Many business owners have the best intentions for delivering their product or service to the masses. Unfortunately, many struggle with cash-flow restrictions at some point during the business lifecycle that hampers those efforts.
Cash flow can be limited due to seasonal dips in business, a change in product or service offerings, or customers who simply do not pay on time. When cash flow becomes an issue, a merchant cash advance may be an option for businesses that meet the qualification criteria.
What is a Merchant Cash Advance?
A merchant cash advance is a type of business financing that helps a company raise capital quickly. Unlike a traditional bank loan, a merchant cash advance provides access to funding in as little as a few days, even if the business has little-established credit or the business owners have a lackluster credit history. Merchant cash advances are meant to be temporary cash-flow solutions as opposed to long-term financing tools because they carry high fees and require daily repayment.
Here’s a guide on how merchant cash advances work, their benefits, risks, and alternatives.
How Do Merchant Cash Advances Work?
A merchant cash advance is designed to assist businesses that receive their primary revenue from credit card and debit card sales, like retailers or restaurants. This financing vehicle is not structured as a loan in the conventional sense. Instead, it gives qualified businesses an upfront sum of cash in exchange for a cut of future credit and debit sales.
Merchant cash advances are repaid through daily or weekly withdrawals from the business, calculated as a percentage of total daily sales. The lender assigns a “factor fee,” or multiplier rate, at the time of approval. That fee dictates the total amount to be repaid, and payments remain in place until the original lump sum is fully repaid.
Businesses may repay with a fixed daily or weekly withdrawal, or as a percentage of sales. With fixed payments, the amount owed each day or week does not change. The method of using a percentage of sales means payments could fluctuate along with daily credit and debit sales.
For example, a business that receives a merchant cash advance of $50,000 with a factor rate of 1.4 owes a total of $70,000 back to the lender ($50,000 x 1.4). The typical repayment period for a merchant cash advance is one year, so a percentage of credit card sales are siphoned off from the business each day to repay the debt.
The percentage used is also assigned by the lender at the time the agreement is put in place. If a business with the example above had a repayment rate of 10 percent, that percentage of sales would go back to the lender every day until the full $70,000 was repaid.
Businesses that apply for a merchant cash advance can do so online with most lenders, but they need to provide detailed information regarding their credit and debit card sales and average revenue per month. Credit history and score does not necessarily matter in getting approval, but the financial track record of the business is important.
What Are the Risks of Using a Merchant Cash Advance?
Merchant cash advances can be a smart way for businesses to get quick access to capital that may be needed to cover a large inventory purchase, buying equipment, expanding to a new location, or even developing a new product or service. The fast turnaround for funding, simplified application process, and substantial advance amounts are all benefits to consider in conjunction with the risks of merchant cash advances.
The most common risk of this business financing vehicle include the following:
- High APR – The total cost to borrow with a merchant cash advance is far higher than other business financing vehicles. Adding up the interest and funding or origination fees that are all rolled into the total payback amount, business owners can end up paying an effective APR anywhere between 40% to 350%. The total APR is based on the size of the advance, and how long it takes to repay the amount borrowed.
- Higher sales mean higher APRs – For most merchant cash advances, a business with a higher sales volume typically pays more in a shorter period of time. This is because the repayment is calculated as a percentage of the daily credit or debit card sales. Businesses with strong credit and debit sales then pay a larger amount each day, but the repayment period is not extended to make the payment lower.
- No early repayment benefit – Merchant cash advances are repaid based on the fixed amount calculated from the factor rate mentioned above. The total amount repaid is set at the time of signing a contract with a lender, and so there is no benefit in paying off the amount early. The interest is already built into the amount, unlike bank loans or lines of credit.
- No federal oversight – One of the biggest risks with a merchant cash advance is the lack of regulation from a federal regulatory body. These financing vehicles are commercial transactions and are regulated by the Uniform Commercial Code (UCC) in each state, unlike loans which are regulated by banking laws.
- Credit score risks – Even though a merchant cash advance is intended to help businesses in need of fast cash that may have less than ideal credit, a lender may ultimately pull a business owner’s credit during the application process. This results in a hard inquiry added to the owner’s credit report which may bring down his or her credit score.
- Debt cycle risks – Merchant cash advances also come with the risk of pushing a business into a nasty cycle of debt and repayment. The cash received from a merchant cash advance is fast and, in most cases, easy to get. This makes the strategy a go-to for businesses that cannot qualify for other forms of financing. Over time, using multiple merchant cash advances can add up to a significant cost burden.
- Confusing contracts – Finally, the terms merchant cash advances are not always clear. The structure of daily repayment, the factor fee, and the percentage of sales used to pay back the advance create a confusing contract that makes it difficult to understand the full cost of an advance. Additionally, merchant cash advance lenders are not required to provide the APR, so it is a challenge to compare the cost to other financing options.
Comparing the Alternatives
Merchant cash advances may seem like the right solution for quick cash and an easy application process, but it may be beneficial to look elsewhere for financing. Other sources of capital include small business loans or invoice factoring that can offer more flexibility, affordability, and longer-term management of payments for business owners who qualify.
Merchant Cash Advance vs. Small Business Loan
Small business loans may be available through a bank or credit union with far lower interest rates and funding fees than merchant cash advances. Repayment for small business loans may also be longer than merchant cash advance products, making it more affordable in the long run. However, traditional bank and credit union loans can be hard to come by for businesses that do not have established credit or strong financials.
Small businesses loans are available through a variety of online lenders as well. OnDeck, for instance, offers business loans up to $500,000 with interest rates starting as low as 9.99% for the most qualified businesses. OnDeck business loans are repaid daily or weekly, similar to merchant cash advances, but repayment terms can extend to up to 36 months. An approval for an OnDeck loan does not require the best credit history, but businesses must be in operation for at least two years and have a strong financial history.
Merchant Cash Advance vs. Invoice Factoring
Businesses may also qualify for invoice factoring as a solution to capital needs. Two popular options are BlueVine and Fundbox. BlueVine offers invoice factoring loans ranging from $1,000 to $100,000, with rates ranging from 17.50% to 60.00%. Fundbox offers invoice factoring from $5,000 to $5 million, with rates ranging from 15.00% to 59.00%.
With an invoice factoring loan, the lender offers a lump-sum payment for invoices owed to the business, and there are no recurring fees if the customer pays the invoices on time.
Repayment terms for these loans are similar to merchant cash advances in that they are shorter than conventional business loans. However, invoice factoring can be more cost-effective than a merchant cash advance in terms of the total fees charged to the business over time.