Your Default Rate Is Too Low, And It’s Hurting You

There may be no word as terrifying to stakeholders in the merchant cash advance business than the term ‘defaults’.

In an industry where a significant portion of revenue is generated from daily or weekly automatic withdrawals from a merchant’s bank account, defaults can cause deep and lasting problems. Not only do they eat into profits, but they damage relationships with banks and processors- both of which are essential to the success of any merchant cash advance company. Defaults can also be contagious: if one merchant in a large portfolio decides to stop making payments, it can have a ripple effect that leads to other merchants doing the same thing.

All these are reasons why MCA companies go to great lengths to avoid defaults at all costs: they exhaustively screen merchants before approving them for funding and do all the due diligence needed to ensure they can follow realistic payment plans. They also attach a fee to every deal to cover the percentage of the deal they expect will not come back, and conventional thinking would be to aim to keep that number as low as possible.

That’s a lot of work to keep that default rate low, but what would you think if I were to contend your default rate is too low, and it’s hurting your bottom line?

Fear of defaults is paralyzing MCA funders and inevitably leading them to leave opportunities-and money- on the table.

Better Accounting Solutions has been the leading accounting firm in the MCA space for over a decade, and has seen this across the board:

Many MCA companies have adopted a risk-averse approach to avoid defaults, opting for sure-fire deals in higher positions, rather than taking calculated risks that could enhance their bottom line. In the name of capitalizing on low-risk deals with a lower chance of default, many companies choose to fund deals where they charge smaller fees than what they could be charging if they choose to fund deals others are wary of taking.

Let’s look at two deal examples for an example of my thesis:

Average Andrew is the perfect merchant for an MCA company. He is getting a $100,000 advance with a deal length of 7 months (140 days) and with his rock-solid history, his default rate is a meager 6%. The RTR on the deal is 44%, the UR fee is 7%, broker’s commission is 10%, meaning the profit on this deal will be $35,500- a net unit profit percentage of 35%, profiting $5000 a month. He is a great client, and a pleasure to work with.

Now let’s examine his buddy, Reformed Ricky. He’s made some mistakes in the past and now wants a business advance to grow the business he believes is The One. No one else wants to touch him, so you offer him a deal of $35,000. Because he is a riskier advance proposition, you can raise the RTR to 49%, and the UR fee to 12%. On a deal like this, the commission is around 14% and the default rate will be a whopping 18% on a merchant like this, but the profit to be made on this deal is $10,150- a 29% net unit profit, getting $3,383.33 monthly profit over the length of the deal.

Now, looking at the structures of both deals, why would I advocate that someone advancing Reformed Ricky instead of Average Andy? What’s the advantage of working with the weaker merchant over the perfect one?

It’s simple:

Because of his history, you can set the duration of Reformed Ricky’s deal to 60 days (3 months). That means according to the terms of his deal, your profit is 9.67% a month. You’ll be stunned to learn that when you break down your monthly profit on Average Andy’s deal, it is a considerably smaller percentage of 5.00%!

This means every month you’re making more back on the smaller deal, and are getting it to work for you by placing it into new deals and generating more income for you, because of its shorter term. If you’re only taking deals with longer outstanding balances, it will take you a considerably longer amount of time just to make a smaller profit percentage.

On top of this, we also have to account for the compounding effect you will quickly be seeing when you take these ‘riskier deals: because you’re earning more money per month due to the shortened duration of supposedly weaker deals, you will be able to turn it around more times per year, supercharging your growth quicker than what you’d be seeing you stuck to only ‘traditionally-safe’ deals.

I’m not advocating for funders and brokers to be irresponsible and create a new and much less entertaining version of The Big Short, throwing money around to people that don’t stand a chance of paying it back.

I am saying that they should consider funding merchants and positions they were wary of till now, and responsibly assessing the opportunities and upside for them at those positions.

Of course, this doesn’t mean that you should mindlessly funnel money into every deal that comes your way. You still need to be responsible and vet your investment opportunities carefully, and of course, if it turns out you’re picking the wrong deals and your default rate explodes, you will have to reevaluate your approach.

However, working from a place of fear is not the way to grow and thrive, certainly in this business. Moreover, by avoiding risk altogether, MCA companies are likely to become less competitive over time. After all, it’s only through taking risks and innovating that businesses can thrive in today’s rapidly changing world, especially in the rapidly evolving and growing MCA industry, where more and more people are seeking to find their niche.

A great number of successful investors in MCA companies have complained to me that their partners are too conservative with the deals they are choosing to fund and leaving too much capital in the bank, costing the investors higher facor rates instead of working for them.

This approach is a way to break away, and ahead, of the pack, because only by taking the opportunities others keep passing by will MCA companies be able to grow and compete in the long run.

Think You’re Good at Closing Deals in the US? Apply Your Skills in the UK or Australia

Think you’re well-versed in the SMB finance business? You might want to take advantage of a fast pass being offered to replicate your success in the UK or Australia.

The opportunity stems from a proposal posted on LinkedIn by Capify CEO David Goldin. Goldin’s got two decades of experience in the business itself and 14 specifically in the UK/Australian markets. Now he’s looking to personally select a handful of brokers and/or small funding companies and guide them on expanding their business overseas.

But why?

Goldin believes that US operators could bring a certain dynamic lacking in the other markets, complete dedication to a single product where there is a lot of opportunity. “There’s very few MCA shops there,” he said. “Very few of them that are MCA-only companies.”

And so the dedicated MCA broker shop is something uniquely American and could prove to be a potent model if applied abroad. Brokers do play a major role in those markets but they’re a jack of all trades, Goldin explained, offering every product there is, resulting in limited throughput for a single core product. Markets like the UK and Australia offer some unique advantages in that they’re English speaking and the products themselves are already established. Goldin said that there’s an opportunity for US operators that “know how to sell risk-based capital” to come in and leverage the Capify infrastructure and intellectual capital.

To be clear, he’s not talking about sitting in an office in New York or Miami and calling business owners in Sydney and London, but about actually opening up a local office in those markets.

“You got to have a local presence,” Goldin said. “A remote company doesn’t work. You need to actually be there.”

All this would be set up and developed with the guidance of Capify, a benefit that would shorten the learning curve of doing business in a new market. “There’s a lot of stuff to navigate,” he said. “Different regulations, different rules, different clients.”

AltFinanceDaily first began exploring the Australian market in 2015. At the time, there were about 20 alternative lenders operating in the country. Since then the market has flourished. The population of Australia is only 26 million people, about two-thirds that of Canada, but Goldin said that it’s not as competitive.

“The US is bigger but also 50x the competition,” he said.

For anyone interested in this opportunity, the best way to contact him is through LinkedIn. The original post can be found here.