Introduction
When small business owners find themselves under a tight funding pinch, a Merchant Cash Advance or MCA may present an attractive option. The concept of getting a lump sum of money that can be applied to cover up-front operating expenses like payroll, inventory, or marketing without having to wait for long approval cycles can prove very attractive. The temptation of quick funding is especially strong for small companies that might not be eligible for conventional loans. Nevertheless, although an MCA can provide quick access to funds, it is accompanied by a number of risks that should be well considered before going forward.
What is a Merchant Cash Advance?
A Merchant Cash Advance is a type of financing where a lender advances a lump sum to a business in return for a share of its future credit card sales or bank deposits on a daily basis. It is not really a loan but rather a purchase of future sales. The payment is made through deductions from the business’s income on a daily or weekly basis, which can vary depending on sales performance.
The beauty of this type of funding is that companies do not have to provide collateral, and the process of getting approved is comparatively fast and easy. Unlike a traditional loan, where the borrower’s credit score is a determining factor in getting approved, MCA lenders care least about the borrower’s credit score and more about the cash flow of the business and its future capability of repayment. This makes it especially appealing to small businesses with imperfect credit histories or those that are unable to get funding from conventional lending institutions.
The Attraction of Merchant Cash Advances
The main reason business owners use Merchant Cash Advances is the quick funding. In most situations, businesses are able to obtain the cash they require within a matter of days, which is much quicker than traditional loans. This quick funding can be important for businesses that operate in cash flow unpredictable industries or for businesses that have unexpected expenses that need to be addressed immediately.
Also, MCA lenders normally don’t impose the same level of qualifications as the conventional banks. Conventional loans usually involve an extensive application procedure, credit reporting, and an extended approval period. For comparison, Merchant Cash Advances usually place more emphasis on the day-to-day credit card sales or deposits of a business, and so they present an alternative opportunity for businesses whose revenues are seasonable or fluctuating.
Another appealing aspect of MCA financing is its flexibility. Because repayments are made against a percentage of daily or weekly sales, businesses are not bound by a set monthly payment regimen. This leaves room for months when sales have been slower, with the repayment falling that much lower, granting some leeway during lean months.
The Risks of Merchant Cash Advances
Despite their attractiveness, Merchant Cash Advances come with significant risks. While the ease of access to funding may appear to outweigh these risks initially, it is important for business owners to fully understand the potential downsides before committing to an MCA agreement.
High Costs and Interest Rates
One of the most important disadvantages of Merchant Cash Advances is the expense. Although the lender doesn’t charge a standard interest rate like a loan, they do charge a factor rate. This factor rate sets the amount a business will owe, and at times, this can be many times more than the initial loan.
Factor rates will vary between 1.1 and 1.5 or higher, so that the company will be repaying $1.10 to $1.50 for every dollar it borrows. That does not sound like a lot at first, but considering that the repayment time can take anywhere from several months to a year or more, the overall cost of the MCA can soon become crippling.
For instance, if a company takes a loan of $50,000 with a factor rate of 1.3, the repayment amount would be $65,000. This is a huge premium than what would be offered as a traditional interest rate on a loan, and most business owners might not be able to pay back the whole amount because of the hefty price tag attached.
Unpredictable Repayment Terms
Another negative aspect of MCAs is that the repayment terms are unpredictable. Because repayments are calculated as a percentage of future bank deposits or credit card sales, they can vary with the company’s income. In times of high sales or peak seasons, a company might discover that the repayment levels are greater than expected, which could strain its cash flow. Conversely, when the business has slow times, repayments will be less, but this doesn’t necessarily mean the business will never have financial difficulties.
The unpredictability of the repayment schedule can complicate it for business operators to budget and plan accordingly. With fixed monthly payments, traditional loans afford less room for irregular cash fluctuations. In the case of an MCA, the daily or weekly repayments can provoke cash shortages, particularly if sales fluctuate. This can make it hard for businesses to budget and could lead to delayed repayments, which may provoke extra fees or penalties.
Debt Cycle Risk
One of the most alarming risks of Merchant Cash Advances is possibly falling into debt cycle. While companies struggle with paying off heavy repayment amounts, they end up taking on further MCAs or other types of short-term funds to repay current debt. This can form a vicious borrowing and repayment cycle, which is becoming harder to get out of.
Due to the high fees and uncertain repayment conditions, most business owners end up depending on additional MCA financing to service current debts. This can very easily snowball, and before long, the business is no longer able to make significant strides in retiring its debt. This can, over time, cause financial instability, which can render the business unable to recover or expand.
Impact on Business Cash Flow
One of the main uses of a Merchant Cash Advance is to give businesses a fast influx of money. Nevertheless, the repayment, which is often made daily or weekly, can seriously affect a business’s cash flow, particularly where sales are unstable.
For those companies that experience seasonal sales or low-revenue periods, the repayment requirements can become onerous. Consequently, the company could find it difficult to cover operational expenses, salary bills for employees, or buying inventory, despite fulfilling MCA terms. This places the company in a vulnerable situation because the repayment needs are prioritized above other financial needs, and defaulting on these needs can attract extra charges, fines, and even litigation.
Limited Regulations and Transparency
Whereas traditional loans are governed by government agencies, Merchant Cash Advances are less transparent and less regulated. This lack of regulation can leave business owners without a clear picture of the terms and costs of an MCA. In most instances, the agreement terms are not explained properly at the time of signing, and business owners do not learn the true cost of borrowing until it is too late.
Although some states have started to implement regulations to safeguard business owners against predatory lending activities, most states still do not have clear regulation in the MCA industry. This absence of standardization and transparency can make it difficult for business owners to compare MCA offers and make sound decisions.
The Impact of Defaults
When a company defaults on an MCA, the lender can pursue legal action to recover the amount. As the repayment is based on the business’s daily bank deposits or credit card sales, a default can have devastating effects on the business. At times, the lender can try to seize property or file other legal actions to recover the debt.
Defaults can also negatively affect the business’s reputation, and it becomes challenging to obtain future funding. The harm to a business’s credit standing could result in increased borrowing rates or the inability to obtain financing in the future, further exacerbating the financial problems.
Alternatives to Merchant Cash Advances
While Merchant Cash Advances can be an attractive option for businesses in need of quick cash, it is important to explore alternative financing options that may offer more favorable terms and less risk. Some of the alternatives include:
- Conventional Business Loans: While conventional loans usually have a long application process, they generally have lower interest rates and more stable repayment schedules. If a business is eligible, this can be a cheaper option in the long term.
- Lines of Credit: A business line of credit is a loan provided to a company to borrow cash as required with repayment terms which are usually less stringent than those of an MCA. It is charged only on the sum borrowed, which makes it cheaper.
- SBA Loans: The Small Business Administration offers loan programs with lower interest rates and longer repayment terms, making them a more affordable option for businesses that qualify. SBA loans are particularly attractive for businesses looking to expand or make significant investments.
- Invoice Financing: In case of bad cash flow due to overdue invoices, invoice financing can be a way out. It enables a company to borrow against its outstanding invoices, with the repayment depending on the collection of the invoices.
- Peer-to-Peer Lending: Peer-to-peer lending sites bring lenders and borrowers together, usually giving them more attractive interest rates and terms than traditional financial institutions.
Conclusion
Merchant Cash Advances can be a tempting solution for business owners who need quick funding, but they come with significant risks that should not be overlooked. High costs, unpredictable repayment terms, and the potential for falling into a debt cycle make MCAs a risky option for many businesses. Prior to considering an MCA, however, it is important that owners of businesses take a very close look at their financial situation, learn how much borrowing will actually cost and look into other, perhaps more financially advisable, financing alternatives that can support them better in the long run. Ultimately, while MCAs have the advantage of quick capital, they are not always the best option for companies interested in expanding and flourishing without shouldering the weight of having too much debt.
