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Square competes with small-business lenders

Kallie Wesley was 21 when she opened Juxtapose, a Tampa, Florida-based apparel and interior design studio, with her sister. After a few years the Wesley sisters were ready to expand and open a second storefront, but when the now-25-year-old Kallie went looking for an SBA loan, she couldn't get approved. That's when payment-processing start-up Square stepped in, offering the Wesley sisters a merchant cash advance earlier this summer.

Storeowner using Square card reader
Yuriko Nakao | Bloomberg | Getty Images

Best known for making credit card readers that plug into mobile phones and tablets, Square has been extending merchant cash advances to small businesses already using its payment-processing software and systems through a program it calls Square Capital. In exchange for a lump-sum payment, a small business agrees to pay back to Square a fixed amount plus the original cash advance, deducted from the business as a percentage of its daily credit card sales.

This type of funding fills a niche, since it is an option for small businesses like Juxtapose, which cannot access conventional loans. As a result, lenders can charge higher interest rates than banks.

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Since May, the San Francisco-based company has issued these advances to roughly 10,000 small businesses using $50 million of its own cash, said Square spokeswoman Faryl Ury. Eligibility is based on a business's monthly sales and history with Square. Most of these cash advances have been for less than $10,000, and Square typically takes 4 percent, 7 percent or 10 percent of a small business's daily card sales until the advance is paid off, Ury said.

In August, Victory Park Capital handed Square Capital a hefty investment to ramp up the program and extend more cash advances to more merchants. According to Ury, Square isn't releasing the exact amount of the investment, but the cash from Victory Park will allow Square to "extend hundreds of millions of dollars as quickly as possible."

The investment comes at a time when Square finds itself in flux. While the company continues to grow—Ury said Square employs more than 800 people and processes "tens of billions of dollars" annually—the company still has not turned a profit. Another, separate investment of $100 million into Square, announced in September, brings the company's valuation to $6 billion, but Square is also competing in an increasingly crowded payments sector against the likes of PayPal, Google and now Apple.

"The pressure is on for them to really start figuring out how to keep merchants, and keep merchants that are processing on a regular basis and at a respectable volume," said Phillip Parker, a former independent agent in the credit card–processing industry and founder of the merchant-account reviewing website CardPaymentOptions.com.

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So the foray into merchant cash advances looks like a play for not only a new revenue stream but also for new Square merchants. After all, only Square merchants can receive cash advances through Square Capital—and the only way for a merchant to pay back that cash advance is to stay with Square.

But how good a deal are merchant cash advances, which aren't regulated like loans and aren't subject to usury laws? With a traditional loan, interest owed declines as a business pays down its principal balance. Not so with a merchant cash advance, where a business is paying back a fixed amount. Parker said the annual percentage rate of interest on a merchant cash advance is "always around 10 to 20 percent," a number that can jump astronomically if a business has a gangbuster month in sales.

For that reason, merchant cash advances are often associated with notorious payday loans. But merchant cash advances "don't seem to have the same sorts of problems as payday loans," said Parker. "If you can't reduce the interest rate you pay by paying back quicker, it makes the interest rate seem a lot larger, but as long as merchants understand that ahead of time, then I don't personally see any issues with [merchant cash advances]," he said.

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While Square sometimes extends "personalized offers" to businesses with a 10-month payback period in mind, there's no set payback period for a company to pay off the advance. "There's a set cost written in a dollar amount, which never changes, no matter how long it takes a merchant to complete the advance," said Ury. And if a small business goes out of business before the cash advance is paid off? Ury said Square works with businesses on a "case-by-case basis."

"These aren't necessarily businesses that have no other way," she said. "It's often businesses that have gotten capital elsewhere, but they don't necessarily want to spend another year applying for money."

Or in the case of the Wesleys, small-business owners who couldn't get capital elsewhere. The merchant cash advance allowed Kallie and her sister to open a second storefront in St. Petersburg, Florida, in September and hire a manager and employees to staff it. "Without Square Capital, we would have never been able to do this," said Wesley.