Last Updated on August 9, 2024
Shield Funding TeamSmall business owners have many options to meet their working capital needs, each suited to a business’s circumstances. Small business owners who need a cash infusion in a hurry, who don’t want to wait months for a bank to approve a loan, or otherwise can’t qualify for a bank loan, often look to merchant cash advances.
A merchant cash advance is an advance against future credit card sales. The provider analyzes your past few months of sales to project future sales and advances money against those sales. Your repayment typically comes out of daily or weekly sales.
Whenever you’re making a business decision you should carefully weigh the pros and cons, but particularly when borrowing. Here’s how a merchant cash advance breaks down into pros and cons.
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First, the positives. There are several reasons that a merchant cash advance might best suit your borrowing needs.
It can take months for a bank to approve a small business loan, but MCA providers can fund an advance within days or even the same day. They typically only look at your business’ past few months of credit card receipts and bank statements to determine how much you qualify to borrow. For small business owners in immediate need of cash, a MCA is a great option.
Part of the easy underwriting process is because MCA providers don’t require borrowers to post collateral. You won’t have to wait while they verify other business assets, or have them appraised.
With a traditional bank loan, you might have to pledge business assets like equipment or personal assets like investment accounts. That puts your collateral at risk – if you default on the loan, the bank will seize the collateral. With a merchant cash advance, this is never a concern.
A merchant cash advance lender could pull your credit, but it’s not the deciding factor in the approval process. Borrowers with bad credit can still get approved as long as their business’s cash flows support repayment. This makes a merchant cash advance a good choice if you already know your credit score will prevent you from getting a bank loan.
Borrowers repay traditional lending products through one, large monthly sum. This payment typically falls on the same day of the month, and there’s no flexibility to shift the payment. If you had a slow week, or sales are down, you’ll have to come up with the money somehow.
A merchant cash advance provider doesn’t get repaid through a monthly, large payment. Instead, they take a daily or weekly percentage of sales as their repayment. This could give you a lot of breathing room.
Because repayment on a merchant cash advance is a percentage of sales, it aligns with your cash flows. In your MCA agreement you’ll find a holdback percentage. This is the percent of credit card receipts the provider takes as their repayment.
If you had a holdback of 15% and sales for one day were $1,500, you’d pay $225 on your advance. If sales hit $15,000, you’d pay $2,250. Because the amount you pay on your merchant cash advance is based off of sales, it mirrors any seasonality in your business. This means that payments are less likely to hurt your business’s cash flows.
If you choose the split withholding or lockbox withholding payments methods, it’s all automatic. Your credit card processor or bank splits your credit card receipts between your account and the MCA provider. No more worrying – did I mail the check? Automatic payments make repayment easy.
Merchant cash advance providers don’t charge an interest rate, they charge a factor rate. The factor rate – expressed as 1.2 or 1.5 – is a flat fee assessed on the advance. You pay back the advance plus that amount no matter what.
This protects you from changes in an interest rate, like how a credit card’s rate can reset while you’re paying off a balance. It makes it easier to gauge the MCA’s impact on your business because you know exactly how much you’ll be paying back. But a factor rate can be expensive, as we’ll discuss below.
While they could pull your credit score while approving the advance, a merchant cash advance provider might not. They don’t report the advance to credit bureaus, either. If your credit score has dropped due to a high debt utilization ratio, the MCA won’t sink it lower.
A MCA provider doesn’t care how you use the funds – assuming you’re not doing anything illegal! With other loan products, you might have to use the capital to purchase equipment or a building. An MCA gives you the freedom to spend the advance as you deem best for your business.
Despite all the positives a small business owner could realize from taking out a merchant cash advance, there are some definite downsides.
The downside to that quick and easy approval process? You pay more to borrow. Lenders always compensate for risk by charging more.
A factor rate of 1.5 on a $25,000 advance would mean a total repayment amount of $37,500. You’ll pay $12,500 for that advance.
And because the advance repayment fluctuates over a period of six months or more, it’s difficult to calculate the APR upfront. Your final APR could be in the triple digits.
If you’re already struggling with cash flow management, be sure that you know how a MCA will impact your budget. If you typically spend or place orders based on a day’s credit card receipts, don’t forget to deduct the provider’s holdback. Depending on your repayment method, that money won’t ever go into your account.
When you pay off a traditional, amortizing loan early, you save on interest. But because MCA providers charge a factor rate, not interest, there’s no benefit to paying off your advance early. You will pay the provider’s entire fee, no matter what.
Because MCAs are typically repaid with a percentage of credit card sales, the annual percentage rate, or APR, depends not just on the total fees paid but also on how quickly you can repay the advance.
Lower sales leads to smaller payments spread out over a longer time, so your APR drops. But if sales are booming, you’re making larger payments on the MCA. It’ll be paid off sooner, and you’ll pay a higher APR.
For example, the company might offer you a $150,000 advance with a factor rate of 1.3, for a total repayment of $195,000. If you repay it in just six months, the APR would be a minimum of 60%. If you repay it in 12 months, the APR would be a minimum of 30%.
Merchant cash advances aren’t a loan, they’re a form of commercial financing. As such, they operate with no federal oversight. This means that they don’t have to provide you with the same disclosures and calculations – such as APR – as a bank, and there’s no one overseeing them and making sure you’re treated fairly.
Because the industry is unregulated, there’s no standardization in contracts. Unlike a loan document, which has disclosure requirements, every merchant cash advance provider could include different information in their contract. And if it’s your first time taking out a MCA, you can’t rely on past knowledge to understand the contracts.
Merchant cash advance providers use terms like “holdback,” “factor rate,” and “purchase price,” instead of APR or interest rate. Borrowers should take the time to make sure they fully understand these contracts.
Some MCA providers but restrictions upon how you operate your business in their contracts. For example, you can’t close for an extended period of time, or your cashiers can’t encourage customers to pay in cash. They might disallow offering a discount to cash-paying customers.
If you had a family medical emergency and needed to close for a week, they might not allow it. And since you agree to the advance’s terms, you might not have the choice. Be sure that you’re comfortable with any operating restrictions in the MCA advance paperwork before you sign.
While we’re on the topic of losing control of your business – some MCA providers require that you use a specific credit card processor. If they have a partnership or pre-existing relationship with the processor, it makes it easier for them to collect their repayment. But that processor might not offer the best fees, and you could incur transition costs to switch.
An MCA is a temporary solution, often serving as a bandage over more serious wounds. While they can be used effectively to get you out of a sticky cash flow situation, or to purchase inventory at a heavy discount, they can’t be relied upon for capital funding long-term.
What happens if you do try to use a MCA to address deeper issues within your business or long-term capital funding? You could fall into a cycle of debt.
If the MCA isn’t repaid by the term’s end, you might have to take out another advance to repay the first one. Instead of getting out of debt, you’re just rolling it forward. Due to a MCA’s high cost, it may prove impossible to ever get out of debt.
If the merchant cash advance provider does decide to pull your credit score, it’s a five point ding. And, while they don’t report that you’ve taken out the debt, or a good payment history, they do report defaults. If you default on the MCA, it will hit your credit and lower your score.
If your MCA provider takes their repayment through lockbox withholding, you’ll have to wait an extra day for the funds from credit card sales to be released. The bank receives the money from your credit card sales and then sends the portion to repay the provider to their account. You wait an extra day to get your money, which could further exacerbate cash flow issues.
Only you can decide if the benefits of a merchant cash advance outweigh the drawbacks. Look at every positive and negative item on this list and think about how they’d impact your business, then make an informed decision.
