What is a Merchant Cash Advance?
At some point or another, your small business may need a capital injection. While 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, as this is how the amount is refunded.
But before asking merchants for a 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 differs from a traditional loan in that it does not include the technical details of a short or long term loan, such as guarantees and a fixed repayment term.
A merchant cash advance is more akin to factoring, in which a lender gives a cash advance against an invoice and then collects both the invoiced amount at a later date and a commission from the business for the advance. . Indeed, 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 sets them outside of certain banking laws and regulations that traditional financial lenders must comply with.
In a factoring business, the finance provider purchases a portion of a business’s future receivables. In an MCA agreement, the company’s receivables are in the form of credit and debit card sales. This is a riskier approach for the lender because there is no invoice. 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 begin the process of receiving an MCA the same way you would begin applying for a typical bank loan: your business applies to receive funding from an MCA provider as you would a bank loan. Next, the finance provider analyzes your business details to determine its eligibility to receive the advance.
The most important detail an MCA provider will need to understand about your business is the amount you receive in credit and debit card sales. Since an MCA is paid primarily as a percentage of your company’s credit and debit card sales, the MCA provider will need to assess how much of your cash flow is received in this way. It is from these credit and debit card statements that the provider will determine the cash advance rates and terms for your business.
In your MCA application, you must provide your company’s bank statements so that the supplier can assess your company’s earnings from credit and debit card sales. As such, an MCA is best for a business that derives 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 determine how risky an advance is for your business and set the factor rate, and the business profile shows how long your business has been in business. Suppliers rely on future sales from your business, so they want to know if the businesses will still be active for the duration of the advance. [Are you looking for a small business loan? Check out our reviews picks for the best small business loan and financing options.]
Merchant Cash Advance Conditions
Once you’ve received your cash advance, consider the following:
1. Amount and duration of the advance
Consider the total amount that will be advanced and how long you will have to repay it. Typically, the amount of a cash advance ranges from $2,500 to $250,000, while the duration of the advance 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, multiplied by the amount of the advance, tells you what you owe in total. When this factor rate is converted into the annual percentage rate of charge (APR), it becomes equivalent to 15% or more. [Want to know more about factoring? Check out our reviews.]
Each day, a percentage of your company’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 paid off.
To facilitate day-to-day payments to the lender, an MCA agreement is entered into with the collaboration of a credit card processing company. Credit card processors can deduct the appropriate percentage of the day’s total sales and send that amount to the MCA provider, and send the rest to your business bank account.
Another way to make day-to-day payments easier is to authorize the MCA vendor 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 manage the account, in which case the automated clearinghouse sends its share to the MCA provider.
Why are merchant cash advances ideal for small businesses?
At some point, you will probably need financing for your business. Maybe you need to expand your business by adding employees, buying new inventory, or changing your business location. In recent years, MCAs have become more popular for small businesses looking to achieve new financial goals.
This trend began following the global financial crisis of 2008 which saw the collapse of several large banks and credit unions, as it became much more difficult for small businesses to obtain loans. Fintech companies saw an opportunity to fill the void and seized it. In 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 solved some of the restrictions on small businesses and lenders.
Here are some of the reasons your business might consider a cash advance instead of a traditional bank loan:
Less documentation and easier approval
In addition to being more accessible to small businesses and entrepreneurs, MCA vendors do not have strict requirements. In contrast, to approve a traditional loan, a bank must analyze your company’s financial and banking statements, which detail your company’s cash flow and help the bank determine the amount of loan to issue. This automatically disqualifies many small businesses that have low profit margins 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, the bank is unlikely to give you a loan. Although MCA providers also check your credit score, they only use it to determine the factor rate; you will nevertheless obtain a cash advance.
Since an MCA comes with the guarantee of future credit card sales, you are not required to provide any guarantee. In contrast, to get a traditional small business loan from a bank, you may need to use the most valuable assets you have as collateral, which would be lost if you were unable to repay the loan. MCAs provide your business with the financing it needs without risking any critical assets.
A typical commercial bank loan takes at least several weeks as bank staff review your loan application and assess their own risk. A typical MCA is processed and disbursed within 24 hours or a few days, depending on the situation. This makes it ideal for emergency situations where an immediate influx of cash is needed for business survival.
Traditional variable interest rate loans have an amortization schedule that causes the amount you owe to fluctuate over time. Because you’re repaying a combination of interest and principal, if you don’t make payments in accordance with the loan agreement, you could end up paying more for the loan. MCAs don’t work that way. Although you must repay the advance as you collect outstanding invoices, the factor rate, which is set at the start of your contract, does not change.
What are the disadvantages of merchant cash advances?
Although there are many advantages of merchant cash advances, they also have some disadvantages.
The most glaring problem with MCAs is their high cost. At first, the factor rate gives the impression that the debt would be low, but in reality, the interest rate is quite high. In some cases, the rate can reach three digits, which is much higher than the interest rate for a bank loan. In fact, a merchant cash advance is one of the costliest forms of business financing available.
Effect on cash flow
Depending on the agreement you have with your supplier, an MCA can negatively affect your company’s cash flow. When you repay a cash advance to a merchant, the funds are often deducted daily from your business credit card sales. This can have a major impact on your business’s ability to operate in the future.
The fine print
MCA agreements contain clauses that could affect the way you run your business. For example, some providers may not allow you to close your business for a period of time until you repay the loan in full. If you have a seasonal business, this could be a problem. MCA vendors may also discourage you from accepting money from your customers, as they will not be able to collect those sales.
Additional reporting by Matt D’Angel.