Introduction
When entrepreneurs are in immediate need of capital, they usually opt for a merchant cash advance (MCA) as a solution. An MCA gives companies a sum of cash upfront in return for a share of future revenues, usually from credit and debit card sales. This option is attractive due to the speed and ease of the application process relative to more conventional types of business loans. While MCAs might appear to be an attractive option, though, they do carry huge risks that should be carefully weighed by business owners before entering into this financial product.
Here, we dive deep into understanding what merchant cash advances are, how they operate, the pros and cons, and why they may be a risky option for companies despite the promise of quick capital. It is important for any business owner considering an MCA to understand these risks because the implications of an ill-conceived decision may be long term and harmful to the bottom line of their business.
What Is a Merchant Cash Advance?
A merchant cash advance is not technically a loan. Rather, it is a form of financing where a company is given a sum of cash up front in return for a percentage of its future sales. Repayment of an MCA works by automatically deducting a fixed percentage of daily or weekly credit card sales until the debt is repaid. The rate deducted is usually called the “holdback” rate, and it is determined by the terms of the agreement.
MCAs are usually utilized by small business owners who might not qualify for conventional loans because of reasons such as bad credit history, minimal financial records, or absence of collateral. The process of applying for an MCA is typically much easier than applying for a traditional business loan, and it can be approved in a matter of days. This makes MCAs appealing to businesses that require quick cash flow to pay for things like payroll, inventory, or unexpected repairs.
How Does a Merchant Cash Advance Work?
The application for an MCA often begins with an application to a merchant cash advance finance company. The business’s daily credit card transactions are examined by the lender in order to determine the size of the money that can be advanced. The owner of the business does not have to give collateral or submit to a hard credit check, which makes MCAs an attractive option for those who might not qualify for regular loans.
Upon approval, the business is paid a lump sum of money. The lender will then determine the holdback rate, or how much percentage of daily credit card sales will be taken as repayment. This method of repayment is also flexible, in that it will change in correlation with the daily sales of the business. When sales are greater, the business will repay more; when business is slower, the amount repaid will be less.
One of the most identifying features of an MCA is that the repayment term is not fixed. Rather, the repayment term is adjustable depending on the sales volume of the business. This implies that businesses may repay their debt ahead of schedule if their sales rise, or longer if sales are lower than expected.
Merchant Cash Advance Benefits
For businesses that need quick access to capital, there are several advantages to using an MCA. First and foremost, MCAs provide fast funding. The approval process is much quicker compared to traditional loans, which can take weeks or even months to finalize. In some cases, businesses can receive their funds within a day or two, allowing them to address immediate cash flow needs.
A second major benefit of an MCA is the flexibility of the repayment schedule. As payments are determined by daily credit card sales, companies only pay more when they are making more. This can be a godsend for companies that have fluctuating sales or seasonal slowdowns, as their repayment will be adjusted according to their earnings.
Also, since MCAs are not collateral or credit-check-requiring, they are sometimes less difficult to procure than traditional loans. For struggling businesses with lower credit ratings or fewer options in other types of financing, MCAs can be a lifeline that offers needed capital without the obstacles that sometimes come with more conventional lending choices.
Why Merchant Cash Advances Can Be Risky
Although the seeming advantages, merchant cash advances have serious risks that can have long-term implications for a business. The risks are usually more than the benefits, particularly when business owners are not aware of the terms and conditions of the contract. High costs, the risk of debt cycles, and the absence of regulatory guidance are some of the main risks involved with MCAs.
High Costs
One of the main reasons that MCAs are dangerous is the exorbitant cost of borrowing. Although MCAs offer immediate access to capital, they do so at a high cost. The effective annual percentage rate (APR) of an MCA can be considerably higher than that of a standard loan, at times reaching more than 100 percent or even more. This is due to the fact that MCAs are usually designed as short-term advances with high interest rates and fees.
Whereas with traditional loans, interest charges are set upfront, MCAs are not necessarily transparent about the real cost of borrowing. Using the holdback rate, among other fees, business owners will struggle to identify the actual total amount they are going to be charged throughout the duration of the advance. Through this lack of transparency, companies end up paying significantly more than they originally anticipated.
The Risk of Debt Cycles
The other significant danger of merchant cash advances is that companies can become trapped in a debt trap. Since repayment is based on daily sales, companies end up paying more than they can when there are slow periods of sales. As the debt mounts, they will have to get another MCA to finance continued expenses, and this can create a cycle of borrowing and repayment.
This debt cycle can be especially hazardous for small businesses with low margins or sporadic sales. The business eventually winds up struggling to keep up with the daily payments, resulting in more financial hardship and even threatening its long-term viability.
No Regulatory Protection
Another problem with merchant cash advances is the absence of regulatory protection relative to traditional loans. The lack of uniform regulations allows the terms and conditions of an MCA to be highly variable between lenders. Some lenders can engage in predatory lending, providing terms that are hard for businesses to fulfill or comprehend. Without a set framework for such agreements, companies can find themselves locked into unsatisfactory conditions that they didn’t fully appreciate when they signed for the advance.
This dearth of control also means companies won’t be afforded the same legal safeguards they would enjoy from more conventional funding arrangements. For instance, if a business fails to repay a loan, the lender can have recourse through the law to take property or seek other means of repayment. In the case of an MCA, though, the lender’s recourse is often limited to garnishing future sales, putting the business in a vulnerable position with not enough legal recourse.
Impact on Cash Flow
While an MCA provides for flexibility in repayment, it can also negatively affect a company’s cash flow. Since repayments are based on daily sales, a high percentage of revenue can be drained to repay the advance. For companies with low margins or heavy operating expenses, this can cause a cash flow shortage that will prevent other costs such as rent, utilities, or employee wages from being paid.
Moreover, companies depending mostly on credit card sales will see their stream of revenues very much influenced by the percentage being held back. Consequently, their ability to pay their ongoing costs and satisfy the MCA’s repayment responsibilities becomes compromised. That can in turn create other instability in finance and add still further pressure on operations of the company.
Alternatives to Merchant Cash Advances
As risky as merchant cash advances are, business owners can look to alternative financing options that can provide more beneficial terms and fewer financial missteps. A few of the most popular alternatives are traditional business loans, lines of credit, and invoice factoring.
Traditional Business Loans
For companies with good credit and a solid financial history, a conventional business loan can provide better terms than an MCA. Loans of this sort have lower interest rates and longer terms, enabling businesses to repay their debt over time without the risk of defaulting on a weekly or daily basis. Traditional loans do, however, need collateral and a more detailed approval process, which can make them harder to secure.
Lines of Credit
A line of credit is a flexible form of borrowing that enables business owners to take funds as needed. Businesses only pay interest on the borrowed amount when they have a line of credit, and they can access the line as many times as they need. This can be less expensive for businesses that need capital access but don’t wish to pay the exorbitant rates of an MCA.
Invoice Factoring
Invoice factoring enables companies to sell their receivable invoices to a factoring company for immediate cash in exchange for funds. It is an appropriate option for firms with a large number of outstanding accounts, but urgent liquidity needs. The factoring firm collects the invoices, while the firm gets a lump payment upfront, but often at a discount.
Conclusion
Merchant cash advances can provide businesses with quick access to capital, but it is an option that comes with serious risks that must not be ignored. Exorbitant fees, the risk of debt cycles, and the absence of regulatory protection render MCAs a potentially hazardous choice for companies that are not ready to deal with the financial issues that might occur. Business owners need to carefully consider the advantages and disadvantages of an MCA before making a decision and look at other sources of financing that might provide better terms and more reasonable repayment schedules. Knowledge of the possible drawbacks of merchant cash advances is important for any business owner seeking funding without risking their long-term financial health.
