Maintaining cash flow and covering essential expenses can be a challenge for small business owners. When faced with limited options and a pressing need for quick funding, a merchant cash advance (MCA) can be helpful.
Read on to learn what a merchant cash advance is, its advantages and disadvantages, when businesses use them, and how to apply for one. We’ll also explore some alternative loan options if you decide an MCA isn’t right for your business.
Key Points
• A merchant cash advance is a funding option that provides cash upfront in exchange for a percentage of the business’s future sales or receivables.
• Repayment can be through a fixed percentage of daily credit and debit card sales or fixed daily or weekly withdrawals, offering flexibility but potentially impacting cash flow.
• MCAs are particularly beneficial for businesses with fluctuating cash flows, those that lack collateral, or businesses unable to qualify for traditional loans due to poor credit or limited business history.
What Is a Merchant Cash Advance?
A merchant cash advance is a small business funding option that allows you to receive money in exchange for future sales. MCAs are technically not loans since they offer cash upfront in return for a portion of a business’s future sales. For this reason, they do not have to follow small business lending laws.
Since they aren’t loans, MCAs don’t require collateral, and merchant cash advance companies typically won’t look at your credit scores to determine approval. However, there is little government regulation on MCAs, which can lead to some merchant lenders engaging in practices that are costly to your business.
Merchant Cash Advance Example
Merchant cash advances charge a factor rate instead of a traditional interest rate. A factor rate is a decimal multiplier used to calculate the total amount you’ll repay on a loan or, in this case, an advance. Most factor rates range from 1.1 to 1.5 depending on the lender and your specific business.
Let’s say you want a merchant cash advance for $75,000. Assuming a factor rate of 1.3, you’d pay a total of $97,500 over time to get that $75,000 now ($75,000 x 1.3 = $97,500). This does not include any additional fees the lender may charge.
To pay the MCA back, a portion of your daily or weekly credit card sales will be automatically withdrawn from your account. The lower your credit and debit sales are, the longer it will take you to pay back the MCA. However, the longer it takes, the lower your overall annual percentage rate (APR) will be. Keep in mind that MCAs are one of the most expensive forms of borrowing for small businesses.
How Does a Merchant Cash Advance Work?
A merchant cash advance is not a loan but a financing option that allows small businesses (“merchants”) to get a cash advance for business expenses in return for a portion of their future sales or receivables. Unlike traditional loans, an MCA involves purchasing future sales at a discount. Typically, the process looks like this:
1. Apply for the MCA: The merchant applies for a cash advance, providing necessary business and financial information. The merchant and MCA provider agree on the terms, including the percentage of future sales or fixed payments.
2. Application approved: The MCA provider reviews the application and approves the advance based on business performance and future sales projections.
3. Funds received: Once approved, the merchant receives the cash advance, usually within a few days.
4. Repayment: There are two repayment options. A percentage of daily debit and credit card sales is automatically deducted until the advance is repaid or fixed amounts are withdrawn directly from the merchant’s bank account on a predetermined schedule. The advance is fully repaid once the agreed-upon amount, plus any fees, has been collected.
This structured process ensures that small businesses can quickly obtain the funds they need while clearly understanding their repayment obligations.
Factor Rate Used for Merchant Cash Advances
So, what goes into the factor rate merchant cash advances use?
As noted earlier, a factor rate is a decimal figure that reflects the total amount to be repaid on the merchant cash advance. They often range from a rate of 1.1 to 1.5, depending on the terms of the advance.
Similar to how traditional lenders calculate interest, merchant cash advance companies calculate factor rates by assessing the potential risk of providing funds to your business. Items that may affect the factor rate you receive include:
• The type of industry your business operates in
• Your business’s financial history
• Credit and debit card sales
• Your number of years in business
To calculate how much you could owe on an MCA, you’d typically multiply the entire amount of the merchant cash advance by the factor rate. For example, if you’re getting a cash advance of $5,000 and your factor rate is 1.3, then the total amount you’ll owe is $6,500. Here’s the calculation:
$5,000 × 1.3 = $6,500
The factor rate does not include any additional fees that may be associated with the cash advance, so check with your merchant cash advance company to make sure you’re aware of any additional costs. This step is important, as some merchant cash advances have been known to have APRs in the triple digits.
Other Fees in Merchant Cash Advances
It’s important to be aware of the various fees that MCA lenders may charge in addition to the cost of the merchant cash advance itself. These fees can significantly impact the overall cost of the financing. They include:
• Origination fees: MCA providers charge origination fees for processing the application and setting up the advance. This fee is typically a percentage of the total advance amount and can range from 1% to 5%. It’s a one-time fee deducted from the advance before the funds are sent to you.
• Underwriting fees: Underwriting fees cover the cost of evaluating the risk associated with providing the advance. This process involves assessing your creditworthiness, sales volume, and business health. The fee compensates the MCA provider for the time and resources spent on this evaluation. Like origination fees, underwriting fees are often a percentage of the advance amount but may also be a flat fee, depending on the provider.
• Administrative fees: Administrative fees cover the ongoing management of the advance. These fees can cover a range of administrative tasks, such as account maintenance, payment processing, and customer support. While some providers include these costs in the factor rate (the fee structure used to determine the total repayment amount), others may charge them separately. Administrative fees can vary widely and may be a monthly fee or a percentage of the advance.
• Other potential fees: Merchants might also encounter electronic fund transfer fees, early repayment fees, and fees for insufficient funds if scheduled payments cannot be processed. These additional costs can add up, so review the terms and conditions of the MCA agreement carefully.
Merchant Cash Advance Repayment
Merchant cash advance repayment terms are distinct from traditional loans. Instead of fixed monthly payments, repayment is typically tied directly to sales, providing flexibility and scalability with your business’s cash flow.
Credit Card Sales
This repayment method involves the provider taking a fixed percentage of your daily credit and debit card sales. This percentage, known as the holdback rate, usually ranges between 5% and 20%. Because repayments are based on sales, the amount paid each day fluctuates with your business’s revenue.
For example, suppose your business receives an MCA of $50,000 with a holdback rate of 10%. On a day the business makes $1,000 in credit card sales, $100 (10% of $1,000) would go toward repaying the advance. If sales drop to $500 the next day, only $50 would be deducted. This structure provides a cushion during slower periods, as payments reduce in line with decreased sales.
Fixed Withdrawals
Some MCAs use fixed daily or weekly withdrawals from your bank account. This method provides predictability in repayment amounts but lacks the flexibility tied to sales volume. The fixed amount is determined based on the advance size, the factor rate (the fee structure used to calculate the total repayment amount), and the anticipated repayment term.
For example, say you take out a $30,000 MCA with a total repayment amount of $39,000 over 12 months. If the provider opts for daily fixed withdrawals, the repayment might be calculated as follows: $39,000 divided by 260 business days (assuming a five-day workweek), resulting in a daily repayment of approximately $150.
Alternatively, for weekly repayments, $39,000 divided by 52 weeks equals about $750 per week. While this method provides consistency, it can strain cash flow during slower periods.
What If You Default on an MCA?
Defaulting on a merchant cash advance happens when you can no longer make your daily or weekly payments. If this happens, the MCA lender can file a lawsuit against you, possibly freeze your personal and/or business bank accounts, or even contact your vendors to try and collect payments directly.
If you think you may struggle with making your MCA payments, it’s best to stay one step ahead and apply for a small business loan to pay off the MCA. You can also contact the MCA lender directly to see if you can negotiate new terms.
Small Business Loan vs. Merchant Cash Advance
Merchant cash advance is the most common term used for such financing, but you may also see MCAs referred to as credit card processing loans, business cash advance loans, merchant loans, or merchant advance loans. Just remember, these aren’t loans. That means they come with little federal oversight and require you, the borrower, to do your due diligence when researching your options.
Traditional small business loans are different from MCAs because they provide merchants with a sum of money, typically for a specific purpose, which is then repaid in regular installments. Small business loans tend to have longer repayment terms and stricter approval requirements than MCAs. Whereas a traditional lender like a bank or online loan provider may look at your credit scores and require collateral, merchant cash advance companies usually do not.
Small business loans come with fixed or variable interest rates, which are applied to the principal balance. Interest rates on small business loans can vary depending on the loan type and borrower but may be lower than the factor rates you’d encounter on a merchant cash advance.
While there may be fees associated with a small business loan, APRs are typically lower than those of MCAs. This means that small business loans tend to be more affordable than merchant cash advances. Examples of lending options that could be workable alternatives to MCAs include:
• Equipment financing
• Invoice factoring
• SBA loans
• Small business loans
• Working capital loans
• Online business loans
4 Common Uses for a Merchant Cash Advance
One of the most common reasons a small business owner would choose a merchant cash advance is to access quick funding for short-term business expenses.
Businesses of any size can use merchant cash advances, but they are particularly helpful for startups with little to no business history, businesses with low or no credit that don’t want to apply for a bad credit business loan, small business owners without collateral, and businesses unable to qualify for loans from traditional lenders.
Here are some of the most common reasons businesses use MCAs.
1. Fill Cash Flow Gaps
If a small business has fluctuating cash flow that prevents it from making bill payments or payroll, a merchant cash advance can act as supplementary funding until cash flow returns.
2. Emergency/Unexpected Expenses
If short-term business loans are not accessible to cover unexpected expenses, small business owners can opt for merchant cash advances that could get them cash within a couple of days.
3. Inventory
Small businesses with consistent credit and debit card sales can use MCAs to purchase inventory and then repay the advance with a percentage of the revenue from inventory sales.
4. Seasonal Fluctuations
Some businesses experience significant revenue variation depending on the season. To ensure there’s always cash on hand, small business owners can get a merchant cash advance to cover expected losses during slow times.
Benefits and Risks of Merchant Cash Advances
Like any source of business financing, a merchant cash advance has advantages and disadvantages. Generally, MCAs are a last resort due to their high cost, but there could be times when it’s the right choice for your business. Let’s look at some of the pros and cons so you can make the best decision for your business.
Pros of Using MCAs
• Quick funding: Unlike a traditional loan, MCAs often provide you with funds in a matter of days.
• Minimal paperwork: Merchant lenders offering cash advances typically require a simple application and only need to see basic financial information about your business, like a record of recent credit card transactions.
• Unsecured: Business owners do not need to offer collateral to obtain a merchant cash advance.
• Payments may change with sales: If the merchant cash advance is based on a percentage of sales, the repayment amount might adjust depending on the success of your business.
• Don’t need perfect credit: If you have low credit scores, haven’t established business credit, or are struggling to get a short- or long-term business loan, a merchant cash advance can help supplement, as it is one of the few no-credit check business funding options.
Cons of Using MCAs
• Expensive: Factor rates are typically 1.1 to 1.5, depending on the terms and conditions of the MCA. When you consider additional fees and APRs possibly in the triple digits, a merchant cash advance can be significantly more costly than a traditional loan.
• No advantage to early repayment: With a merchant cash advance, you typically pay a set amount regardless of how much of the balance you’ve paid off. Merchant cash advances do not amortize like a loan, in which case you could pay less interest when you pay off the balance early.
• Lack of government oversight: Because MCAs are considered commercial transactions, merchant cash advance companies can offer cash advances to those who otherwise may not qualify for a small business loan. However, the lack of specific government regulation can also lead to questionable financing practices and less protection for your business.
• Don’t promote good credit: Merchant cash advance companies are not required to report to credit agencies. If you’re trying to build good business credit, using an MCA is unlikely to help the same way a loan would.
• Hard to get out of debt: If you struggle to get loans, relying on high-APR merchant cash advances has the potential to keep you in a debt cycle that can be hard to get out of.
• Cash flow restriction: While using an MCA can help secure funding in the short term, it could hurt cash flow in the long term. If you agree to give your merchant lender a high percentage of your daily credit/debit card transactions, for example, cash flow may run leaner during the MCA repayment period, especially if your sales are high.
Applying for a Merchant Cash Advance
Merchant cash advance companies make it fairly simple to apply for financing. The process typically involves the following steps:
• Fill out an application: A merchant lender may ask for basic identification like your Social Security number, business tax ID (EIN), and contact information.
• Collect and provide necessary documentation: This can vary depending on the MCA company, but you may need records of credit card transactions, business banking statements, lease agreements, gross revenue, and tax returns.
• Approval: A decision can take as little as 24 hours or a few days, depending on the company.
• Set up credit card processing: Your business may be required to set up credit card processing with a specific partner of the MCA provider.
After you’ve been through the application and approval process, you’ll have funds deposited into your small business account. Payments are typically deducted automatically from this account until the entire merchant cash advance is paid off.
Alternatives to Merchant Cash Advances
Because of their lack of regulation and incredibly high APRs, merchant cash advances are usually considered a last resort. Before taking on an MCA, consider these small business lending options:
Invoice Factoring
Invoice factoring uses unpaid invoices as collateral in exchange for a cash advance from a lender. This is different from an MCA, which is based on projected sales. Invoice factoring also typically has a lower APR than MCAs, generally falling between 15% to 35%.
Inventory Financing
Inventory financing is an asset-based loan provided to pay for products that will be sold at some time in the future. The inventory acts as collateral for the loan.
Equipment Financing
Equipment financing is a secured loan to purchase machinery, vehicles, or other business-related equipment.
Recommended: Leasing vs. Purchasing Equipment for Businesses
SBA Loans
SBA loans are backed by the U.S. Small Business Administration (SBA) and offered by banks and other approved lenders. They typically come with competitive rates and terms, but the approval process is lengthier than it is for other small business financing options.
Personal Loans
Personal loans are typically unsecured and based on your personal credit history (not business credit) and income. Personal loans can be used for almost any purpose, including business expenses.
Commercial Real Estate Loans
Commercial real estate loans provide funds to purchase business-related real estate, such as an office space or retail shop.
Business Credit Cards
Like a business line of credit, business credit cards can be used for short-term business needs. Business credit cards use a revolving line of credit, with interest charged only on unpaid balances from previous billing cycles.
Online Small Business Loans
Some online business lenders offer similar loan options as a traditional bank. They typically have a faster approval process and may offer more options (albeit usually at higher interest rates) for people with lower credit scores.
Business Lines of Credit
Business lines of credit are a flexible, revolving form of financing that allows you to use the funds as you need them, pay them back, and use them again. Interest is only charged on the amount you borrow.
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FAQ
What is a merchant cash advance?
A merchant cash advance (MCA) provides a lump sum to a business in exchange for a percentage of future sales or fixed daily or weekly withdrawals.
How much is a merchant cash advance fee?
MCA fees, typically represented by a factor rate, can range from 1.1 to 1.5 times the advance amount, depending on the provider and risk assessment.
What is the difference between an MCA and a loan?
An MCA is repaid through a percentage of daily sales or fixed payments, offering flexibility, whereas a loan requires fixed monthly payments with interest, regardless of business revenue fluctuations.
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