Obtaining business financing is an essential topic for any business plan.  Recently, I was thinking about the problem of raising capital to fund a growing small business.  Obtaining funds for working capital is something that many small business owners must wrestle with regularly.  It turns out there can be many pitfalls and unexpected traps.  As always, it is important to read the fine print, in order to understand the high cost of easy money.

An advertisement offers easy money; but what are the terms?

This all began because I clicked a link on a Facebook advertisement.  It’s not something I do often, but the ad intrigued me.  The advertiser was offering me easy money for the express purpose of growing my business.  That’s interesting, I thought; but what are the loan terms?

The ad was targeted at micro-enterprises who use PayPal to process most of their sales.  The advertisement’s copy and landing page both emphasized how fast and easy it is to obtain business financing from this particular lender.  The landing page had almost no explanatory text, and not a word about the loan terms.

The landing page

Interestingly, when I clicked through from the ad to the website, the landing page was a study in maximizing conversions.  Not only was there almost no text copy; there was absolutely no navigation.  There was no header navigation menu, no sidebar menu, no footer menu; not even the logo was clickable, which is pretty unusual.  Almost the only option presented to the visitor was to fill out and submit the form to sign up for an account.

[Please note: I am not linking to the landing page in question, for various reasons.]

Understanding the loan terms

So naturally I manually edited the URL in my browser’s location bar, and went to the website’s homepage.  That still didn’t say anything about the loan terms; but after clicking around for a while, I found a mystifying chart that offered an explanation of sorts.  Here’s the link:

https://www.kabbage.com/how-it-works/what-does-it-cost

The chart shows a repayment schedule for a 6-month loan.  (Note: the fine print says that the loan is not a loan; the lender calls it a “merchant advance.”)  Each month, the borrower pays 1/6 of the principal, plus a variable fee which may range from 1% to 10% of the total loan amount.  Red flag, that’s a pretty significant spread.

I wasn’t sure I understood; but thankfully they offered an example. Looking at the example customer, it became clear that the loan terms vary depending on a score assigned to the borrower by the lender.  This score is essentially a measure of creditworthiness; but instead of basing the score on a standard credit rating, this score is based on things like your company’s monthly turnover and the popularity of your company’s social media profiles.  That’s bad news for me, because I don’t spend a lot of time trying to win popularity contests…

But the example customer had an “excellent” score.  (Note that the example customer enjoyed average monthly revenue of $37,000: more than most cottage industries bring in for an entire year.  The hypothetical example customer is pulling the best part of a half million dollars a year selling dog grooming supplies on eBay, and has no need of the quick cash terms offered here.)  Anyway, the example customer repaid a $10,000 loan in 6 months with only $1,000 in fees.

What is the APR?

At this point, it’s a math problem.  I couldn’t resist the challenge.  Sure, obviously the example customer paid 10% of the original loan amount in fees over a 6-month period.  But what is the APR?

Enter Excel’s Rate function.  I finished my last accounting class more than a year ago now, so I was a bit rusty, but I got a quick refresher from the Microsoft Excel Rate function documentation here.

Of course, calculating the rate requires even payments.  In other words, the spreadsheet function expects the payments to be the same every month.  In this case, the lender has made it difficult to calculate the rate because the payments are different from month to month.  Fine, fine, a quick workaround is to average them out.  Based on the data in the chart provided, I calculated that the example borrower made average monthly payments of $1,833.34 for six months.  That works out to 2.8% interest… monthly.  Doesn’t sound too bad, right?  That’s because we’re not used to thinking about “monthly” interest rates.  Nobody talks about a “monthly” interest rate.  Real financial institutions talk about annual rates: the APR.  In this case, you get the APR by multiplying the monthly rate by the number of months in a year.

The answer is 33.5%.  This loan carries a 33.5% APR.  Youch!  And that’s the best case scenario, if you have stellar credit, booming business, and a fantastic social media presence.

A more realistic scenario

The company’s example page did not supply a worst-case scenario, but we can calculate it.  Based on the loan terms described, our worst-case scenario customer would be looking at average monthly payments of $2,066.67 on that same $10,000 loan.  Our Rate calculator says this is equivalent to a…  wait for it…

Did you get that?  This loan works out to a 78.2% APR.

78.2% APR

I’m not joking!  Do the calculation yourself by typing =RATE() in any Excel spreadsheet.

Nper is 6 months
Monthly payment of $2,066.67 must be entered as a negative number
PV the present value of the loan is the loan amount: ten grand.

Conclusion: Easy money is expensive

Well, the lesson here is that easy money is expensive.  If you can’t get angel investors or venture capital and you need a loan to grow your business, go to a bank.  Don’t borrow money from payday lenders or online, um, “merchant advance” outfits.  It might be quick and easy, but it will cost you.

Have questions about planning for business growth?  Ask Mardesco to help you write a business plan that’s sustainable and attainable.

[Mardesco is not affiliated with any financial institution or financial products industry.]