If your small business needs quick access to cash, merchant cash advance loans can be an attractive option. Funding is usually quick, eligibility requirements aren’t particularly strict, and you don’t have to worry about collateral.
But a cash advance from a merchant can easily make matters worse, and if you can’t repay, it could land you in serious financial and legal trouble.
Before you consider using a cash advance for your business, it’s important to know what you’re getting into and how to protect yourself and your business.
What is a Merchant Cash Advance?
A merchant cash advance loan is not technically a loan. Rather, it is an alternative form of financing, in which you receive an upfront payment in exchange for a portion of your future sales.
Historically, merchant cash advances have only worked for small businesses whose revenue comes primarily from debit and credit card sales. But now, just about any business can get one.
Repayment terms typically range from three to 12 months, but some providers may offer longer terms. There are two ways to repay a cash advance:
- Percentage of daily sales. You agree to pay a percentage of your daily sales from debit and credit card sales. This payment will fluctuate each day depending on your sales.
- Fixed withdrawals. If your income is not primarily from debit and credit card sales, you can authorize the provider to make daily or weekly withdrawals from your bank account based on your estimated monthly income. This payment will not change regardless of your current sales.
Instead of charging an interest rate like a traditional loan, merchant cash advances charge what’s called a factor rate, usually between 1.2 and 1.5. This rate determines the amount you will ultimately repay. For example, if you receive a $10,000 advance and your factor rate is 1.4, you multiply the two numbers to get a total refund of $14,000.
How a Merchant Cash Advance Works
To give you an idea of what a merchant cash advance looks like, here’s what you can expect for the different types of repayment options.
First, let’s say you have strong credit and debit card sales, so you go with the traditional option. You take a $50,000 advance with a factor rate of 1.4. Your monthly card sales are $75,000 and you agree to allow the vendor to deduct 10% of your daily sales.
In the end, you’ll end up paying $70,000 over 280 days. Although merchant cash advances do not use annual percentage rates, you can use an online calculator to show that the APR for the merchant transaction is 93%.
Remember though that with this option, your daily payments are based on your sales figures. Ten percent of your daily sales based on $75,000 in monthly revenue gives you an approximate daily payout of $250.
But your actual daily payout may be higher or lower, depending on how well your business performs. If your sales increase, you will repay the advance sooner and your APR will be higher. If they decrease, it will take longer, but the APR will also be lower.
Now, if you were to opt for fixed daily payments instead of a percentage of your sales, the merchant cash advance provider would calculate your fixed payment based on your monthly sales. Take 10% of $75,000, then divide that number by 30 to get a daily payment of $250.
But unlike the traditional repayment method, with this one your daily payment stays the same regardless of your sales performance, so the 93% APR is a safe bet.
Either way, the APR is higher than most small business loans, which can be less than 5%.
“Companies typically seek short-term funding in order to take advantage of a short-term opportunity, and most expect a return on investment that is significantly higher than the cost of capital they use to fund the opportunity,” says Ben Johnston, COO of Kapitus, which offers a number of financing options for small businesses.
Advantages and Disadvantages of Merchant Cash Advances
Although merchant cash advances can provide a quick injection of cash, the disadvantages usually outweigh the advantages.
- Quick Funding: You usually don’t need to provide a lot of documents when you apply, and you can usually get funding within a week.
- Weak eligibility conditions: Merchant cash advance providers are often willing to work with small business owners with low credit ratings. You also don’t need to provide collateral, which is a common requirement with other business financing options.
- Payments may adjust based on sales: If you choose a traditional merchant cash advance, your payments won’t stay fixed if your sales decline. This could put less strain on your budget than a typical installment loan.
- High costs: Merchant cash advance APRs can easily reach triple digits, making it one of the most expensive forms of business financing. In addition to the merchant cash advance factor rate, providers may add administrative fees that increase the total cost.
- Increasing sales increases APR: If your sales increase, you’ll repay your cash advance sooner. But unlike traditional loans, where you’ll save money on interest charges if you pay off the debt sooner, the interest on a merchant cash advance is fixed. Therefore, paying it off early through higher sales only results in a higher APR.
- Fixed payments can harm: If you opt for fixed payments taken from your bank account and your sales decline, withdrawing this fixed amount from your account on a daily or weekly basis can put a heavy strain on your budget.
- Personal guarantee: Although you don’t need to post collateral, the merchant cash advance provider will usually require a personal guarantee, which means that if your business can’t repay the debt, you are obligated to repay it with your personal income. and active.
- No federal regulations: Because merchant cash advances are considered business transactions and not loans, they are not subject to the same federal laws that traditional business lenders are required to follow. Instead, they are regulated by the Uniform Commercial Code, which is not as strict as federal laws like the Truth in Lending Act.
- Predatory clauses: Many merchant cash advances include a confession of judgment clause. “(It) effectively takes away the business owner’s right to defend themselves if the MCA provider takes legal action after they stop making payments,” says Leslie H. Tayne, financial attorney and managing director of Tayne Law. Group in New York. Merchant cash advance contracts can also contain confusing jargon and calculations that can make it hard to know what you’re getting into.
- Danger of cycling debt: Like payday loans, merchant cash advances are often used by small business owners who cannot get approval for other forms of financing. If you cannot afford to make your payments, you may need to take out another advance to help repay the first. This can help you avoid dealing with personal collateral or a lawsuit, but it only adds to the cost of debt and can exacerbate the problem.
How to Get Out of a Merchant Cash Advance
Depending on your situation, the options may be limited. But if you have a cash advance from a merchant and are having trouble keeping up with the payments, here are some potential ways to end your contract:
- Pay it back with another loan. If you qualify, you may be able to get a term loan or line of credit to pay off the debt. Just be sure to run the numbers, as some online loans and lines of credit charge higher interest rates and have short repayment terms, which may not help your situation. If you have an asset that you can use as collateral to secure a loan, that can help lower the cost. “While not a great option because rates are high, these types of loans have no prepayment penalties,” says Tayne, “and could be a good idea for businesses struggling with multiple advances. funds to traders”.
- Obtain money from other sources. Options may include getting a loan from a family member or friend, selling some business assets you don’t use, renting out some of your office space, or even tap into your personal savings.
- Settle the debt. If your credit is in bad shape and you can’t get another loan or money from other sources, you may be able to settle the debt for less than you owe. This process, however, can be tricky, especially if there is a confession of judgment clause. Consult an attorney before pursuing this approach.
- File the balance sheet. This is an option of last resort that you should only consider if your situation is serious enough that you have no other recourse. As with the settlement, it is a good idea to consult an attorney before pursuing bankruptcy.
Is a merchant cash advance right for you?
Merchant cash advances can sound appealing, especially if you need short-term capital and can’t get it anywhere else. But if you’re not careful, getting one can ultimately do your business more harm than good.
Before applying for a merchant cash advance, take the time to consider other business loan options like business credit cards and research solutions that don’t involve debt.
“When considering any type of growth capital, small businesses must first define what opportunity they want to capture and what they expect to get out of that opportunity,” says Johnston. “Next, they must explore the financing options available to them within the timeframe required to take advantage of the opportunity. Finally, small businesses must calculate whether the expected income from the opportunity, minus the cost of financing, offers a return sufficient for the risk being assumed.”
In other words, are you getting the merchant cash advance to take advantage of an opportunity and grow your business? Will the MCA be self-financing? If not, then you should reconsider.