08 Jan commercial financing in 2023
“I’m from the Government, and I’m here to help you.”
Small business owners, continuing to struggle with the aftermath of Covid, should prepare for significant changes in the 2023 environment for new commercial financing. In addition to higher interest rates due to the Federal Reserve’s increase in interest rates, proposed regulations affecting small business borrowers are likely to drive many lenders from the market. Funding alternatives like merchant cash advances, invoice factoring, and short-term loans will disappear as the Federal and State government force consumer-like loan disclosures on lenders to small businesses.
In 2021, the Consumer Financial Protection Bureau (CFPB) proposed rules expanding consumer-like loan details for most funding to small business borrowers.[i] Representative Velazquez (D-NY) subsequently introduced H.R. 6054 – the Small Business Disclosure Act of 2021 extending the CFPB’s authority to regulate small business financing like the Bureau’s oversight of consumer lending.
Several states, notably California[ii] and New York,[iii] passed laws in 2022 requiring small business lenders to disclose the
- total amount of funds provided,
- total dollar cost of financing,
- term or estimated term,
- method, frequency, and amounts of payment ,
- a description of prepayment penalties, and
- the total cost of financing expressed as an annualized rate (APR) (until January 1, 2024).
Seven other states[iv] – Connecticut, Missouri, New Jersey, North Carolina, Virginia, Utah, and Maryland – have introduced legislation requiring similar disclosures but are unlikely to be in force before 2023.
Don’t Fix it if It’s Not Broke
According to the SBA, there are more than 32 million small businesses in the U.S., more than 99.9% of all companies. Opening a business is high risk with a failure rate of more than 20% during the first year. Most small businesses need additional working capital during their early years to survive. Small businesses are unlikely to find banks or credit unions receptive to their needs as they approved less than 22% of applications in 2021 and 2022.[v]
Non-bank lenders stepped into the gap abandoned by banks pursuing more established businesses and their ability to pay hefty fees for ancillary services. Through necessity, small business owners choose non-bank lenders for their faster decision process, lower collateral requirements, and more flexible product terms compared to bank lenders. The banking industry advocates for stronger regulation of non-bank lenders for competitive reasons, afraid that more business owners will turn to new, innovative, technology-superior newcomers.
Historically, many profitable small companies have had to close their doors because they were not able to meet short-term cash flow needs.[vi] Cash advances are primarily used for working capital during slow periods or bridging gaps between doing work on a significant project and getting paid. The infusion of working capital is short-term, typically repaid in months, not years.
The U.S. Chamber of Commerce notes that nonbank lenders can be a helpful avenue when securing funding when a business doesn’t qualify for a traditional bank loan or doesn’t want to borrow from a bank.[vii] According to Paul Kupiec of the American Enterprise Association, non-bank finance companies are critical for small businesses with their innovation and willingness to provide financing and services that banks have abandoned. The line between banks and non-bank lenders will effectively disappear if the proposed regulations are passed in their present form, specifically the requirement to include the disclosure of an Annual Percentage Rate (APR) for all commercial loans.[viii]
APR Expansion is a Red Herring
The 1968 Truth in Lending Act required disclosure of the APR in nearly all consumer credit transactions.[ix] Regulators justified the disclosure requirement with the assumption that borrowers could not understand the cost of various loan options. They neglected that APR for transactions with variable interest rates, payment periods, or interim fees complicates the calculation and can produce misleading results.
APR calculations are misleading for funding options with indeterminate repayment amounts and terms such as merchant cash advances, invoice factoring, and short-term loans. For example, the amount repaid for a cash advance is established by multiplying the cash advance by a Factor rate (1.1 to 1.5 of the cash advance) based on the lender’s perspective of the risk of repayment. The advance is repaid by a series of payments equal to a negotiated percentage of sales or credit card receipts over an indeterminate period until an agreed total repayment is met. The variable payment condition benefit small business owners by tying payment amounts to the level of sales or credit card receipts, instead requiring an arbitrary, fixed amount.
Numerous studies suggest that consumers with APR disclosures continue to misunderstand the data and choose more expensive options.[x],[xi] Are small business borrowers better able to understand APR than consumers? A 2020 study by the Kingsley-Kleinman Group for the Small Business Finance Association (SBFA), an association of non-bank small business lenders, found that APR disclosures are more likely to confuse potential borrowers than help them make a decision.
A blanket requirement to provide an APR calculation would be impossible for merchant cash advances, invoice factoring, and other short-term funding options typically repaid in months, not years. The most likely result is lenders offering such funding products will cease offering such products in states where APR disclosure is required.
Small business owners will likely contend with a challenging financing environment in 2023 and 2024 from the combination of higher interest rates due to the Federal Reserve’s rate increases. Aleksandar Tomic, an economist and associate dean at Boston College, notes that the impact on small businesses is exaggerated because they lack the tools and flexibility of larger companies.[xii] The loss of funding options like merchant cash advances and other short-term solutions due to changing regulations will make survival more difficult.
[i] Staff. (2021) CFPB Proposes Rule to Shine New Light on Small Businesses’ Access to Credit. Consumer Financial Protection Bureau News Release. (September 1, 2020) CFPB Proposes Rule to Shine New Light on Small Businesses’ Access to Credit | Consumer Financial Protection Bureau (consumerfinance.gov)
[ii] Staff. (2022) DFPI’s Commercial Financing Disclosure Regulations Approved to Become Effective as of December 9, 2022. California Department of Financial Protection & Innovation Press Release. (June 14, 2022) DFPI’s Commercial Financing Disclosure Regulations Approved to Become Effective as of December 9, 2022 | The Department of Financial Protection and Innovation (ca.gov)
[iii] Staff. (2021) ACTING SUPERINTENDENT OF FINANCIAL SERVICES ADRIENNE A. HARRIS ANNOUNCES NEW PROPOSED REGULATION PROMOTING TRANSPARENCY IN LENDING TO SMALL BUSINESSES. New York State Department of Financial services Press Release. (September 21,2021) Press Release – September 21, 2021: Acting Superintendent of Financial Services Adrienne A. Harris Announces New Proposed Regulation Promoting Transparency in Lending to Small Businesses | Department of Financial Services (ny.gov)
[iv] Sadler, J. & Belfort, G. (2022) Update on state small business commercial financing disclosure laws. Consumer Finance Monitor, Ballard Spahr LLP. (February 16, 2022) Update on state small business commercial financing disclosure laws | Consumer Finance Monitor
[v] Staff. (2022) Biz2Credit Small Business Lending Index™ Reports Loan Approval Percentages Dropped at Banks and Credit Unions in November. Biz2credit.com (visited December 28, 2022) Small Business Lending Index November 2022 – Biz2Credit
[vi] Prosser, M. (2015) Why do small business lenders avoid talking about APR? Forbes magazine. (June 22, 2015) https://www.forbes.com/sites/marcprosser/2015/06/22/why-do-small-business-lenders-avoid-talking-about-apr/?sh=6aeae39b10db
[vii] Betterton, K. (2022) What Is A Nonbank Lender? U.S. Chamber of Commerce Newsletter. (May 20,2022) What Is A Nonbank Lender? Pros and Cons (uschamber.com)
[viii] Kupiec, P. (2021) Putting bank regulations on non-bank lenders will stifle innovation. The Hill. (May7, 2021) Putting bank regulations on non-bank lenders will stifle innovation | The Hill
[ix] Staff. (2015) Truth in Lending Act. Consumer Financial Protection Bureau, pp.14-22. (April, 2015) 201503_cfpb_truth-in-lending-act.pdf (consumerfinance.gov)
[x] Soll, J. B., Keeney, R. L., & Larrick, R. P. (2013). Consumer Misunderstanding of Credit Card Use, Payments, and Debt: Causes and Solutions. Journal of Public Policy & Marketing, 32(1), 66–81. http://www.jstor.org/stable/43305554
[xi] Mckenzie, C.R., & Liersch, M.J. (2011). Misunderstanding Savings Growth: Implications for Retirement Savings Behavior. Journal of Marketing Research, 48, S1 – S13. Misunderstanding Savings Growth: Implications for Retirement Savings Behavior – Craig R.M. Mckenzie, Michael J. Liersch, 2011 (sagepub.com)
[xii] Lauria, P. (2022) Interest Rate Increases: 4 Concerns for Small Businesses. Business News Daily. (Downloaded January 2, 2023) How Interest Rate Hikes Impact Small Businesses (businessnewsdaily.com)