Why Square Is Overhauling Its Popular Financing Product

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By all appearances, Square's foray into small-business finance has been a big hit with its customers.

Since the payments pioneer launched its merchant cash advance product in May 2014, Square has provided roughly $450 million in financing to merchants, with total advances for each quarter surpassing the last.

So why is Square ditching cash advances and replacing them with a business loan product — and teaming with a bank to do it?

Square says the changes to Square Capital, as the product continues to be known, will benefit its customers and hopefully fuel even faster growth. But the moves also have legal and regulatory implications for Square and other online lenders that are all navigating issues related to state interest-rate caps.

When it announced the overhaul last week, San Francisco-based Square signaled to its customers that they will see little change.

While Square Capital is now technically a loan, it continues to resemble a merchant cash advance. Businesses that take merchant cash advances get cash upfront in exchange for a fixed percentage of their future sales.

Just as before, select merchants that use Square to process their card payments will be offered financing after they log into their accounts.

"Square Capital is still as fast, simple, and transparent as ever," Jacqueline Reses, who leads the product for Square, wrote in a blog post last week.

"There is no burdensome paperwork to apply, qualified sellers can get funds as soon as the next business day, repayment happens as a fixed percentage of your daily card sales, and the cost of the loan is a fixed dollar amount that never changes."

Square, best known for its slender card readers, cited two specific reasons for the change.

First, a Square official said that structuring the financing product as a loan will enable it to grow at a faster rate, since investors are more familiar with loans than they are with cash advances.

Since its launch, Square Capital has been financed by Victory Park Capital and Colchis Capital, and those two firms are expected to continue investing in the product, while Square also looks to bring aboard new investors.

Square Capital is already enjoying rapid growth. Between the fourth quarter of 2014 and the same period a year later, quarterly cash advances grew from an estimated $30 million to nearly $150 million, according to a recent analysis by Wedbush Securities.

The torrid pace of growth worries Gil Luria, a Wedbush analyst who has a neutral rating on Square. He fears that some merchants getting credit from Square will have a hard time repaying.

"At the rate that they're growing this product, I think there's reason for concern," Luria said.

Square noted that the loans will be underwritten by Celtic Bank, a $451 million-asset institution in Salt Lake City. Celtic Bank, which was not previously involved with Square Capital, will also issue the loans.

The second reason that Square cited for switching to a loan structure is that borrowers will now be able to make early repayments, an option that was not available to them before.

But borrowers who avail themselves of the early payment option will actually be paying higher interest rates than they would otherwise, so it's not clear whether many borrowers will select this choice.

In one example on Square's website, a merchant gets offered $10,000, and owes a total of $11,300. The repayments are made via automatic deductions equal to 13% of the merchant's card sales.

Under the early payment option, the hypothetical borrower still owes the entire $11,300, but the term of the loan is shorter, which results in a higher interest rate.

For Square, there may be another advantage to structuring Square Capital as a loan product: less exposure to lawsuits.

From time to time, merchant cash advances have been challenged in court as violating state interest rate caps. The cases can hinge on the details of how the products are structured, which shed light on whether usury laws apply.

"Merchant cash advances are not loans if they are properly structured," said Scott Pearson, a Ballard Spahr attorney who has represented industry participants.

But Pearson added that the standards for determining whether usury laws apply are not entirely clear.

"It's difficult to get all of your customer-service people to always use the right words when you're discussing the transaction," he said.

By partnering with Celtic Bank, Square may be able to lessen its potential exposure to lawsuits, since banks are not subject to state interest rate caps.

On the other hand, there are also widely publicized legal questions about whether online lenders will be able to continue partnering with banks as a way to avoid the same state rate caps.

"I'm not sure either structure is perfect. Both of them have a level of risk associated with them," Pearson said.

Square announced the changes to its financing product at a time when California officials are scrutinizing the online lending industry.

Square is one of 14 companies — others include Lending Club, Prosper Marketplace, Social Finance, and PayPal — that were asked in December to respond to a series of detailed questions from California officials.

Square does not hold a lending license in California, and it has not applied for one, according to the California Department of Business Oversight.

Square declined to comment on the record about whether legal or regulatory issues factored into its decision to restructure Square Capital.

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