usually less than a year.

"There's no question that the merchant's cost for this kind of financing is going to come in more than a conventional loan," Chung said. "But it's pretty much a foregone conclusion that a conventional bank will reject this merchant for their much needed loan.

"The merchants interested in a program like this may have a sketchy or distressed credit history. They'll have things like past tax issues, a list of delinquencies, collection matters, liens or judgments that would be an automatic red flag for a conventional bank."

Because the cash advance industry caters to businesses that can't get traditional funding, it has got a reputation for being a sort of corporate loan shark, the funding of last resort for desperate merchants in their last gasp before bankruptcy. This simply isn't the case, industry spokespeople insist.

'A Risk Worth Taking'

There is a risk to cash advance providers and a fairly high risk (hence the high cost to the merchant for the money), but they use sophisticated models to determine the future likely credit card purchases. They also offer the cash with relatively short payback periods to help mitigate risk.

Although approval isn't as onerous as it is for most bank loans, few cash advance providers will approve new merchants without a history of credit card transactions. Few will approve sums larger than what merchants can reasonably expect to earn from credit card transactions in a year.

"The provider of the cash advance takes all of the risk," Sheinbaum said. "The risk is high, but since it is paid out of projected future sales, it is typically a risk worth taking."

Seasonal businesses that need cash to carry them through lean seasons or merchants who have an unexpected downturn in business (say because of road construction, building repairs or extended illness) might find a need for a cash advance until business picks up again. However, merchant cash advance companies say that ailing businesses are not the only merchants interested in this kind of program.

Many types of businesses are often underserved by traditional funding institutions. "Take for example a restaurant," Gardner said. "It could be a very successful business, but a traditional bank wants to see tangible assets. Perishable foods or used restaurant equipment just won't make the cut, even if that restaurant is packed every night."

There are many examples of times when owners of healthy small businesses could use cash to help build their businesses but can't get the traditional funding necessary. These include franchisees who have exhausted their savings to purchase their first franchise and want to open a second one; merchants whose competitors have closed and have the chance to buy their competitor's old inventory or move into a new location; expansions; buyouts; or simply the desire to move quickly on a perceived new opportunity.

A Way to Open Doors

For ISOs and MLSs selling cash advance programs, a merchant's need for cash creates a great point of entry for new business as well as an additional revenue stream.

"Standalone processing has become something of a commodity," Goldman said. "Providing working capital to businesses gives ISOs a way to differentiate themselves. It's a service that every business needs at one time or another, and providing it can build a loyalty that is hard to achieve with processing alone."

"The playing field for ISOs has become more intense and difficult," Chung said. "The profit margin continues to drop, so the ability for ISOs and credit card processors to earn income based on credit card processing alone has been limited.

"And many merchants already have their Visa/MasterCard relationships in place, so it gets tougher to identify businesses that may have an interest in changing over. That's why the ability of ISOs and credit card processors to offer financing to their customers is evolving into a lucrative opportunity."

Gardner called it an unbelievable door opener for ISOs. "Think of it like this: If you offer a business a free terminal or lower processing fees or $100,000 in working capital, which door will open first, faster and wider? Getting credit card processing isn't difficult for these business owners, but getting financing can be," he said.

As more and more processors begin offering cash advance programs the sales differentiation aspect might diminish, but as the industry matures more standardization may occur. This creates more clarity and requires less explanation on the part of cash providers or ISOs and MLSs selling their programs.

"Because every agent can offer processing but very few are offering cash, the cash advance program has become a wonderful acquisition tool," Sheinbaum said. "Merchants who are anxious to receive a cash advance are less interested in their discount rates, giving sales offices a good bit of pricing power.

"We have also found that when merchants participate in a cash advance program, attrition decreases dramatically. And last but certainly not least, commissions on cash advances are extremely high, significantly higher than commissions on processing," he said.

How ISOs and MLSs Get Paid

Commission structures vary, of course. As an example, American Microloan offers a 2% - 4% referral commission on the loan amount up front and 1% - 2% on a residual income when the loan is completed. Gardner said an ISO's commission at North American Bancard usually runs "around seven points" and that the average commission is about $2,100 up front, with a residual of $33. "It's much more lucrative from the onset than credit card processing," he said.

"As a model, say it is a $25,000 loan for six months," Chung said. "The ISO stands to earn about $1,000 up front and $150 - $300 residual, which continues during the account relationship.

"Let's say that the ISO generates one such lending transaction a week of $25,000. The extra income here could easily exceed $50,000 a year. And this payment process to the ISO takes the form of an ongoing annuity for the life of the borrowing relationship," he said.

The life of the relationship can be surprisingly long. According to Gardner, more than 80% of all merchants renew their future receivables purchase agreement, thus continuing the incremental revenues for ISOs and MLSs and ensuring low attrition. The industry is in its infancy," he said. "In 2003 you could count on one hand the number of companies offering something like this. But as merchants learn about it, I think it will only get more and more popular."