A merchant cash advance is a very specific type of financing for small companies. Business owners have a mind-boggling number of options when it comes to financing. There are SBA loans, equipment loans, lines of credit, credit cards, and any number of others. Compared to the arduous process of qualifying and applying for a more traditional loan, a merchant cash advance can seem like a fast, simple way of acquiring working capital. But what is a merchant cash advance? Are they different from any other loan?
The short answer is “yes”. But a merchant cash advance is a relatively costly financing option and should be used only sparingly and as an option of last resort.
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What is a Merchant Cash Advance?
Put simply, a merchant cash advance is the act of a lender buying a percentage of future credit card sales. When you’re approved, you receive a sum of money upfront and then work to repay it. It sounds like a loan, but once you get into specifics of how the repayment works, you’ll see that it’s an entirely different concept altogether.
Because the repayments are made through future receivables from debit and credit card sales, the types of businesses that typically deal with most credit cards are going to be best suited to an MCA. A restaurant in need of funding, for example, will be a much better option than a laundromat.
How is a Merchant Cash Advance Different From a Traditional Small Business Loan?
For a traditional loan, you’ll work with a financial institution by providing any number of documents to prove you’re worthy of that loan. There’ll be a hard credit pull – and your score will need to be excellent. Your interest rate will be determined based on your credit, the length of the repayment period, the size of the loan, and what type of loan you’ve gotten. Then you’ll make monthly payments.
For a merchant cash advance, the first thing to know is that your business must process transactions with credit or debit cards. In a traditional loan, you’ll repay through a monthly payment at the bank. An MCA is repaid through a portion of daily or weekly processing of credit card transactions.
Another big difference between MCAs and traditional loans is interest. Because a merchant cash advance is, by definition not a loan, the MCA provider doesn’t make money by charging an interest rate as a percentage. Instead, they use what’s called a factor rate.
A factor rate is a number that, when multiplied by the size of the upfront cash advance, shows the total amount of money the small business owner will need to repay. If a business receives a $100,000 merchant cash advance with a factor rate of 1.2, that business will need to repay $120,000 (100,000 x 1.2).
How Much Do I Pay an MCA Provider Each Day?
Remember, an MCA is the act of an MCA provider buying a chunk of future credit card transactions. MCA providers are paid by taking a certain percentage, typically between 5% and 20%, of a business’s credit card receipts.
Because of the difference like the transaction versus a traditional monthly payment, there are serious upsides to an MCA. If sales are doing poorly for whatever reason, it means that payments on an MCA will be smaller. Instead of worrying about if there’s sufficient cash flow for that monthly payment, the cash comes out of the credit card transactions each day.
If a business does $1,000 in credit card transactions and their repayment terms dictate that they pay 7%, that means their payment that day is $70. On a slow day, if that same merchant does only $350 in credit card transactions, they’ll only pay about $25.
When Should My Business Use a Merchant Cash Advance?
There are any number of business needs that would be well-suited to a merchant cash advance. It’s important, though, to remember that an MCA is probably best-suited when the advance amount is used for something that will provide greater credit card sales immediately.
Keep in mind that a merchant cash advance will reduce your future cash flow because a significant portion of your future credit card sales will be used to repay the cash advance.
That having been said, there are a few areas where MCAs are particularly effective.
Bad Credit. Merchant cash advances typically have lower or no credit score thresholds than traditional loans, so if your business is in dire need of a lump sum of cash, but has poor business credit, an MCA might be an excellent option. Bad credit doesn’t mean you won’t be able to get the funding you need.
Inventory Discounts. If there’s a situation where some sort of product is available at a steep discount, an MCA might be the key to getting that inventory for your business. Because they tend to be incredibly fast, with a simple application process, you can receive business funding almost immediately, allowing you to take advantage of momentary opportunities.
Finance Other Debt. If a monthly payment on a term loan is causing short-term cash flow issues, an MCA is an option that could set things back on the right track. You could use an MCA to pay off the debt with the monthly payment and begin using credit card processing to repay the loan on a smaller scale.
Are There Any Downsides to a Merchant Cash Advance?
As mentioned, MCAs should be used with discretion and an option of last resort. They’re a high-risk, high-reward financing option.
High interest. The APR (annual percentage rate) for a merchant cash advance can be incredibly huge. Because they tend to be a shorter-term lending option, those high factor rates can sometimes lead to APRs in the triple digits. When you repay an MCA quickly, that APR goes up. If you borrow $100,000 with a factor rate of 1.5 but repay it within a year, you’ve got an APR of 50%!
In addition, like any other lender, merchant cash advance companies are in the business to make money and minimize risk. While you can certainly get a merchant cash advance with poor credit, that poor credit may also lead to a higher factor rate, a higher APR, and a larger repayment amount.
Hurts cash flow. Because the payments are made to merchant cash advance providers through credit and debit card sales, you’re trading up-front cash for long-term hits to cash flow. If you’re operating a type of business that experiences regular periods of slow activity, losing that piece of credit card payments can make working capital a difficult thing to find.
Doesn’t build credit. Because a merchant cash advance is not a traditional bank loan or another type of small business financing, your payments are not reported to credit bureaus and your on-time repayment of an MCA doesn’t actually help build your credit. On the other hand, if you fail to repay the MCA, it can lead to a report of your default, thus causing damage to your credit history. So if you sought out an MCA because of poor credit, an MCA can lead to even worse credit, which would require further poor credit financing.
What alternatives to merchant cash advances are there?
While a merchant cash advance can be the right choice for many companies in the right context, there are other types of financing available depending on your needs.
Short term loans. If you’re seeking an MCA for a short-term opportunity like discounted inventory or emergency upgrades or repairs, you might want to consider a traditional, but short-term loan – particularly if you’ve got good credit. This would mean going through the typical approval process with a bank or other financial institution, but would likely lead to a much smaller interest rate.
Business credit cards or Lines of credit. Acquiring a business credit card or line of credit is a way of taking action before an emergency occurs. Many merchant cash advantages are sought because of a short-term emergency where capital is necessary for a business to continue. Business credit cards or lines of credit can be used to prevent the need for an MCA. If an emergency or opportunity springs up, those options allow you to make the necessary expenditures while only paying interest on what is spent.
Equipment Loans. If you’re considering an MCA due to a damaged piece of necessary equipment, an equipment loan might be a better option. Your credit won’t need to be as sterling as it would in a traditional bank loan, as the bank will use the new business assets as collateral.