Merchant cash advances can be fast but risky
While on the prowl for fast financing, you’ve probably come across a merchant cash advance (MCA) provider touting offers that seem too good to be true. These providers connect business owners with much needed capital within a matter of days, and they won't look askance at poor credit or a less-than-stellar business history. Be warned, however: Without cautious planning, this type of financing can trap your business in a dangerous cycle of debt.
How do merchant cash advances work?
An MCA provider offers a business a sum of money that is then paid back over the course of several months (three to 12, most often) at a rate determined by the business's monthly revenue. Repayments are typically made daily through a percentage of the business's credit card transactions.
MCAs are designed for businesses whose revenue comes from credit card sales, like restaurants and retail stores, but many MCA providers now service other industries. Technically, MCAs are not loans but commercial transactions, meaning they aren't regulated like loans, which we discuss in more detail below.
There are two numbers to keep in mind when looking at an MCA offer: the factor rate and the withholding rate.
The factor rate (sometimes called a buy rate) is a number (typically between 1.1 and 1.5) assigned to you by your provider based on your business's monthly revenue. This number is fixed and determines the total amount you're responsible for repaying.
The withholding rate is a percentage assigned to you by your provider that determines the size of each payment. This number will be the amount you repay each day that will change based on how much you earned in credit card sales that day. If your withholding rate is 10 percent, and you made $2,000 in sales that day, your provider would take $200 from your business bank account for that day. If you made slightly less the next day, your payment to your provider would be slightly less.
The convenience of a MCA makes it an appealing option for business owners in a pinch. However, this type of financing presents some serious risks that no entrepreneur should ignore.
What's so bad about merchant cash advances?
One of the gravest dangers of MCAs is the toll they take on your cash flow. Daily repayments make it harder for your bottom line to recover from slow days. If your revenue drops, you'll either prolong your repayment period or find yourself struggling to recover from those hefty withdrawals. If sales are better than expected, there's no benefit to paying early – you may even be charged a prepayment penalty.
MCAs are also infamous for their extreme APRs (annual percentage rates), which can climb as high as 350 percent. Because the total amount you owe is calculated at the beginning of your term, you won't have the opportunity to pay less over time as the amount owed on your original advance gets smaller.
This may sound superficially similar to other forms of short-term lending, but merchant cash advances are not loans. Legally, they are transactions: You are "selling" future earnings in exchange for fast cash. As such, MCA providers are not federally regulated and under no obligation to keep their rates low. Also, because MCA providers don't report to credit bureaus, this kind of financing won't help your credit.
Is it ever a good idea to get a merchant cash advance?
In some rare cases, MCAs are a reasonable last resort. These scenarios could include:
- Your business isn't earning much and doesn't meet the minimum revenue requirements for other alternative lenders
- Your poor credit score disqualifies you from other financing options
- Your business has outstanding liens and bankruptcies
MCA providers won't ask for collateral, so you won't risk losing your possessions with this type of financing. Also, while MCAs won't help your credit score, they won't hurt it either.
Before you commit to a MCA, make sure you've explored all of your other options for a small business loan. Some alternative lenders can approve you for a more affordable loan as quickly as an MCA provider could, and some will offer lines of credit to business owners with poor credit scores. It pays to be cautious – don't gamble with the future of your business.