New Players in an Old Game
Peter Lucas
Card factoring isn’t new, but now funding companies have harnessed ISOs to sell the credit to merchants. It can beef up ISOs’ commissions and help them sell processing service and gear. They just need to read the terms carefully. It’s no secret that margins on credit processing and terminal leasing have been eroding for years as merchants play acquirers off one another to obtain cut-rate pricing on service and equipment. Many merchants will not only listen to any independent sales organization offering a chance to save them a few cents per transaction and toss in a free terminal, but also in most cases will break an contract to take the deal. As a result, ISOs have had little choice to but to slash margins to remain competitive. Tired of competing solely on price, ISOs have begun selling a product they know practically every small merchant needs—cash. The product, known as credit card factoring, allows merchants to receive a cash advance against future card receipts in return for paying a fixed percentage of those receipts to the funding company. While funding companies have directly marketed card factoring to merchants for years, primarily to restaurants, the use of ISOs as sales agents has injected new life into the product, and in turn provided ISOs with a way to boost commissions and residual income. “Factoring is a product that replaces the upfront commissions that have been eroded on terminal leasing and that gets merchants away from focusing on processing costs,” says Steve Pavent, a vice president for My Sales Office, a St. Petersburg, Fla.-based ISO. “Any merchant that needs cash will listen to an ISO, which is not always the case when you approach them about processing alone.”
‘Long-Term Revenue’
ISOs typically earn a percentage of the money advanced, which varies by the funding company. New York-based AmeriMerchant, which actively works with more than 25 ISOs, pays a commission of $1,600 on a $10,000 cash advance. “Selling funding is a good way to generate an immediate revenue stream,” says Jeffery Levine, owner of Merchant Payment Processing Solutions, a Fort Lauderdale, Fla.-based ISO that markets funding on behalf of AmeriMerchant. Factoring is also a major selling point with merchants. Levine says about 20% of the processing deals cut by his sales force and 12% of those netted through his telemarketing staff come as a direct result of offering merchant funding. More important, factoring helps prevent merchants from jumping to another processor offering lower pricing, as merchants are contractually bound not to switch processors until the funding company has received its share of the card receipts purchased in full. Merchants receive their money in seven days or less and the average length of a factoring contract is nine months. Even better is that most merchants will renew their contract, which ensures a longer-term processing relationship with the merchant for the ISO and puts more money in its pocket. “Most merchants will sign three to four funding contracts over the life of our relationship with them, so it provides a long-term revenue stream we don’t get from other parts of our business,” says Levine. AdvanceMe Inc., an Atlanta-based funding company, has a 75% renewal rate among its merchants, according to chief executive Glenn Goldman. In addition, the average length of a merchant relationship with an AdvanceMe ISO is 27 months, compared to about 18 months for ISOs that don’t offer funding, says Goldman. While figures on how much money is being advanced to merchants through card factoring are hard to come by, AdvanceMe has funded $750 million to more than 15,000 merchants over the past nine years, says Goldman. From 2001 through 2006, dollars funded to merchants by AdvanceMe grew 241%. Thanks to the entry of ISOs into the business and a growing roster of funding companies, merchant awareness about factoring is about 27%, compared to 1% just a few years, according to Goldman. “Awareness is out biggest competitor,” he adds. What cements the merchant relationship with the ISO is the availability of a cash advance merchants can’t necessarily get from a bank that can be used for growth or equipment upgrades. “Providing a cash advance the merchant can receive in seven days or less opens the door to selling processing and POS equipment,” says William Widis, president of Capital Consolidators Inc., an AdvanceMe ISO. “It also creates referrals from merchants. Funding is a value-added product that ISOs can offer to small businesses.”
Not the ‘Cheapest’ Credit
Unlike traditional loans, which require fixed monthly payments that include interest charges, factoring is a cash advance against future card receipts. Funding companies purchase a fixed amount of card receipts for which they take a flat percentage. Most funding companies, which typically obtain their capital from private investors, investment bankers, and even hedge funds, take about 25% of the funds advanced.
For example, if a merchant needs $10,000 in cash, the funding company will charge 26%, or $2,600, of the merchant’s next $10,000 in card receipts. The merchant pays the percentage out of daily card receipts until the entire $2,600 is paid to the funding company. The money is routed to the funding company via the ISO, which deducts the funds when processing the card transactions. Because of the way factoring works and the cost of the funds, merchants typically take between $10,000 and $25,000 in cash advances so as not to crimp their cash flow. But some funding companies will qualify merchants for up to $175,000 in funding. “You really don’t want to buy more than 90% of card receipts because it can hurt a merchant’s cash flow and that does neither party any good,” adds Goldman. “The aim is to provide funding to help the merchant grow their business.” That growth may come in the form of adding a second location or buying office or kitchen equipment. Levine says he sold $100,000 in funding to a brew pub in Boca Raton, Fla., that used the money to purchase a new tank for its brewing operation. While the restaurant owner most likely had enough financial assets to qualify for a bank loan, he instead opted for the funding because the terms were more palatable, according to Levine. “It’s not necessarily the cheapest source of funds, but business owners don’t have to put up outside collateral to qualify for the loan or go through the loan-qualification process,” explains Levine. “And because funds are drawn against future card receipts, if the merchant has a bad month, they aren’t struggling to come up with a loan payment, since what they owe is a percentage of their actual card receipts for that month.” This formula is what makes factoring so attractive to merchants. When it comes to small-business loans, banks typically have stiff qualifying criteria based on the type of the business and the personal credit history of the business owner. If the merchant can’t qualify on those two initial criteria, and many don’t, the bank usually rejects the application, according to Diane Naczi, senior vice president of marketing for AdvanceMe. “Funding companies will look at the viability of the card revenues and how long the merchant has been in business, and they have shorter contract lengths than banks, which prefer to lend money for more than a year,” says Naczi, who joined AdvanceMe from Bank of America Corp. “Funding companies have a different approach to how they value a merchant’s business.”
Read the Fine Print
One of the advantages funding companies have in evaluating risk is the ISO, which usually has a solid history of the merchant’s card receipts and knows the ebb and flow of the merchant’s business. That information is combined with scoring criteria and risk models for specific types of businesses, such as restaurants and seasonal businesses. Much of the internal risk criteria used by funding companies is gathered from prior merchant contracts. AdvanceMe has built a riskscoring model based on 10 years worth of merchant data that uses 40 variables to score the account. The scoring models help detect when merchants are simply taking a cash advance to prop up their balance sheets. “There are a lot of merchants looking for funding in a last-gasp effort to stay afloat,” says Capital Consolidators’ Widis. “Underwriting is important, because defaults don’t benefit the ISO or the funding company.” ISOs also need to take a hard look at the terms of their affiliation with a funding company. Some will require exclusive agreements with them or that the ISO use a specific processor that has an affiliation with the funding company, according to My Sales Office’s Pavent. “Some funding companies do have strategic relationships with processors that compete with us and that is something to consider,” he adds. Merchant Advance Solutions, a San Antonio, Texas-based funding company that sells directly to merchants, requires that merchants signing a contract with it use Kansas City, Mo.-based processor Retrieve Corp. “That is a requirement because Retrieve is our processing affiliate,” says Travis Holt, principal of Merchant Advance Solutions. While Retrieve does not market on behalf of Merchant Advance, Holt says that his affiliation with Retrieve is through a business associate that previously had ties to the processor. Even so, having the flexibility to turn to another funding company if a merchant application is rejected can make the difference between getting the processing business and not. “If the primary funding company declines an applicant, I can go to other sources and that’s a plus,” says Merchant Payment Processing Solutions’ Levine.
Commission Squeeze?
With the growing popularity of card factoring among merchants, pressure is building on the cost of funds as more players enter the market. As competition among funding companies increases, the concern is that a lower cost of funds to the merchant will erode ISO commissions. “Merchants are becoming price sensitive to the cost of funding as the number of funding companies increases,” concedes Widis. “Although the cost of funds is coming down, reductions haven’t been drastic enough yet to impact commissions.” Still, odds are that funding costs for card factoring won’t be subject to the same downward pressure as interest rates for loans because funding companies fill a niche that banks and other lenders can’t or won’t, according to funding experts. That’s good news for ISOs because they can offer an alternative funding source that merchants often find preferable to taking a credit card cash advance or getting a personal home-equity line of credit after they have been rejected for a loan.
“Once a merchant’s need for cash has been identified, this is one of the easiest products and most profitable products an ISO can sell,” says Pavent.