For most small businesses, it’s necessary to find ways of funding your business’s operation, whether it’s start-up costs, expansion, or renovation. Very few SMB owners have the capital on hand from the get go. And we’ve talked plenty about how to secure loans, grants, and other financial assistance, both from traditional and non-traditional lenders, as well as some additional forms of financial relief offered by the United States federal government, state governments, and even municipalities and communities following the COVID-19 pandemic.
But one that we haven’t talked about extensively are merchant cash advances (MCA). These are another way that businesses can raise quick capital to keep themselves afloat. So what is a merchant cash advance, how are they different from traditional loans, and what are the pros and cons? Let’s dive into the topic so your business can make the best decision for your future.
Note: For the sake of simplicity, MCAs in this article are often referred to as loans or lending. These are not loans, however.
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A relative newcomer to the realm of financing, merchant cash advances originated in the 1990s. And though similar to a loan, there is a key difference. A loan is paid back in installments over a set period of time. Instead, an MCA is money given to the business but leveraged against future sales. The lender will, therefore, receive the money by attaining a percentage of future sales. The funds are not owed until the merchant actually makes a sale.
Traditionally, MCAs are for businesses that primarily accept payment from credit and debit card sales. Businesses can set up an MCA agreement in two ways:
- Receive cash upfront that will be repaid through a set percentage of future credit and debit sales
- Receive cash upfront that will be repaid through a fixed amount on a set time schedule from your bank account. This is referred to as an Automated Clearing House (ACH) and is more similar to a traditional loan.
The repayment structure is determined by the lender beforehand. Lenders will determine the risk using a factor rate. A risk factor is typically between 1.2 and 1.5. The lower the factor rate, the higher the fees will be.
Ostensibly, the latter of the two repayment structures mentioned above – the ACH – was implemented to help businesses that do more cash transactions qualify for an MCA.
But let’s break down in more detail how businesses can repay these advances. Let’s say that a merchant was given a risk factor of 1.3 for a cash advance of $100,000. Based on the risk factor, the fees will be $40,000 for a total repayment of $140,000.
With the percent of credit and debit card sales, the lender will automatically deduct a percentage until the $140,000 is completely repaid. The time frame for repayment will be estimated by the lender, but it ultimately depends on the total credit and debit sales made by the business. In the end, the more sales your business makes the faster the loan will be repaid.
If your cash advance provider agrees to take 5% of all credit and debit sales and you make $500,000 the first month, they take $25,000. But if you only make $250,000 the following month, they’ll only take $12,500. Again, the final amount will depend on your sales, allowing you some flexibility in slower months.
Fixed withdrawals leave you with less flexibility. Under the same scenario, you’d be given a set amount to be repaid based on your average sales. But the final amount paid will always be the same, instead of fluctuating from month to month.
Well, we’ve covered how MCAs work, so let’s take a look at traditional lending. When a business owner is in need of funding they might look for bank loans through the following steps:
- Put together a business plan
- Apply for the loan through a banking institution
- Determine if approved or not
- Set interest rates
- Consider short or long term loans
More favorable loans – long-term loans with low-interest rates – are harder to come by. Borrowers must have a great credit history and years of operation.
Newer businesses usually apply for short-term loans for capital that needs to be used quickly. These loans are for smaller amounts and must be repaid quickly. Both may also require collateral to be secured.
A line of credit with a bank is also similar to a short-term loan. These provide immediate capital assistance to businesses whenever they need it. Like either of these loans, interest must be paid on any line of credit used until it is repaid in full.
We’ll get to the cons in a minute, but there are some upsides to going the route of a merchant cash advance.
Pro #1: It’s easy to get. If your business needs immediate financing, an MCA may be the way to go. Traditional loans can take weeks to process, far too long for some urgent situations. Cash advances may only take 48 hours to reach your account.
Pro #2: You don’t need great credit. It can be remarkably difficult for new merchants to qualify for a traditional loan. Too often it’s a catch-22 of trying to qualify by showing you have a viable business without having the years of experience necessary to prove it. The old mantra of needing to spend money to make it is thrown out the window if you can’t get any money from the beginning. Instead, cash advances are available for those who don’t necessarily qualify for the traditional loan.
Pro #3: MCAs never require traditional collateral. Instead, the collateral is in the form of future sales. The provider will only look at your current sales to determine how much you qualify for and the terms of repayment.
While there is a time and place for this form of borrowing, it should never be your first option.
Con #1: There’s not a lot of flexibility. MCA providers will not work with you once the terms are agreed upon. And your interest will be high.
Con #2: Yes, interest will be high. So will the fees. Because it’s a riskier loan to offer (no collateral, credit history, years in operation required) the provider is going to charge a pretty penny in fees. In fact, your annual percentage rate (APR) might even be in the triple digits. And it will likely be at least 50%. You’ll certainly find hidden fees, too. Be prepared to get nickel and dimed throughout.
Con #3: There’s no ability to pay it off faster to save money. If your plan is more aggressively repaid, the APR will be higher. And there are certainly no refinancing options in your favor.
Con #4: It hurts cash flow. Obviously, a percentage of your sales each week or month going back to the provider will hurt your cash flow and growth over the course of the loan.
Con #5: It’s just kinda shady. These lenders have a reputation for a reason. Because the lending is determined to be commercial transactions rather than loans, the industry is not regulated and it’s hard to separate the fairer providers from the real sharks.
While there may be some extreme circumstances that warrant an MCA, it should be a final resort for any business. The downsides are simply too dramatic and risk putting you out of business. Do your research first and look for friendlier alternatives before making the dive.
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