Virginia moves to regulate a high-cost small-business financing option

BY DAVE RESS Richmond Times-Dispatch

A complex and often high-cost financing option for small businesses is set to become easier to follow with a State Corporation Commission order dictating what providers need to tell users.

The option, called sales-based financing, is an advance of money to a small business that the small business repays with a set portion of daily sales.

Basically, the deal, also known as a merchant cash advance (MCA) means that if a small business’ sales on a given day are slow, its payment that day would be less.

But the real cost can be high, and the deals can be hard enough to understand that Del. Kathy Tran, D-Fairfax, decided some standardized disclosures would be a good idea.

“They can be very complicated and very confusing,” Tran said.

And it is easy for people to get in over their heads – she said she’s heard that from a lawyer who works with Asian American businesses in Northern Virginia to figure out such offers.

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“A lot of restaurants in Richmond were affected; there was one who arranged an MCA and when the pandemic hit his business couldn’t keep up and so took out another MCA to pay off the first and nearly went under,” she said.

The General Assembly agreed, unanimously, with Tran’s argument that small businesses deserved some protection – making Virginia one of only four states, along with California, New York and Utah, to do so.

Now, the SCC has approved regulations that require sales-based financing firms to make specific disclosures about finance charges, total amount to be repaid, estimated number of payments and payment schedules and several other critical terms.

Virginia now also bans the “confession of judgment” language in many of these deals that shut off the possibility of going to court to sort out disputes over what’s been paid and what’s still owed.

Tran’s law says arbitration of disputes has to be done in Virginia, and not out of state, as some sales-based financing agreements required.

And it says firms offering this kind of financing have to register with the SCC so that it, and the General Assembly, can stay on top of a kind of deal that had been pretty much under everyone’s radar.

One major player, PayPal Inc.’s sales-based financing unit, told the SCC Bureau of Financial Institutions that it provided close to $19 million to 1,143 Virginia small businesses last year.

Some 70% of its advances were to borrowers in counties that lost 10 or more bank branches since the 2008 recession and more than a quarter of its advances were to business in low- and moderate-income census tracts, Bernardo Martinez, PayPal vice president for global merchant lending, told the SCC.

The basic idea has been around since the late 1980s, in the form of a three-way transaction through which the advance would be repaid from a fixed share of a company’s future credit card receipts, with the credit card company handling and paying the split between the firm that made the advance and the merchant that made the sales.

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For many small businesses, it meant it was easier to get funds, since it was the businesses’ cash flow and not the personal credit rating of the owner that mattered.

But just as with a credit card when a consumer only makes the minimum payment, the real cost can end up being a lot more than first thought.

In addition to repaying the amount of money advanced, the small business must repay a so-called “factor,” which is often between 20% to 50% of the amount of the advance, according to a recent Federal Trade Commission report.

“MCAs have very high costs — including, in some cases, estimated APRs in the triple digits. As a result, many business owners who obtain MCAs may struggle to successfully repay them,” the FTC said, referring to the annual percentage rate for credit deals.

Sometimes, the MCA provider’s daily draw from the business’ bank account doesn’t match what the business saw for that day’s revenue. That’s at issue in one New York health care startup’s lawsuit against its MCA firm.

Because the business owner signed a “confession of judgment,” giving up the right to go to court, the MCA firm has at the same time obtained a court order demanding payment of $800,000, according to a recent report by The City, a New York online news outlet.

The FTC report said it has heard concerns that some MCA providers engage in aggressive, and potentially misleading, marketing practices, often paying large commissions to brokers who bring in deals.

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