Is a Merchant Cash Advance Right for Your Small Business?

·8 min read

If your small business needs quick access to cash, merchant cash advance loans can be an attractive option. Funding is generally quick, eligibility requirements aren't particularly stringent and you don't have to worry about collateral.

But a merchant cash advance can easily make matters worse, and if you can't repay, it could put you in serious financial and legal trouble.

Before you consider using a merchant cash advance for your business, it's important to know what you're getting yourself into and how to protect yourself and your business.

[Read: Best Small Business Loans.]

What Is a Merchant Cash Advance?

A merchant cash advance loan isn't technically a loan. Rather, it's an alternative form of financing, in which you receive an upfront payment in exchange for a portion of your future sales.

Historically, merchant cash advances have worked only for small businesses with revenue that comes primarily from debit and credit card sales. But now, just about any business can get one.

Repayment terms typically range from three to 12 months, but some providers may offer longer terms. There are two ways you can repay a cash advance:

-- Percentage of daily sales. You agree to pay a percentage of your daily sales from debit and credit card sales. This payment will fluctuate every day based on your sales.

-- Fixed withdrawals. If your revenue doesn't primarily come from debit and credit card sales, you can allow the provider to take daily or weekly withdrawals from your bank account based on your estimated monthly revenue. This payment won't change regardless of your current sales.

Instead of charging an interest rate like a traditional loan, merchant cash advances charge what's called a factor rate, typically ranging from 1.2 to 1.5. This rate determines how much you'll ultimately repay. For example, if you receive an advance of $10,000 and your factor rate is 1.4, you'd multiply the two figures to get a total repayment of $14,000.

How a Merchant Cash Advance Works

To give you an idea of what a merchant cash advance looks like, here's what you can expect for the different types of repayment options.

First, let's say that you have strong credit and debit card sales, so you go for the traditional option. You take an advance of $50,000 with a factor rate of 1.4. Your monthly card sales are $75,000, and you agree to allow the provider to deduct 10% of your daily sales.

Ultimately, you'll end up paying $70,000 over 280 days. While merchant cash advances don't use annual percentage rates, you can use an online calculator to show that the APR for the commercial transaction is 93%.

Remember, though, that with this option, your daily payments are based on your sales figures. Ten percent of your daily sales based on $75,000 in monthly revenue gives you an approximate daily payment of $250.

But your actual daily payment may be higher or lower, depending on how well your business performs. If your sales increase, you'll pay off the advance sooner, and your APR will be higher. If they decrease, it'll take longer, but the APR will also be lower.

Now, if you were to opt for fixed daily payments instead of a percentage of your sales, the merchant cash advance provider would calculate your fixed payment based on your monthly sales. Take 10% of $75,000, then divide that number by 30 to get a $250 daily payment.

But unlike the traditional repayment method, with this one your daily payment remains the same, regardless of your sales performance, so the 93% APR is a sure thing.

Either way, the APR is higher than most small business loans, which can be less than 5%.

"Businesses generally seek short-term financing in order to take advantage of a near-term opportunity, and most expect a payback significantly greater than the cost of capital that they are using to finance the opportunity," says Ben Johnston, chief operating officer at Kapitus, which offers a number of small business financing options.

[Read: Best Unsecured Business Loans.]

Pros and Cons of Merchant Cash Advances

While merchant cash advances can provide a quick infusion of cash, the drawbacks generally outweigh the benefits.

Pros

-- Fast funding: You typically don't need to provide a lot of documentation when you apply, and you can usually get funding within a week.

-- Low eligibility requirements: Merchant cash advance providers are often willing to work with small business owners with low credit scores. You also don't need to provide collateral, which is a common requirement with other business financing options.

-- Payments may adjust based on sales: If you choose a traditional merchant cash advance, your payments won't stay fixed if your sales decrease. This could put less of a strain on your budget than a typical installment loan.

Cons

-- High costs: Merchant cash advance APRs can easily climb into the triple digits, making them one of the most expensive forms of business financing. In addition to the merchant cash advance factor rate, providers may tack on administrative fees that increase the total cost.

-- Increased sales hike the APR: If your sales go up, you'll pay off your cash advance faster. But unlike traditional loans, where you'll save money on interest charges if you pay off the debt early, interest on a merchant cash advance is fixed. As a result, paying it off early through higher sales only results in a higher APR.

-- Fixed payments can hurt: If you opt to have fixed payments taken out of your bank account and your sales go down, having that fixed amount come out of your account on a daily or weekly basis can put some serious stress on your budget.

-- Personal guarantee: While you won't need to put up collateral, the merchant cash advance provider will typically require a personal guarantee, which means that if your business can't repay the debt, you're on the hook to pay it off with your personal income and assets.

-- No federal regulations: Because merchant cash advances are considered commercial transactions and not loans, they're not subject to the same federal laws that traditional commercial lenders are required to adhere to. Instead, they're regulated by the Uniform Commercial Code, which isn't as strict as federal laws like the Truth in Lending Act.

-- Predatory clauses: Many merchant cash advances include a confession of judgment clause. "(It) effectively takes away the business owner's rights to defend themselves if the MCA provider files a lawsuit after they stop making payments," says Leslie H. Tayne, a financial attorney and managing director of Tayne Law Group in New York. Merchant cash advance contracts can also contain confusing jargon and calculations that can make it hard to know what you're getting yourself into.

-- Danger of cycling debt: Like payday loans, merchant cash advances are often used by small business owners who can't get approved for other forms of financing. If you can't afford to make your payments, you may end up taking out another advance to help you pay off the first. This can help you avoid dealing with the personal guarantee or a lawsuit, but it only compounds the cost of the debt and can exacerbate the problem.

How to Get Out of a Merchant Cash Advance

Depending on your situation, options may be limited. But if you have a merchant cash advance and you're struggling to keep up with the payments, here are some potential ways you can get out of your contract:

-- Pay it off with another loan. If you qualify, you may be able to get a term loan or a line of credit to pay off the debt. Just make sure you run the numbers, because certain online loans and lines of credit charge higher interest rates and have short repayment terms, which may not help your situation. If you have an asset that you can use as collateral to secure a loan, that can help lower the cost. "While they aren't a great option since rates are high, these types of loans have no prepayment penalties," says Tayne, "and could be a good idea for businesses struggling with multiple merchant cash advances."

-- Get cash from other sources. Options may include getting a loan from a family member or friend, selling off some business assets that you're not using, renting out a portion of your office space or even dipping into your personal savings.

-- Settle the debt. If your credit is in poor shape and you can't get another loan or cash from other sources, you may be able to settle the debt for less than what you owe. This process can be tricky, though, especially if there's a confession of judgment clause involved. Consult with an attorney before pursuing this approach.

-- File for bankruptcy. This is a last-ditch option that you should consider only if your situation is dire enough that you have no other recourse. As with settlement, it's a good idea to consult with an attorney before pursuing bankruptcy.

[Read: Best Bad Credit Loans for Small Businesses.]

Is a Merchant Cash Advance Right for You?

Merchant cash advances may seem appealing, especially if you need short-term capital and you can't get it anywhere else. But if you're not careful, getting one can ultimately do more harm to your business than good.

Before you pursue a merchant cash advance, take some time to consider other business loan options like business credit cards and research solutions that don't involve debt.

"When considering any type of growth capital, small businesses should first define the opportunity at hand and what they expect to earn from that opportunity," says Johnston. "Next, they should explore those financing options available to them in the time frame required to take advantage of the opportunity. Finally, small businesses should calculate whether the expected income provided by the opportunity, less the cost of financing, provides a sufficient return for the risk being assumed."

In other words, are you getting the merchant cash advance to take advantage of an opportunity and grow your business? Will the MCA pay for itself? If not, then you should reconsider.

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