Are Merchant
Cash Advance Predatory?

Last Updated on April 2, 2024

Shield Funding Team

Table of Contents

Small businesses often experience ups and downs in cash flows. Whether it’s due to seasonality or because a large customer didn’t pay their invoice on time, even successful small business owners can find themselves short of cash. When payroll is due Friday and you don’t have the funds, where do you turn for money? 

A quick online search for fast, convenient, capital will return several options – among them merchant cash advances or MCAs. Providers can fund a merchant cash advance within a few days. They are best used to emergency working capital needs and to see your business through a temporary cash flow crisis. 

But merchant cash advances are a controversial lending product. Traditional banks do not offer them, and lawyers often caution against taking one out. Many claim that MCAs are predatory. 

We will help you cut through the noise on the internet to decide for yourself if a merchant cash advance could help or harm your business. 

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Do you need a merchant cash advance? Shield Funding offers competitive rates and terms on it’s unsecured funding programs and can get you money the same day you apply. We have been assisting business owners for almost two decades with a five star rating.

What is A Merchant Cash Advance?

Merchant cash advances allow small business owners to turn future sales into cash in the bank now. If your small business does a large volume of credit sales it can qualify for a MCA. Merchant cash providers can advance funds within a few days, helping small business owners make it through a cash flow crunch or cover emergency expenses. 

When you apply for a MCA, the provider analyzes your past few month’s sales. Based upon this analysis, they create a projection of future sales and give you a cash advance. Instead of paying the advance back through a once a month, lump sum payment, you pay it back through daily deductions. The MCA provider takes a set percentage – often around 15% – of your daily credit card sales as their repayment.

This variable repayment schedule can be good for businesses that struggle with cash flow because the advance’s repayment schedule aligns with revenues. But it can create uncertainty when you’re budgeting to cover operating expenses. Merchant cash advances can be quite expensive, which is one of the reasons people wonder about their legality. 

Are Merchant Cash Advances Legal?

Laws about small business lending vary by state. Courts in New York have ruled that they are not loans, or “disguised loans” because if the merchant does not make any money, the lender makes no money. As well, the lender only makes their percentage of the merchant’s sales and therefore the MCA has an indefinite repayment term. New York state law has ruled that MCA’s are not loans based on the following provisions;
  • whether principal is “put in hazard” versus “in some way secured;”
  • existence of a reconciliation provision; and
  • an indefinite versus a fixed repayment term.
California, Minnesota, and other states have passed laws and regulations to better control the merchant cash advance market. However, even when state law puts them in the category of a loan, they are still legal.

Why Do Some People Think Merchant Cash Advances are Predatory?

Merchant cash advances operate outside of the traditional banking industry. Alternative lenders make it possible for small business owners to access needed capital, but because they’re not subject to the rules and regulations that govern banks some people take a dim view of MCA providers. They point out that these lenders:

  • Do not have a bank charter
  • Are not regulated or licensed
  • Do not have to give borrowers with disclosures about total cost and APR 
  • Charge extremely high interest rates
  • Often request that borrowers sign a “confession of judgment” to borrow

But it’s important to note that what some view as a downside of MCA providers – the lack of bank charters, licensing, and regulation, is what allows them to extend credit quickly. Traditional banks must perform an extensive underwriting process on any lending product. It can take months for a small business owner to have a loan approved – and if they’re borrowing due to an emergency they could be out of business by then!

Merchant cash advance providers fill a gap between traditional lenders and business owners who need fast cash – but what about the other objections to MCAs? 

Why are Merchant Cash Advances so Expensive?

It can take months for a bank to approve a traditional loan. They perform extensive underwriting – which includes verifying your business’s cash flows, examining financial statements, pulling credit reports, and more to determine your ability to repay the loan. MCA providers will pull your credit, obtain a copy of your driver’s license, and request the past few months of credit card statements, but their underwriting process is less intense and time consuming than a traditional lender.

What makes it possible for you to get cash quickly increases their risk. When they don’t have months to verify if you can repay the MCA, there could be an increased likelihood of default. The best way for a lender to protect themselves against this risk is to charge more for the advance.

MCA lenders don’t charge an interest rate, like a loan, but rather a factor rate. Expressed as 1.0 or 1.5x, they multiply the factor rate by the amount of the advance to get the advance’s total cost. For example, a $200,000 loan with a factor rate of 1.5 would cost $300,000. You’d pay $100,000 for the advance.

In simple interest, that works out to 50%. This can confuse people who are aware of the usury laws in their state. Usury laws cap the amount of interest that lenders can charge on a loan. Lenders who violate these laws can face stiff penalties and lose the right to  both their principal and interest. But, because MCAs are not legally loans, they are not subject to usury loans. 

Another reason that MCA providers charge more than a traditional lender for their advances is the uncertain repayment schedule. Their repayment depends on your future sales, which creates unpredictability for their cash flows. If you have a slow month, it could take longer for them to get paid back. (Note that some providers perform occasional reconciliations or a “true-up” to  smooth deductions out to their repayment percentage). 

There’s no doubt about it – merchant cash advances are not a cheap way to borrow. Their high cost is why some people think that MCA’s are predatory. Another reason is that some providers require that borrowers sign a confession of judgment when taking out an advance.   

What is a “Confession of Judgment?”

A confession of judgment or COJ  is a written agreement that some MCA providers require borrowers sign when taking out an advance. When the borrower signs the confession of judgment they are acknowledging liability and amount of damages before actually defaulting on the merchant cash advance. The document waives the borrower’s right to a legal defense.

Merchant cash advance providers like confessions of judgment because they save them time and money. If you default on, or don’t repay, your MCA, they don’t have to take you to court to get their money back. Without a confession of judgment, it could take months of legal battles to prove that you owe the money. With one, they can immediately pursue recompense.

Because borrowers waive their right to legal representation and cannot defend themselves against a lender’s claims in a court of law when they sign a COJ, critics of merchant cash advances accuse providers of taking advantage of borrowers. But, is that true?

Do MCA Providers Take Advantage of Borrowers?

Merchant cash providers fill a need in the lending marketplace. They do not force small business owners to apply for an advance. While they do charge high fees and ask borrowers to sign a COJ, this makes sense within the context of the high levels of risk they assume when advancing funds. An applicant does not have to take out the advance if they are unhappy with the advance’s factor rate and terms. 

The reality is that there is risk whenever a small business owner borrows. If you take out a secured loan, you could lose your collateral (such as machinery). Defaulting on a line of credit could result in a lien against your business. It is the borrower’s responsibility to understand how the advance could impact their business.

If you budget carefully for how the advance will impact your cash flows, and have a clear repayment plan, a MCA could be a good fit for your funding needs.