How Do Merchant Cash Advances Work for Small Business Financing?

November 10, 2022

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A merchant cash advance can be a helpful solution when your business needs funding quickly. They’re fast, and simple, and can help your company get the money it needs in order to grow. There are several key differences that separate a merchant cash advance from a more traditional bank loan: the application process is far more streamlined, and MCAs are more readily available to companies with poor credit. Read on to discover the unique features that make MCAs a specialized tool for many types of businesses.

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What is a Traditional Bank Loan?

To understand what makes a merchant cash advance unique, it helps to understand your basic term loan.

Term loans encompass a variety of forms of lending. Short-term and long-term loans both qualify, as do equipment loans, and several types of government-backed SBA loans. While there are a few distinct differences between these forms of lending, like whether any asset is held as collateral, they all function the same way.

Each of these financing options involves a borrower applying to a financial institution. That institution then evaluates the creditworthiness of the potential borrower and determines an appropriate loan size, interest rate, and repayment term. This process can take weeks or even months, and qualifying for a large bank loan can be difficult.

Lenders receive information about potential borrowers through credit bureaus, which use that company’s credit history to determine a business credit score. The theory is that the higher a business’s credit score, the more likely that business is to repay its debts.

If approved, the borrower receives the entire lump sum at once and makes monthly payments until the loan is paid back in full, plus the agreed-upon interest rate. Those monthly payments are typically fixed payments, but borrowers pay less in total interest if the loan is paid back more quickly than agreed upon.

What is a Merchant Cash Advance?

A merchant cash advance is very different from a term loan and is by definition not a loan. Instead, an MCA provider buys a portion of future credit and debit card sales. This may seem like a small distinction, but that difference in definition is what makes MCAs such a unique and helpful funding option in many cases. It also means that there are a few additional important differences between MCAs and loans.

  • Merchant cash advances don’t have interest rates. Instead, cash advance companies make money by charging a factor rate. Factor rates are numbers typically between 1 and 2. When multiplied by the size of the advance, the factor rate shows the total amount that will be repaid. If a company takes a merchant cash advance of $6,000 at a factor rate of 1.25, for example, that company will repay $6,000 x 1.25, or $7,500. That’s a fixed payment amount, meaning that no matter how quickly you pay the advance back, it’ll be $7,500.

  • Because there’s no interest being charged, there’s no benefit to paying that $7,500 back early. If you do manage to pay that $7,500 back very quickly, you’re driving up the APR on that cash advance, and there’s no way to change the rate you’re paying.

  • APR, or annual percentage rate, is the total cost of borrowing money over the course of a year. It’s a helpful metric because it adjusts the rate of borrowing over the period of a standard timeframe and takes every fee into account.

  • Cash advances are typically repaid using a daily or weekly percentage of all credit and debit card transactions. That means that your repayment amount in a slow week of business will be much lower than it will be in a week with higher sales volume.

    Some MCA providers will also allow for fixed-size payments. For these payments, an agreed-upon amount would be debited from your business bank account at regular intervals. Insufficient funds would then lead to punitive fees.

How Do MCA Providers Choose a Factor Rate?

There are several factors that go into your factor rate. Primarily, MCA providers want to see evidence of regular cash flow.

MCA providers will want to see your bank statements. It’s important to these companies to know how much money are you bringing in each month since your income is directly tied to them getting paid. They’ll also want to see your company’s basic demographic information – how old it is, the industry it’s in, and how many people work for you.

In short, you’ll need to demonstrate that your company has solid monthly credit card sales and is in a position to keep those sales steady for the foreseeable future. And after that, factor rates are just like interest rates in that they’ll be lower for companies that are seen as a safe bet to make their payments.

What are the Benefits of a Merchant Cash Advance?

The fact that a cash advance isn’t a loan is the reason for many of the benefits (and drawbacks) of MCAs.

  • Flexible payment size. When you’re paying back a traditional bank loan, there’s no consideration made for the sales you’ve made this week or month. The payment size is the payment size. Merchant cash advances, however, are dependent on credit card sales. If you had fewer sales, you’ll make a smaller payment. When you’ve got a bunch of credit card payments, you’ll pay a bit more.

  • Not dependent on credit. Because business cash advances aren’t loans, the approval process is very different. That’s great news for small business owners running companies with bad credit. What matters to merchant cash advance providers isn’t your credit score – it’s your future credit card sales, and those two are independent. If you’re a startup without a long credit history, you may struggle to achieve good credit or find a lender willing to work with you. But if sales look good, you’ll find that merchant cash advance companies will be willing to work with you.

  • MCAs move very quickly. Cash advances are one of the fastest forms of business financing. Many MCAs hit your bank account within a single business day after you press “Submit.” That speed can be particularly helpful if you’re in dire straits or are looking to take advantage of an opportunity. If you run a pizzeria and your pizza oven is broken, you don’t have weeks or months to wait on a traditional business loan. You need to get pies out the door. An MCA can help with that.

Are There Drawbacks to a Merchant Cash Advance?

  • While there are significant upsides to an MCA, there are a few things to know that could cause some small business owners to consider whether a different type of financing would better fit their needs.
  • Cash flow issues. While the flexibility of the varying payment sizes can be an advantage for an MCA, business owners considering a cash advance should remember that they’re going to be losing a significant percentage each day. The amount of your daily credit card transactions going to your MCA payments is called the holdback, and it can range from 10% to 20% of total transactions. That’s a significant portion. If you’re seeking an MCA due to working capital shortages, keep that holdback in mind.

  • Expensive. Cash advances can have some of the highest APRs in the business funding ecosystem because of the use of factor rates over interest rates. The APR on a merchant cash advance also grows as you pay them back more quickly. To lower APR, you generally want to pay an MCA back slowly. But ironically, paying back an MCA slowly means that you’re facing lower daily credit card sales, and thus cash flow issues. This is part of the give and take that comes with MCAs. If you use a merchant cash advance right, you can use that upfront payment to drive sales in the near future, which makes the money you’ve borrowed more expensive.

Would a Merchant Cash Advance Work for My Company?

There are certainly some drawbacks to a merchant cash advance, but that doesn’t mean that an MCA isn’t the right call. There are a few things to consider when you’re deciding whether to go for an MCA or a different form of small business financing.

  • How quickly do you need the money? If you’re facing a funding emergency and don’t have access to a line of credit that’d allow you to operate, an MCA might be a good choice. They move very quickly with generous eligibility requirements, so you can face an emergency immediately.

  • How much money do you need? If you’re looking to make a major purchase, like real estate or a vehicle, you may want to go with a more traditional bank loan. Advance amounts typically won’t reach up into the high levels that a bank loan will, making them ineffective lending options for larger purchases. Plus, MCAs typically have short repayment schedules. You’d be hard-pressed to pay back the price of a building in just a few months.

  • How’s my credit? If your credit is stellar, you might want to consider a more traditional small business loan. A loan will likely come with a smaller total cost and might give you more time to repay the borrowed amount. Merchant cash advances work well for companies with poor credit but strong monthly revenue.

  • Is my revenue fairly regular? Speaking of that monthly revenue, is it fairly regular? With merchant cash advance holdbacks eating up a significant portion of your daily income, an unpredictable expense or drop in sales could be disastrous. Your cash flow will likely be at least partially hindered, so make sure that if you’re leaning toward a merchant cash advance, you’re projecting some stability and wiggle room in your income.

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