The recent news of OnDeck’s IPO filing, and the estimated valuation of $1.5 billion have generated a lot of discussion around alternative small business lending.
In recent years, online commercial lenders (commonly selling merchant cash advances) have grown in popularity in the small business community. As traditional commercial banks tightened their underwriting standards, following the financial crisis in 2008, online lenders like OnDeck offered fast access to money through an easy application platform and quick underwriting decisions.
The concept of “easy money” is not new—nor is the truth that if it’s too good to be true—it probably is. As is the case with any form of funding, it's always important to do your homework and know what you are getting into. At the end of the day, it’s your business and personal assets on the line and financial decisions once made are hard to reverse.
This post will help you understand what the financial impact of an OnDeck loan can be.
OnDeck offers loans from $5,000 to $25,000, with loan terms ranging from three months to two years. To simplify, let's look at the first example from the chart below, which we took directly from OnDeck's website. It's a $25,000 loan with 6 months payback period. So, what's the interest rate on this loan? You may think: this $25,000 is going to cost me $4,250 to borrow, which is equivalent to a 17% of every dollar borrowed. Correct?
You need to also add in the 2.5% loan origination fee. 2.5% of $25K is $625. Big deal, so the total cost of the loan will be $4,875 and the interest rate will be 19.5% (total payback of $4,875 divided by the principal amount of $25K), right?
Wrong again! - try 108% which is the effective annual percentage rate (APR) for the loan. We explained APR in a previous post—but essentially it’s a good equivalency measure for comparing different funding costs.
*Source: OnDeck's Website
No wonder there’s no “interest rate” to be found on OnDeck’s price sheet. You see, OnDeck’s pricing table fails to mention the two biggest factors that impact a loan’s interest rate—payback time and payment frequency. Think about your mortgage, if the payback amount is the same; is it more affordable to have a 30-year mortgage instead of a 15-year? Think about your car payments, would you rather make quarterly payments or monthly payments?
OnDeck promises a lending decision in minutes, and cash in your account as fast as one business day. BUT…you also start paying back the next day AND every day until you the loan terminates in 6 months.
So reworking OnDeck’s pricing table to show how much you pay each day and the effective APR – it looks like this:
What’s the financial impact on your business if you have to pay $163 every day for six months? And what kind of strain will it put on your cash flow? If you need money fast, you are most likely already in a tight cash situation. What will change your cash position overnight? Can you afford this daily obligation the day after you get the funding?
Estimating future cash flows can be tricky and the last thing you want is to have to take on further debt to support your repayment commitment, which will only weaken your cash position even further. Just like credit card debt, it can snowball.
OnDeck loans are personally guaranteed and your assets, such as your house and cars are liens against your default. We caution entrepreneurs to think about the consequences of their obligations before taking on high costs loans. The risk can impact your personal life, beyond your business.
We hope you now have a better understanding of the financial impact on OnDeck loans. The convenience and speed is attractive, but it comes with a high cost and risk. And if you’re a successful entrepreneur, you have better funding options if you plan ahead.
Merchant cash advances, like those provided by OnDeck, can help you out in a pinch, when an unpredicted, one-time event results in reduced cash flow, threatening your relationships with customers and vendors, but they are not a sustainable option for your on-going capital needs. These loans put too much of a strain on your future cash flow, and increase the risk of losing your personal assets. If you must—borrow the absolute minimum and prioritize its repayment.
We always advise our entrepreneurs to have a clear strategy for capital raising that includes funding emergency situations. Do the research now and have a solution you can manage so you are not backed into making a fast, un-researched decision if the time comes.
At Lighter Capital, our model best suits growing technology companies looking to fund sales and marketing or product development. We are always transparent with our entrepreneurs and want to make sure revenue-based financing makes the best sense for them. You can see how our RevenueLoans work here. But don’t be afraid to ask us any question you need to in order to be 100% clear before making a commitment.