Merchant Cash Advance: A Complete Guide

A merchant cash advance is a financing product available to help meet the capital needs of small business owners. Used correctly, they can be the right choice for your business.

According to the Federal Reserve in a 2022 survey of the prior full year, 8% of small businesses sought out merchant cash advances, with an approval rate of 52%, down significantly from the 80% approval rate in 2019. While their approval rate is still pretty high and the ease of funding make MCAs look appealing to many borrowers, you should make sure you fully understand this sometimes confusing loan product before taking out an advance.

In this guide, we’ll walk you through the ins and outs of merchant cash advances, including their pros and cons. Armed with this information, you can make borrowing decisions that support your business’ success.

What is a Merchant Cash Advance?

A merchant cash advance or MCA, also known as a business cash advance, is when a borrower sells a percentage of future sales at a slight discount to a lender for an upfront cash advance. You are pledging to repay the advance out of your future sales, and the lender has a right to take repayment from them.

The lender deducts a percentage of your daily sales until the advance and their fees have been repaid. If your business experiences a slow cycle, the repayment amount also decreases. This makes an MCA an excellent choice for businesses that experience cash flow slumps and need funding with repayment options that align with their cash flow. Keep in mind that the opposite is true, because you agree to a small percentage to be deducted from revenue, the payments are higher when your business increases revenue.

A merchant cash advance is not a small business loan. You are selling future sales through the contract with your lender. So for tax purposes and state laws and regulations it is not treated as a business loan, although there are possibilities for deducting the fees associated with the advance. However, all those options should be discussed with an accountant or CPA, or financial advisor.

How Does an MCA Loan Work?

A merchant cash advance loan is set up as a purchase of sales and not a loan, so the business owner must have existing sales revenue before applying. The lender looks at your past few month’s sales to predict your upcoming month’s credit card receipts. Then, they’ll advance you a sum based on those predictions. Here are the basic steps of the process:

1. A business owner applies for an MCA: The business owner applies for an MCA through a lender or a financing company usually online with a short application. The lender will typically ask for a small amount of additional information or paperwork to verify the business’s credit card sales and cash flow history via bank recent statements.

2. The lender provides a lump sum of cash: If the business is approved, the lender provides the business owner with a lump sum of cash, usually within a few days or sometimes even the same day.

3. The business repays the advance: Instead of making fixed monthly payments like in a traditional loan, the business repays the MCA through a small percentage of its daily credit card sales. This percentage is agreed upon in advance between the business and the lender.

4. Repayment is automatic: The repayment process is automated, meaning the lender takes an agreed upon percentage of the business’s daily credit card sales until the advance and any lender fees are fully repaid. This means that the repayment amount can fluctuate based on the business’s daily sales.

5. Repayment is complete: Once the business has repaid the advance, including the fee charged by the lender, the MCA is considered fully repaid. The customer then can request another advance or move on without any additional business funding.

How is a Merchant Cash Advance Different from a Business Loan?

A merchant cash advance and a business loan are two different types of business funding.

A merchant cash advance is a type of funding where a business owner sells a portion of their future sales revenue to a lender in exchange for a lump sum of cash today. The lender then collects a percentage of the business’s daily sales until the principal advanced as well as the lender’s fee is paid back. This type of financing is usually quicker and easier to get than a traditional loan, but also tends to have higher interest rates.

A merchant cash advance lender primarily looks at your credit card sales when they’re approving the advance. While they may pull your credit score, it’s less important than your sales revenues and cash flow. Also, instead of repaying the advance with a large monthly payment, repayments happen automatically when the lender takes a percentage of each credit card swipe through the credit card processing company.

A business loan, on the other hand, is a set amount of money that a business borrows from a lender, which must be paid back with interest over a fixed period of time. Business loans require more documentation and have more strict eligibility requirements compared to merchant cash advances, but they also often have lower interest rates and set monthly payments.

Another important difference is how lenders charge their fees for both products.

Factor rates vs APR

When you’re applying for a merchant cash advance make sure that you understand the difference between factor rates and APR. If you’ve previously only used business credit cards or bank loans to meet your funding needs, you’re probably more familiar with APR.

A factor rate is a pricing mechanism used in merchant cash advances. It is expressed as a decimal, rather than a percentage, and represents the total cost of the advance, including both the original amount borrowed and the fee charged by the lender. For example, if a business takes a merchant cash advance with a factor rate of 1.3, that means the business will have to pay back the original amount borrowed plus an additional 30% regardless of the time frame it takes to repay the money.

An interest rate, on the other hand, is the percentage of the loan amount that a borrower pays to the lender for the use of the money. Interest rates on business loans are usually expressed as an annual percentage rate (APR), which takes into account not only the interest rate but also any additional fees and charges associated with the loan. For example, if a business takes out a loan with an interest rate of 10%, that means they will pay an additional 10% on top of the amount borrowed each year until the loan is fully repaid.

Converting a factor rate into an APR is a lot harder because of the difference in payment structure and fees. There is however a simple way to help you compare the cost of a merchant cash advance versus a traditional business loan. It is done by using the annualized interest rate.

In the following example in its simplest form, a client takes an MCA of $10,000 with a pay back $13,000 over the course of 180 days, that is a factor rate of 1.3. This means that you are paying $3,000 more than you borrowed.

Now divide the extra amount you’re paying ($3,000), by the amount you borrowed ($10,000), to get 0.3. This 0.3 represents a percentage cost of the advance.

Next, you multiply this percentage cost by 365 (the number of days in a year) to get 109.5. Finally, you divide this number by the expected repayment period (180 days) to get the annualized interest rate, which in this case would be 60.83%.

What Types of Companies Provide MCAs?

You can’t walk into your local bank or credit union’s branch and apply for a merchant cash advance. Traditional lenders don’t offer these loan alternative products. There are a wide variety of online lending companies that offer merchant cash advances. These lenders do not have brick and mortar shops and all their services can be accessed online.

Repayment structure for MCAs

A holdback is a percentage, between 10% to 20%, of your daily credit card transactions that are held back and not released to you. Though you’ll see it as a percentage in your advance documents, it’s not the advance’s interest rate. It’s simply the percentage of daily sales the lender has a right to take for their repayment.

A holdback is the most common way a lender takes their repayment for a MCA. The holdback percentage stays the same until the advance is paid in full. If you select split withholding as the repayment method, the credit card processor will split your credit card receipts between your merchant account and the MCA provider.

Your daily or weekly holdback amount will vary depending on the credit card receipts in your merchant account. When you have a good day with a lot of credit card sales, you’ll make a larger payment on your advance than on slower days with fewer credit card sales.

For example, let’s say you took an advance which had a holdback percentage of 10%. On Monday, you have $5,000 in credit card sales so the MCA lender holds back $750. But on Wednesday you have $12,000 in sales, so they’d hold back $1,200.

The second repayment method is lockbox withholding. This is the least preferred method by small business owners because it delays receiving credit card sales by one day. If your MCA provider chooses this repayment method, your bank sends the portion of your credit card sales that repay the MCA to the provider and deposits the remainder into your bank account.

The third repayment method is an ACH withdrawal directly from your bank account. The MCA provider deducts their payment from a business checking account rather than credit card sales. Bouncing the payment is similar to bouncing a check, so you need to make sure you have the funds to cover the payment in the account at all times.

These daily withdrawals could be hundreds or thousands of dollars, so you must plan for them in your budget.

The Pros and Cons of MCAs

There are pluses and minuses to any lending product. Smart borrowers should review both carefully before making a borrowing decision.

Pros to a MCA

They’re quick and easy. When a small business owner needs cash in a hurry, a MCA is a great option. Instead of waiting weeks or months to receive approval on a bank loan, you can get an MCA in a few days. Lenders examine your business’s daily credit card receipts, evaluating them for cyclical patterns and trends, when deciding how much money to advance. Because they require less documentation to approve lending than a bank loan, they fund faster.

Physical collateral isn’t required. A bank loan or other form of financing might require you to pledge business assets to secure the loan – which means you risk losing them if you can’t afford to repay. MCAs are unsecured – which means the lender doesn’t require physical collateral. Instead, the MCA provider will likely require a personal guarantee. A personal guarantee is a written agreement where your signature indicates agreement to be held personally responsible for repaying the advance. With this agreement, the MCA provider can recoup any losses in the event that you can’t pay.

Sales and payments align. With a traditional loan, you owe a monthly lump sum payment regardless of your cash flows. Since a MCA is repaid from credit card sales, repayments match how well your business is doing. During a slow week or month, you’re not stuck scrambling to cover a large loan payment.

You choose how to use the funds. If you take out an equipment financing loan, you have to buy a piece of equipment with the funds. Other loans require that you maintain certain Balance Sheet ratios or restrict the funds’ use, which means that you’re inviting another party into how your business is run. With a MCA, issuers place few stipulations on how the cash is to be used. Many small business owners prefer this freedom.

Borrowers with poor credit can get funding. It can often be difficult for a small business owner with poor credit to access funding. But since lenders extend a merchant cash advance on the basis of credit card sales, a personal or business credit score is less important. MCAs are one of the most accessible forms of credit if you have a low credit score.

An MCA doesn’t hurt your credit score. Issuers don’t report payments and defaults to credit bureaus (though there are other consequences for defaulting on a MCA), so a MCA won’t hurt your credit score. But a strong history of repayment also won’t boost your score, either.

Cons of a MCA

Your APR could be very high. If you could easily calculate the APR on an MCA, you’d find that it typically ranges from about 40% to 350%. The APR on your advance will depend on several factors. Merchant cash advances are far more expensive than traditional bank loans, whose APRs are typically 10%-15% in 2023; business credit cards, with APRs from 15% to 36% recently, or online small-business loans, with APRs from 10% to 99%.

Higher sales lead to a higher APR., you repay the MCA faster — and, subsequently, APR goes up.

There’s no benefit to repaying early. With a factor rate, you pay a fixed amount of fees on top of the advance, so there’s no way to save on interest with a MCA. When you’re repaying a traditional “amortizing” small-business loan, early repayment results in less interest paid.

You can fall into a debt-cycle. The speed of funding and easy approval of MCAs can trap you in a debt cycle if you’re not careful – especially if you don’t qualify for other types of financing. The extremely high cost and frequency of repayments for the first MCA could cause cash flow problems, leading to a borrower needing to take out another advance shortly after they borrowed the first MCA. A daily payment of hundreds or thousands of dollars, for example, could put a strain on your cash flow and put you at risk of default.

There’s not a lot of federal oversight. Because MCAs are not structured as loans, but as commercial transactions, the industry isn’t subject to federal regulation. They aren’t considered banking transactions so they’re regulated by each state’s Uniform Commercial Code in each state.

Contracts can be confusing. Even if you take the time to read the contract, they’re often loaded with unfamiliar terms (which we define below). MCA providers do not provide APRs, so it’s impossible to compare them with other financing products. The lender may also require signing a legal document called a confession of judgment as part of the advance paperwork. If the company takes you to court, signing that confession of judgement forfeited your right to defend yourself

MCAs can be too expensive for their intended use. While an MCA can be a great way to help your business through a slump, they’re not meant to fund large, long-term projects. If you’re planning an expansion or new investment, you have the time to shop around and get approved for a business loan.

Best uses for a MCA

A merchant cash advance can be a good choice for your business, despite their cost, if you use the funds wisely. The best uses for a MCA spring from temporary, unexpected cash needs that fit well with the short MCA funding timeframe.

1. Help with temporary cash flow problems.

2. Purchasing inventory that you can quickly resell at deep discount.

3. Placing a large inventory order to fulfill contracts.

4. Unplanned expenses.

5. Paying other debts due to avoid default.

6. Cover working capital needs.

Is a MCA Right for You?

If your business is in a temporary cash flow crunch, or needs cash quickly, a MCA could be a good choice. Just make sure that the costs of the MCA make financial sense. Due to the lower qualifying criteria and quick funding timeframe, you’ll pay a premium for a MCA.

There are business owners who successfully use MCAs as an option to access capital, but they always have a plan to repay it and know how it will impact their daily and weekly cash flows.

To get the best rate, and make a MCA a better choice for your business, approach a lender after several months of strong sales. If you have a lower credit score, look into ways to raise it higher before borrowing.

How can a Small Business Owner Qualify for a MCA?

Before applying for an MCA, you’ll want to gather the necessary documentation. You can easily apply online or over the phone, but the process will go more smoothly if you have everything ready for the lender.

To qualify for a MCA less than $100,000, you’ll need this documentation:

A Valid Drivers License
Bank Statements for several months
Proof of Ownership of your business
Property Lease Agreement for any leased spaces
Credit Card Processing Statements
A Voided Check

To qualify for a MCA over $100,000 you’ll need everything on the above list plus:

Personal Tax Returns
Business Tax Returns
A recent Profit & Loss Statement
A recent Balance Sheet
Business Debt Schedule (possibly required)
Potential for Others

Contract Terms in a MCA

Here are definitions for some of the confusing terms you might find in a MCA:

A. Factor rate – the rate you’re paying to borrow the money.

B. Specified percentage, holdback, or retrieval rate – this is the percent held back daily from sale to repay the advance.

C. Purchase price or advance amount – the amount you receive, or your advance from the lender.

D. Receipts purchased amount – total payback amount, or the future credit card receipts you’ve sold to the lender.

How to Manage your MCA

If you decide that a MCA is right for your business, you must manage it as you would any type of debt.

Include your best estimate of daily or weekly repayments in your cash flow projections and budgets. Make sure you save and keep enough cash on hand to cover payments, particularly if you chose the ACH withdrawal repayment method. Don’t budget credit card sales to go elsewhere when the lender will be holding them back.

If you’re repaying the advance from a bank account, make sure you always have the funds available to cover the ACH withdrawal. Bouncing a payment is similar to bouncing a check or credit card payment.

It’s also a good idea to wait to take out another MCA until you’ve paid off the first one. You can receive better rates from a lender once you’ve proven your ability to repay an advance and built up a relationship with them. This also prevents you from falling into a debt cycle.

What Happens if You Default on a MCA?

What happens if you do not pay back a MCA? Most providers include a personal guarantee in their contract so that they can come after your personal and business assets. They could place liens against your personal residence or vehicles, buildings used for business purposes, or other assets.

MCA’s don’t report your on-time payments to credit bureaus, but they do report defaults. If you have a default on your credit history, it will make it harder to get financing in the future.

Only you can decide if a merchant cash advance makes sense for your business. Examine the pros and cons list against your situation, look at how the factor rate will impact your cash flows, and talk to a lender if you need more information.