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If you find yourself in need of additional funds for your small business as soon as possible, you may be considering a merchant cash advance (MCA), which can provide your business funding in short order, without many of the strict requirements of a traditional loan. However, it is crucial to understand the benefits and drawbacks of cash advances, which typically charge fees higher than traditional loans, in order to determine if it is the right decision for your business.
What is a merchant cash advance?
A merchant cash advance allows your business to exchange your future earnings for immediate cash. With MCAs, you receive a lump sum of cash from a merchant cash advance provider, which you pay back using a percentage of your daily sales.
MCAs can be a lifesaver for businesses that need immediate funding. Because repayment is based entirely on how successful your sales are, MCAs may be exactly what your business needs during a slow season. It can also be difficult for new and small businesses to have a high credit score and sufficient assets to put up as collateral for traditional business loans. Meanwhile, qualifying for and obtaining MCAs are much easier.
Despite these benefits, it is important to recognize that MCA rates are often significantly higher than other financing sources. Without a careful review of the fine print, your business may be at risk of amassing significant debt.
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How does a merchant cash advance work?
After obtaining a merchant cash advance, your business will receive a lump sum cash advance very quickly, usually by direct deposit from your provider within just a few days. As soon as you receive the funds, your provider begins collecting a percentage of your daily or weekly credit card and debit card sales in order to pay back the cash advance, in addition to fees. The payback period can be quite short—usually less than 18 months.
The percentage of your card transactions that are taken from your account is called the holdback. The holdback percentage is typically between 10 and 20 percent and remains fixed, so your repayment amount is directly correlated to your sales—if you have a big sales day, the amount of the holdback will be greater than on a slow sales day.
Additionally, because your business does not generate the same amount of revenue every day, the time it takes to repay an MCA can vary. During a slow season, your repayment amount will be less, but the length of time it will take to repay your provider will be longer. Similarly, during a busy season, your repayment amount may be high, but your repayment period is shortened.
Example:
- You take out an MCA, and your holdback percentage is 15%. On Monday, your sales total $1,000, so $150 (15% x $1,000) would be held to pay back your MCA. On Tuesday, your sales total $1,200, so $180 (15% x $1,200) would be held back to pay your MCA.
Your repayment is typically taken as a percentage of your card sales, but it can also be drawn from your bank account via ACH withdrawals if your business does not typically rely on credit or debit card sales. In this scenario, your repayment would likely be a fixed amount, rather than a percentage.
How much does a merchant cash advance cost?
The total cost of your MCA is primarily determined by what’s called a factor rate. The factor rate depends heavily on your business’s credit and overall risk of lending, and it is usually set somewhere between 1.1 and 1.5, with a higher factor rate equating to a higher total cost.
In order to determine the total cost of your MCA, you simply multiply the total amount of cash advanced to you by the factor rate.
Example:
- You take out an MCA for $20,000, with a factor rate of 1.25. The total cost of your MCA is $25,000 ($20,000 x 1.25), which includes the $20,000 advanced to you and $5,000 in fees.
| Cash Advance | Factor Rate | Fees | Total MCA Cost |
|---|---|---|---|
| $20,000 | 1.25 | $5,000 | $25,000 |
Note that some lenders charge administrative fees on top of your factor rate, so make sure to look at the fine print of your agreement to understand your true total cost. Usually, if an administrative fee is charged, it is charged as a percentage of the total cash advanced to you.
Example:
- You take out an MCA for $20,000, with a factor rate of 1.25 and administrative fees of 2%. The total cost of your MCA is $25,400, which includes $20,000 advanced to you, $5,000 based on the factor rate ($20,000 x 1.25), and $400 in administrative fees ($20,000 * 2%).
| Cash Advance | Factor Rate | Factor Rate Fees | Administrative Fees | Total MCA Cost |
|---|---|---|---|---|
| $20,000 | 1.25 | $5,000 | $400 | $25,400 |
Currently, there is no law that determines or limits how much a merchant cash advance provider can charge you in fees. MCAs are not technically considered business loans, so there is little regulation when it comes to them. MCA providers are not forced to follow any state usury laws, which are in place to limit how much interest companies can charge on traditional business loans.
Because of this free reign, MCAs can be an aggressive form of financing, with annual percentage rates (APRs) that can be over 100%. This does not automatically mean that all MCAs come with impossibly high rates, but it is essential for businesses to carefully review their contract and understand the risks involved with this form of financing.
What are the benefits of a merchant cash advance?
- Fast cash: The approval process for MCAs is incredibly fast, and your business will likely begin receiving funds within a few days of submitting your application. This is ideal for businesses that need fast cash and do not have the time to wait for the long processing period that is typical of traditional business loans.
- Easy application process: Unlike traditional business loans, it is much easier to qualify for MCAs. In fact, a poor credit score plays no factor in your eligibility. Many struggling small business owners who are turned down from traditional loans may turn to MCAs to secure the funds they need to keep the doors open.
- High borrowing limits: Most MCAs can allow you to borrow up to $500,000, giving you access to a large infusion of working capital in relatively short order. Depending on your business’s revenues, you may be able to borrow up to $1 million.
- Flexible repayments: Your MCA provider collects a percentage of your daily card sales. This means that the amount you pay is entirely dependent on how much you actually make. This may be ideal for businesses that are having a slow period of sales and need flexibility with their repayment.
- No collateral required: New or small businesses may not have enough assets to provide as collateral and do not qualify for traditional loans. With MCAs, you do not need to put anything up for collateral in order to qualify. As long as your card sales are strong, you stand a good chance of being approved.
- Control over funding: Unlike some forms of business loans, you are free to use your funding however you see fit.
What are the drawbacks of a merchant cash advance?
- Expensive: MCAs are notoriously expensive. They are not subject to any state or federal regulations, so the average APR could reach triple digits.
- Potential for debt and administrative fees: MCAs often include set-up fees, processing fees, and payment fees that can reach as much as double the actual cost of the loan. The high costs of MCAs and daily repayments can quickly put a business at risk for unsustainable debt.
- Strain on daily cash flow: Repayment is taken directly from your daily card sales, so it may be difficult to anticipate how much will be taken from your funds. If your business is doing well, you may have a daily payment of hundreds of dollars, which can be a strain on your daily cash flow.
- Does not build business credit: MCAs are not considered business loans, so they will not help you build business credit. This is important to keep in mind if your business is aiming to strengthen your credit in order to qualify for traditional business loans.
- No incentives to repay early: Typically, paying off a loan early results in less interest being paid. This is not the case with MCAs, as they use factor rates rather than interest rates, meaning a set amount will be owed no matter how quickly you pay back the cash advance. In fact, your contract may include a penalty for early repayment.
- Merchant processor: In order to qualify, most funding companies will require that you have an account with a processor who is contracted with your merchant cash advance provider. As such, you may need to create an account with a credit card processor that is on your provider’s approved list.
How do I qualify for a merchant cash advance?
Although it is much easier to qualify for a merchant cash advance than traditional business loans, there are several factors that determine whether your business can obtain an MCA:
- Annual revenue: Your business needs to provide proof that repayment will not be impossible. Usually, a provider will require annual sales of at least $50,000. In addition, your business will need two years’ worth of credit card sales. MCA providers are quick to approve businesses that show a history of credit card sales since this shows the ability to pay the money back.
- Required documents: There is much less paperwork involved with MCAs, but you will need your business tax ID number, bank and credit card statements, and any business lease agreements.
Applications are available online and approval typically takes place as soon as 24 hours. Your business may begin receiving funding within a few days. It is important to note that although MCAs do not have strict qualification requirements, they do have significant holdback percentages and repayment fees.
Final Word
With an easy application process and funds immediately available to you, a merchant cash advance may be the ideal solution for your business’s financing needs. However, MCAs often come with a lot of fine print, and if you are not careful, you may quickly accumulate significant debt. It is important to carefully review your contract and understand the various risks involved.
