Introduction
Securing financing for a business is something that entrepreneurs have numerous options for. One of the products that have increased in popularity over the years is the Merchant Cash Advance (MCA). This alternative form of financing has the promise of immediate access to funds, frequently within days, and is promoted as a business solution for those companies that won’t qualify for traditional loans. As desirable as this speed and availability are, one must consider the risks and negative aspects that are associated with Merchant Cash Advances. Here in this article, we will get into what a Merchant Cash Advance is, how it works, and why they may not be the best option for every company, even with their guarantee of quick funding.
What is a Merchant Cash Advance?
A Merchant Cash Advance is a form of lending where a business takes out a loan based on its future credit card sales. In essence, the lender makes a lump sum payment to the company, and in exchange, the company will pay back the sum through a percentage of daily credit card transactions. The payment mechanism is done automatically, such that the company is paying a fixed percentage of its daily sales instead of constant monthly payments. Consequently, the payment value changes with the daily income of the company.
Merchant Cash Advances are favored by small businesses who have seasonal spikes and dips in their sales or those who are looking for capital on short notice but might not qualify for the conventional loan. Since the payment is based on the revenue of the business, it can sometimes seem less crippling when there is slower sales volume. But while this payment process may be appealing, it’s wise to realize that the expense of borrowing under an MCA can be much more than other forms of business funding.
How Merchant Cash Advances Work
In order to comprehend better how MCAs work, it is essential to dissect the process both from the lender’s and the borrower’s side. If a business goes for a Merchant Cash Advance, the lender will consider the business’s average daily credit card sales to figure out how much advance it can repay. Using this data, the lender will make an offer for a lump sum advance, which the business can utilize right away.
Once the company agrees to the offer, the repayment starts. The company pays the loan by transferring to the lender a percentage of the company’s credit card sales made every day. The percentage normally ranges between 5% and 20% depending on the advance terms. When sales are high, the amount paid as repayment will be more, whereas when sales are low, repayment will be less.
Although the idea behind an MCA is basic, the repayment terms and fees are what mark it differently from loans that are more traditional in nature. MCAs don’t have interest rates per se. Rather, they’ve got what’s referred to as a factor rate. This factor rate is a number that will be multiplied to figure out how much the borrower actually pays back. For instance, when a company gets an MCA with a factor rate of 1.3 on an advance of $50,000, the company will pay back the amount of $65,000, along with any charges to be paid as part of the loan.
Merchant Cash Advance Advantages
While having their potential risks, there are a number of benefits to employing a Merchant Cash Advance to finance a business. These benefits are among the reasons why this option is attractive to business owners seeking quick access to capital.
- Rapid and Convenient Access to Capital: Perhaps the greatest benefit of an MCA is the rapidity with which businesses can obtain the capital they require. In contrast to traditional loans that can take weeks or even months to be approved and disbursed, MCAs can frequently be approved and funded in a matter of days. For companies with pressing financial requirements, this rapidity can be a lifesaver.
- No Collateral Needed: Traditional loans typically involve collateral, e.g., property or business assets, to support the loan. Merchant Cash Advances, however, are unsecured, i.e., businesses are not required to pledge assets in order to qualify. This makes it a more appealing choice for businesses that have no valuable assets to offer as collateral or do not want to risk their property.
- Flexible Repayment Structure: The repayment structure of an MCA is linked to the daily sales of the business, so businesses do not need to make fixed payments monthly. This can be especially beneficial for businesses with variable revenue, as the repayment amount varies depending on how much sales the business generates per day.
- Minimal Credit Score Requirements: Most traditional lenders put a strong focus on the credit score of a business in deciding whether to approve them for loans. MCAs, on the other hand, are usually less interested in the credit score and more in the sales history of the business. This can make them a good choice for businesses that might have bad credit or no credit history at all.
- Easy to Apply: The process of applying for an MCA is generally easy and fast. Business owners might only need to give some basic financial data, like their daily average credit card sales, and some documents to confirm their business. Compared to loans, applying for an MCA is straightforward and can be done in a matter of minutes.
Risks and Drawbacks of Merchant Cash Advances
Though the advantages of an MCA are clear, there are substantial risks involved with this type of financing. These risks are what make it potentially hazardous for business owners who are not completely aware of the implications of securing such a loan. Some of the major risks involved with MCAs are listed below.
- High Cost of Borrowing: One of the greatest disadvantages of an MCA is that the cost of borrowing is high. As noted above, rather than charging conventional interest rates, MCAs charge a factor rate, which often means businesses end up paying much more than they originally borrowed. Based on the factor rate, the overall repayment sum can be considerably higher than with other types of financing. In other instances, companies will have to repay double or triple the loan amount.
- Brief Repayment Terms: Another disadvantage of MCAs is that they usually have brief repayment terms. Most MCAs are repaid within 6 to 12 months, which implies that businesses should reimburse the advance fairly soon. Although this is convenient for business owners who require quick funding, it might be burdensome for those that lack sufficient cash flow to repay high daily amounts.
- Daily Payments Can Be Alarming: The daily payment nature of an MCA can be alarming for companies, particularly those with fluctuating sales. Under low sales volumes, companies struggle to make the daily payments, which can generate cash flow issues. This causes a vicious circle where the company cannot repay its debt, generating extra fees and interest charges.
- Debt Spiral Risk: Due to the high fees and the short payback periods, companies that use Merchant Cash Advances can end up in a debt spiral. If a company is having trouble making timely payments, it might have to borrow another MCA to cover the first one, and so on, resulting in a continuously growing debt burden. Such a cycle can be hard to escape and can eventually threaten the financial well-being of the business.
- Absence of Regulation: The biggest issue with Merchant Cash Advances is that they are not as highly regulated as traditional lending. With less regulation, some lenders will indulge in predatory lending by providing businesses loans with outrageous fees, opaque terms, or misleading practices. Consequently, business owners will unwittingly accept arrangements that are more costly than they expected.
- Effect on Business Relationships: Since MCA repayments are automatic, the lender has a direct claim on part of the daily sales of the business. This can lead to conflict between the business owner and his/her employees, suppliers, or other stakeholders if the business is unable to fulfill its financial commitments. In other instances, companies might experience that their relations with vendors or suppliers are harmed because they cannot pay their bills in time owing to the daily repayments needed by the MCA.
- Potential for Negative Impact on Credit Score: While MCAs do not typically require collateral or rely on credit scores for approval, failing to make timely repayments can have a negative impact on the business owner’s personal or business credit score. If the business defaults on the MCA, the lender may take legal action, which could lead to a damaged credit score and long-term financial repercussions.
Is a Merchant Cash Advance Suitable for Your Business?
A Merchant Cash Advance can be a great alternative for companies in need of immediate funding and cannot get traditional financing. Yet, it’s also important that business owners realize the entire extent of the terms and conditions involved in an MCA before they decide to get into one. Though the allure of immediate access to money can be strong, the steep fees, brief repayment terms, and other risks involved with this type of financing might make it an inappropriate option for most companies.
Prior to seeking an MCA, entrepreneurs must thoroughly evaluate their financial health, sales forecasts, and capacity to repay the advance. It is important to balance the advantages with the possible risks and decide if there are other financing alternatives that could be more viable in the long run.
In summary, while Merchant Cash Advances provide quick access to capital, they are also fraught with extreme risks that could jeopardize the financial well-being of your company. Business owners need to tread carefully when using MCAs and weigh all their options before arriving at a conclusion. Knowing the real cost of borrowing and its effect on cash flow is imperative to making a well-informed decision that facilitates the long-term success of the business.
