A merchant cash advance can be a valuable tool for small businesses with outstanding invoices.
At some point or another, your small business may need an infusion of capital. Although traditional small business loans are one option, another possibility is a merchant cash advance (MCA). An MCA is a good option for businesses that collect credit card payments, because that is how the amount is repaid.
But before you seek a merchant cash advance, it's important to understand what it is, how it works and if it's a good option for your small business.
What is a merchant cash advance?
A merchant cash advance is a lump sum provided to a business in exchange for future credit card sales. It is different from a traditional loan in that it does not have the technical details of a short- or long-term loan, such as collateral and a fixed repayment term.
A merchant cash advance is more akin to factoring, in which a lender gives an advance of cash against an invoice, and then collects both the invoiced amount at a later date and a fee from the business for the advance. In fact, the companies that offer this type of financing are very careful not to call themselves lenders. This not only gives them some leeway in how they provide financing to small businesses but also puts them outside of certain banking laws and regulations that traditional financial lenders must adhere to.
In a factoring business, the funding provider buys a portion of a company's future receivables. In an MCA agreement, the business's receivables are in the form of credit and debit card sales. This is a riskier approach for the lender because an invoice does not exist. Thus, the interest rates are higher due to the higher risk profile of these cash advances. Despite the costs, there are still circumstances that require a business to take an advance.
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How does a merchant cash advance work?
You start the process of receiving an MCA similarly to how you'd begin seeking a typical bank loan: Your business applies to receive funding from an MCA provider just as you would apply for a bank loan. Then, the financing provider analyzes the details of your business to determine its eligibility to receive the advance.
The most important detail an MCA provider will need to understand about your business is how much you receive in credit and debit card sales. Because an MCA is paid primarily as a percentage of your business's credit and debit card sales, the MCA provider will need to assess how much of your cash flow is received in this manner. It is from these credit and debit card statements that the provider will determine the rates and terms of the cash advance for your business.
In your application for the MCA, you must provide your business's bank statements so the provider can assess how much your business makes from credit and debit card sales. As such, an MCA is best for a business that receives most of its revenue from credit and debit card sales rather than cash and other methods.
Other documents the provider may require include your credit report and business profile. Your credit report helps the provider in determining how risky an advance for your business is and in setting the factor rate, and the business profile shows how long your business has been in operation. Providers count on future sales from your business, which is why they are interested in knowing whether companies will still be active for the duration of the advance. [Are you looking for a small business loan? Check out our reviews and best picks, including our pick for the best merchant cash advance option.]
Terms of a merchant cash advance
Once you have received your cash advance, consider these terms:
1. Advance amount and term
Consider the total amount that will be advanced and how long you will have to pay it back. Typically, a cash advance amount ranges from $2,500 to $250,000, while the advance term can be between three and 18 months.
2. Factor rate
In a cash advance, the factor rate replaces the interest rate, although it is similar. The average rate is between 1.14 and 1.18 and, when multiplied by the advance amount, shows you what you owe in total. When this factor rate is converted to an annual percentage rate (APR), it becomes equivalent to 15% or more. [Want to know more about factoring? Check out our reviews.]
Every day, a percentage of your business's daily credit card sales is deducted from your bank account and sent to the MCA provider. The percentage can be between 10% and 20% and will be charged until the debt is repaid.
To facilitate the daily payments to the lender, an MCA deal is made with the collaboration of a credit card processing company. Credit card processors can deduct the proper percentage of the total sales of the day and send that amount to the MCA provider, and send the rest to your business bank account.
Another way to facilitate the daily payments is by allowing the MCA provider to access your credit card sales. With this method, the provider makes its deductions before sending the remaining funds to your account. Alternatively, your bank can handle the account, in which case the automated clearinghouse sends the MCA provider its portion.
Why are merchant cash advances ideal for small businesses?
At some point, you'll probably need financing for your business. Perhaps you'll need to expand the business by adding employees, buying new inventory or changing your business's location. In recent years, MCAs have become more popular for small businesses that are looking to accomplish new financial goals.
This trend started following the global financial crisis of 2008 that saw the collapse of several major banks and credit unions, as it became a lot harder for small businesses to get loans. Financial technology companies saw an opportunity to fill the gap and took it. By 2015, Bryant Park Capital reported that the MCA industry had provided $10 billion to small businesses. This created an entirely new financial market for small businesses that addressed some of the restrictions imposed on both small businesses and lenders.
Here are some of the reasons your business might want to consider a merchant cash advance instead of a traditional bank loan:
Less documentation and simpler approval
In addition to being more accessible to small businesses and entrepreneurs, MCA providers don't have strict requirements. By contrast, to approve a traditional loan, a bank needs to analyze your company's financial and bank statements, which show details about your company's cash flow and help the bank determine the loan amount to be granted. This automatically disqualifies many small businesses that either have a small profit margin or have been in business for a short time. MCAs have more lenient requirements that can serve these small businesses and startups.
Flexible credit requirements
Banks also check your credit score and credit report. If you have a below-average credit score or a blemish on your credit report, it is unlikely that the bank will give you a loan. Although MCA providers will also check your credit score, they use it only to determine the factor rate; you will get a cash advance nonetheless.
Because an MCA is provided with the backing of future credit card sales, you are not required to provide any collateral. By contrast, to get a traditional small business loan at a bank, you might have to use the most valuable assets you have as collateral, which would be lost if you could not pay back the loan. MCAs provide your business with the funding it needs without risking any essential assets.
A typical business bank loan takes at least several weeks to complete as the bank staff analyzes your loan request and weighs its own risks. A typical MCA is processed and disbursed within 24 hours or a couple of days, depending on the situation. That makes it ideal for emergency situations in which an immediate influx of cash is necessary for the business to survive.
Traditional loans with a variable interest rate have an amortization schedule that causes the amount you owe over time to fluctuate. As you pay off a combination of interest and principal, if you don't make consistent payments with the loan agreement, you could end up paying more for the loan. MCAs don't work that way. While you'll have to pay off the advance as you collect outstanding invoices, the factor rate, which is set at the outset of your agreement, does not change.
What are the disadvantages of merchant cash advances?
Though there are many advantages of merchant cash advances, they also have some drawbacks.
The most glaring problem with MCAs is their high cost. At first, the factor rate makes it seem like the debt would be low, but in actuality, the interest rate is quite high. In some cases, the rate can reach triple digits, which is much higher than the interest rate for a bank loan. In fact, a merchant cash advance is one of the most expensive forms of business financing available.
Effect on cash flow
Depending on the agreement you have with your provider, an MCA can negatively affect your business's cash flow. When you repay a merchant cash advance, funds are often deducted daily from your business's credit card sales. This can have a major impact on your business's ability to operate in the future.
The fine print
MCA agreements have clauses that could affect the way you run your business. For example, some providers may not allow you to close your business for a certain period of time until you fully repay the loan. If you have a seasonal business, this could be a problem. MCA providers may also discourage you from accepting cash from your customers because they won't be able to collect on those sales.
Additional reporting by Matt D'Angelo.