When a small business needs money, small business borrowers typically look to the usual suspects for their business financing: their own bank account, credit cards, and, depending upon their credit score, bank loans.
But there are also a wide variety of creative funding options too—microfinance, crowdfunding, factoring, and merchant cash advances (MCAs). Today we are going to drill down into that last option and explain why, although a viable option, MCAs should not be near the top of any small business owner’s list for emergency business financing.
Merchant Cash Advance Explained
A merchant cash advance is exactly what it sounds like–it is an advance. It’s as simple (but, as you will see, also as complicated!) as that. When you were younger, you may have gotten an advance on your allowance, or, when you were a little older, an advance on a paycheck. Some people even get advances on inheritances.
An advance is money you get now that is owed to you later, right?
Well, that is all an MCA really is, except that here, the small business owner is getting the advance on future credit card sales. In other words:
A merchant cash advance is money given to you by a lender—for a steep fee—that you agree to repay with future debit and credit card sales.
Is a Merchant Cash Advance a Loan?
No, a merchant cash advance is not a loan. An MCA essentially is based on money you plan to make from future credit card transactions. Your sales pay back the advance. A loan is not tied to credit card sales like an MCA is.
Are My Personal Assets on the Hook with a Merchant Cash Advance?
Unlike a mortgage or a car loan, the merchant cash advance isn’t backed up by any collateral. If you miss a payment, they can’t come take away your home or your car. But that doesn't mean you're totally off the hook. Some lenders might ask for a personal guarantee, that is, you agree to pay the debt if your business is unable to.
Danger Will Robinson! Why? Because a personal guarantee means that if the business cannot repay the MCA, you—the guarantor—will have to.
Getting Started with a Merchant Cash Advance
As you have likely surmised, MCAs have been historically geared toward those businesses that get a lot of their income from credit card sales—businesses like retail shops, restaurants, gas stations, and the like.
A service business, like a law firm for example, would not typically be an appropriate merchant for a merchant cash advance.
Let’s say that you need some quick cash because you need to buy a new, refrigerated delivery truck for your floral shop and a great deal popped up.
You need $50,000 pronto. Finding a lump sum like that in a hurry is no easy task and so you decide that a merchant cash advance is the way to go, given that a good percentage of your business comes from credit card sales.
You would Google "merchant cash advance companies,” find one, contact them, and apply. Once approved for the $50,000 advance, you would find out the extra fees and get the funds. But what are those extra fees? Let's find out:
How Much Will a Merchant Cash Advance Cost Me?
MCAs use factor rates to figure out how much you owe on top of the advance. They're like an interest rate, but typically much steeper and calculated differently.
Your factor rate is determined by your small business’ credit history, its financial stability, and the amount of money you want to borrow.
MCA factor rates fall between 1.1 and 1.5.
So, in this example, let’s say your factor rate is 1.5. Rember we were approved for a $50,000 advance, so you'd need to repay—out of upcoming credit card sales—a total of $75,000 ($50,000 x 1.5)...plus administrative fees.
If the administrative fees are three percent, you'd have to pay back a grand total of $76,500 ($75,000 x 3%) on your $50,000 loan! And repayment timeframes in the MCA universe are only between three and 12 months or so.
Repaying with Credit Card Sales
After the application process, you and the MCA provider will agree on your holdback rate or the percentage of your daily credit card sales you’ll set aside to pay the lender.
It may be something like 10 percent. If you, therefore, sell $60,000 a month via credit cards, that means $6,000 a month will be earmarked for repayment, and that $75,000 would be repaid in a little over a year.
But what if sales drop? But what if taking 10 percent of your revenue is too big of a bite out of your operating budget?
Here’s the deal: Sales volume fluctuates. That means that the amount you repay will likely fluctuate. If the fluctuation is downward (due, say, to a pandemic or recession), the amount of time it will take to repay the advance extends.
Repaying with Fixed Repayments
An alternative to daily or weekly credit card withholding is called “fixed withdrawals.” If your revenue doesn’t typically come from credit card sales, then you and the lender can agree to a fixed amount automatically withdrawn from your bank account on a daily or weekly basis. The amount will be determined by your estimated monthly revenue.
Based on our previous example of $6,000/month, the MCA company would debit your account at $1,384 a week.
In this scenario, the repayment term would be fixed and would not deviate due to sales. This might be advantageous as the payments would be predictable (as opposed to being unpredictably tied to fluctuating credit card sales).
The Pros and Cons of Merchant Cash Advances
So, is a merchant cash advance good for business? Like most things in life really, MCAs have pluses and minuses. On the plus side, if your small business has consistent credit card sales and cash flow, you can get an MCA fairly quickly and easily; usually in less than a week.
Speed is a major selling point for what can almost be considered a usurious small business loan. Another benefit is that the advances can be substantial–anywhere from $5,000 to $500,000 is possible.
The bad news? That money and convenience doesn’t come cheap. The total cost of an MCA, considering all fees and everything, can get well into the triple digits. An advance of, say, $50k, could easily have fees and costs half that—$25K. That’s 50 percent!
Here's a list of all the pros and cons for you to consider:
- Speed: This is maybe the biggest benefit. If you have credit card sales, getting a merchant cash advance against them is fast, and sometimes, quick access is the deciding factor.
- Ease: If you have credit card sales, eligibility is easy and bad credit scores aren’t a problem (though they do affect your repayment terms).
- Tied to sales: This is a double-edged sword. Yes, you want to pay off the debt as soon as possible, but even so, it is nice that when sales are down, your payments correspondingly are reduced. This, of course, depends on the type of business you have. For folks who don’t earn their revenue in credit card sales, you’d pay back an MCA in fixed payments from your bank account, and those wouldn’t change.
- Unsecured: As opposed to most traditional bank loans, MCAs are an unsecured debt. There is no business asset collateral required. In the case of a bankruptcy, this debt would be wiped out. The only exception is if your lender asks for a personal guarantee, which would require you to use your personal assets to repay the advance if something goes wrong.
- High limits: Getting funding into the hundreds of thousands of dollars is quite possible.
- No experience necessary: Even startups can get MCAs if they have the credit card sales.
- The cost: Daily, weekly, or monthly payments your merchant cash advance provider will offer, can be very high. This is but one of the dangers of these advances. By contrast, a business credit card carries interest rates in the teens, and business bank loans are well below that.
- Confusion: Between the repayment percentage, administrative fees, and the factor rate, MCA contracts and deals can be confusing.
- No early-payment benefit: You owe what you owe with a MCA and there are no savings by repaying the amount early.
- Repayment challenges: Having hundreds or thousands of dollars pulled every week from either your credit card receipts or your bank account can be a challenge. As such, a debt cycle can occur if you fall into the MCA trap.
- No credit benefit: At least with a loan, when you pay it off, your credit scores reflect that. Not true here. Credit bureaus will never see this repayment. This is an advance, not a loan.
Creative Funding Alternatives to Merchant Cash Advances
There are other small business financing options available, like:
- Microloans: The Small Business Administration guarantees simple, fairly easy to get, microloans up to $50,000, and these can be used for working capital.
- Business line of credit: Consider speaking with your banker about getting a line of credit.
- Credit cards: With cash-back and other rewards, it might behoove you to go this route for your business funding.
- Factoring: If you have accounts receivable (AR), you can sell those to a company known as a factor. Factors buy ARs for less than the actual amount owed and the difference is their profit. Example: You are owed $10,000 in three months. The factor might pay you $9,000 for it today. They would then collect the $10,000 in three months, and that extra $1,000 would be their profit.
Merchant Cash Advances Cost A Lot, But Get You Funds Fast
They are easy to fall into and tough to get out of. That said, in a pinch, an MCA can indeed be a source of quick funding. Just be sure you have a plan to pay it back in a jiffy.