There is a growing need for alternative sources of capital for companies that cannot obtain or do not want traditional loans or private equity investments. Traditionally, there were basically two financing options: debt, which some entrepreneurs and small businesses couldn’t qualify for, or the sale of equity, which leads to a decrease in ownership. An expanding alternative is revenue-based financing (also known as sales-based financing and merchant cash advances), which incorporates some features of both. As with any growing financial industry, the legal framework is changing rapidly and the industry must prepare for it.
What is revenue-based financing?
Revenue-based financing is the extension of capital in exchange for a percentage of the company’s future gross revenue. For example, a revenue-based financing provider provides $100,000 to a company in exchange for 10% of the company’s revenue until the company repays the provider a set amount, usually a multiple of the financed amount (if the multiple was 1.5x, in this example the refund amount would be $150,000). Reimbursement is made periodically by direct debits from the company’s account.
Since there is no fixed monthly payment (because income fluctuates), income-based financing does not have a fixed due date. If a business has high revenue, refunds will be larger and the refund amount will be paid faster. Alternatively, if a business has lower revenues, reimbursements will be lower and the supplier will be paid more slowly. If the business fails, the funder’s repayment is in jeopardy. Thus, revenue-based financing gives businesses more flexibility, with repayment coinciding with actual revenue.
There is little regulatory framework, but this landscape is changing.
Current regulatory framework
Few states currently regulate revenue-based financing. Due to its growing popularity and opportunity for unscrupulous players, some states like Virginia, New York, Utah, and California have regulated or are attempting to regulate revenue-based financing.
On April 11, 2022, Virginia enacted HB1027. HB1027 requires “sales-based financing providers” and “brokers” to register with the Virginia State Corporate Commission by November 15, 2022. It also requires disclosure of certain terms of the sales-based financing agreement. income, such as amount financed, finance charges, repayment amount, estimated number of payments and amounts, fees, prepayment charges, guarantees, and a host of other items. While HB1027 directs the Virginia State Corporate Commission to pass implementing regulations, the law takes effect immediately.
On December 23, 2020, New York enacted the Commercial Finance Disclosure Law (CFDL), which will also require the disclosure of similar redemption terms. Unlike Virginia law, however, the CFDL is not currently in effect. While the CFDL technically went into effect on January 1, 2022, the New York Department of Financial Services does not require compliance until the implementing regulations are final.
On March 24, 2022, Utah enacted the Commercial Finance Registration and Disclosure Act (CFRDA), which requires registration of businesses engaged in “accounts receivable purchase transactions.” Like Virginia and New York, the CFRDA requires mandatory disclosures, including “full dollar cost of trade finance,” but stops short of requiring the calculation and disclosure of an annual rate. percentage. The CFRDA comes into force on January 1, 2023.
Similarly, California has enacted SB No. 1235, which requires specific disclosures for income-based funders. SB No. 1235 and the California Department of Financial Protection and Innovation’s implementing regulations are scheduled to go into effect December 9, 2022 and will require revenue-based financing providers to disclose: the total amount of funds provided; the total dollar cost of the financing; the duration or estimated duration; the method, frequency and amount of payments; a description of prepayment policies; and the total cost of financing expressed as an annualized rate.
Although repayment terms and disclosures have commonly accepted and understood meanings in traditional lending, these definitions do not necessarily correspond perfectly to revenue-based financing. Because revenue-based financing repayment is tied to actual earnings, there is no set repayment schedule and interest rates are not easily determined without estimates or assumptions. With some state regulations taking effect within the next two months, revenue-based funders should closely monitor the development of state laws to ensure compliance, and they should anticipate further scrutiny in 2022 and beyond.
Execution of individual disputes
Revenue-based funders should also be aware of traditional individual delivery methods. Whenever there is an opportunity for profit, there is an opportunity for less scrupulous players to exploit it. Although revenue-based financing is aimed at businesses, not consumers, many businesses seeking revenue-based financing are smaller and in need of capital, and could fall victim to pushy lenders. . Predatory financing could result in claims under state Unfair and Deceptive Acts and Practices (UDAP) laws, usury laws, predatory lending, fraud, good faith, and fair use , and the federal Racketeer Influenced and Corrupt Organizations (RICO) Act.
In a recent series of cases in the United States District Court for the Southern District of New York (SDNY), companies alleged that their revenue-based lenders violated RICO and antitrust laws. usury of the state.1 These plaintiffs alleged that their financings were not really revenue-based financings, but rather thinly veiled predatory lending with usurious rates and terms. Because they alleged the loans were usurious and unlawful, their origination and collection were underlying acts for the RICO civil claims. In each of these cases, liability depended on whether the transactions were genuine sales of future income or disguised loans. If the transaction was a loan, the RICO and usury claims could continue. If, however, the transaction was a genuine sale of future earnings, the claims would fail.
To answer this question, SDNY looked at three important factors to distinguish between a loan and a sale of income. First, the courts looked at the reconciliation to determine if the funding repayments were based on actual revenue received or if they were instead periodic at a fixed amount. Second, the courts have considered whether there is a specific repayment term. If a finance transaction had a set repayment term, it looked like a loan. If, on the other hand, it had an indefinite repayment period, it looked more like a revenue sale. Finally, and perhaps most importantly, the court considered the risk of non-payment. If the financier bears the risk of business failure and has no recourse against the business or the guarantors, then the transaction is more like revenue-based financing. If, on the other hand, the company has guarantees or requires admissions of judgment, then the transactions were more like loans. In each of these cases, the claims survived motions to dismiss and, in Fleetwood Services, the court granted summary judgment to the plaintiff on liability for its RICO claims.
To avoid potential liability under RICO and state usury laws, revenue-based financing providers must ensure that the structure of their financing transactions, taken as a whole, resembles genuine sales of future income and are not simply secured loans disguised as sales.
In addition, income-based funders should also be aware of state UDAP laws. State UDAP laws vary widely in scope of coverage, conduct and industries regulated, and potential exposure. Many state UDAP laws also provide for the possibility of class actions. Finally, the traditional causes of action for breach of contract, fraud and predatory lending are also potential claims.
Implications for revenue-based funders
The growing popularity of revenue-based financing and the need for regulations like those in Virginia, New York, Utah, and California, make revenue-based financing an area of focus in 2022. The presence of malicious actors could have a negative effect. shine a light on an otherwise valuable and necessary source of capital, and attract close scrutiny. Revenue-based funders should closely monitor national regulations and ensure that their products retain the characteristics of revenue-based financing. To avoid costly litigation and exposure, financiers must ensure that their products do not take on the characteristics of loans.
1 See Fleetwood Servs., LLC vs. Ram Cap. Funding, LLC, No. 20-cv-5120 (LJL), 2022 WL 1997207 (SDNY 6 June 2022); Haymount Urgent Care PC, v. GoFund Advance, LLC, No. 22-cv-1245 (JSR), 2022 WL 2297768 (SDNY June 27, 2022); Lateral Recovery LLC c. Queen Funding, LLC, No. 21 Civ. 9607 (CGS), 2022 WL 2829913 (SDNY 20 July 2022).