'Confession of Judgement' Is Crucial for Small Business Growth

This month, roughly 500,000 Americans will start their own businesses. Sadly, many of these entrepreneurs won't succeed. About 20 percent of new companies fail in their first year. Only half survive five years.

Some states are making entrepreneurs' lives even harder by weakening legal contracts known as "confessions of judgment." Without the ability to sign confessions of judgment, small business owners may be unable to obtain merchant cash advances, a popular form of financing.

This interference is uncalled for. Business owners are perfectly capable of making their own financial and legal decisions.

Jumpstarting a business is exhilarating. But it's also challenging, especially since many banks won't lend to young firms. In July, big banks rejected 75 percent of small business loan applications. Even community banks rejected more than half of applications.

As a result, entrepreneurs often turn to alternative sources of financing when they need to purchase new equipment or meet payroll. One of the most common options is a "merchant cash advance" from financial technology companies. These fintech companies can offer entrepreneurs tens of thousands of dollars or more within a matter of days. In return, entrepreneurs give fintech companies a percentage of future sales until they've paid back the cash advance and associated fees.

Merchant cash advances differ from traditional business loans. When banks make a loan, they often demand the entrepreneur offer a building or equipment as collateral. If the entrepreneur defaults on the loan, banks can seize those assets to recover their money.

By contrast, fintech firms take on far more risk. They're offering a lump sum of cash in return for a share of an entrepreneur's future revenues. If the entrepreneur suffers setbacks and revenues decline, the fintech firm may wait far longer to be repaid. And if the business fails, there's a chance the fintech firm will never recoup its money. But they do not seize or sue to take someone’s home, car or unrelated assets.

Unfortunately, entrepreneurs occasionally embezzle cash advances. To protect themselves from such fraud, fintech firms often require entrepreneurs to sign a "confession of judgement" prior to receiving a cash advance as a part of the advance process.

Confessions of judgement are somewhat similar to prenuptial agreements. Business owners and fintech companies preemptively agree what happens in the event of fraud or some other bad faith behavior -- just as couples preemptively agree how to split their assets in the event of a divorce. For instance, the confession of judgement might stipulate that a fintech firm can garnish 20 percent of a business owner's future income until the advance is paid back.

Here's how a confession of judgement works. The business owner and the fintech company select a mutually agreed upon "attorney in fact." If fraud occurs, the attorney in fact simply submits the confession of judgement to a court and the settlement goes into effect.

This prevents the fintech firm from having to file a lawsuit and spend years proving that fraud was committed. By expediting the legal process, confessions of judgement save fintech companies and taxpayers money that would be wasted on court costs.

More importantly, confessions of judgement give fintech firms the confidence to offer financing to small businesses with less than perfect credit. Without merchant cash advances, many entrepreneurs wouldn't be able to expand and hire new workers.

Unfortunately, some states have started to heavily regulate confessions of judgment. Officials worry that small business owners are unwittingly waiving their right to a trial.

For example, Virginia and Maryland enable small business owners to reopen their confessions of judgement. That means a fintech firm could still be forced to file a lawsuit to receive payment, which defeats the purpose of a confession of judgement in the first place. Ohio lawmakers are considering legislation that would effectively ban fintech firms from including confession of judgement clauses in cash advance contracts.

The assumption behind these policies is that confessions of judgement are a predatory practice -- and that protections are needed to prevent abuse. But that assumption is deeply misinformed.

Business owners are usually well-versed in finance, used to negotiating, and adept at weighing risks and rewards. And like almost all entrepreneurs, they have ready access to lawyers.

Put differently, business owners can be trusted to make their own decisions regarding merchant capital.

Entrepreneurs need more than just ambition, guts, and luck. They also need adequate capital. By weakening confessions of judgement, states are jeopardizing millions of small business owners' access to quick and convenient financing.