There are many ways to get a business loan if your company is struggling with cash flow or needs working capital to grow. Popular options range from asking friends and family for support to working with the SBA to get a small business loan. But one of the least understood and utilized financing options is the merchant cash advance (MCA). In this article, we’ll look at everything you need to know about using credit card sales (even future credit card sales) to get loans.
What is a Merchant Cash Advance?
First off, you may be wondering, what is a merchant cash advance. Many small business owners will be unfamiliar with the term, while others may have heard horror stories about these “loans gone wrong.”
In reality, a merchant cash advance isn’t a loan at all. Instead, it’s a type of business financing that provides access to business funding based on future sales or receivables. When you purchase a merchant cash advance, you are selling future credit card sales to the organization that provides your funding. Because they are not loans, they are not regulated and available for companies that don’t qualify for traditional bank loans because of bad credit (both business and personal credit scores).
MCAs have been around since the 1990s and saw a boom during the 2008 financial crisis as many traditional lenders began restricting their lending, with the result that small businesses and startups began looking elsewhere for working capital. Today, Merchant Cash Advance providers generate five to ten billion dollars in revenue annually.
What does this look like in practice? Let’s say a small business owner needs to buy a new $5,000 3D Printer in order to keep up with demand for the widgets they are selling. Due to a pandemic-driven increase in sales, they have a massive backlog, but their old printer is broken beyond repair, and if customers start requesting refunds due to a long wait, the business will go under. After exploring traditional loan options and realizing that it would take 1-6 months to receive funding, they explore a merchant cash advance. This option would provide them with the cash up front in a lump sum, and repayment would be based on every future credit card transaction processed until the advance is paid off.
You can already see the main way an MCA is different than a traditional small business loan. There is no mention of a fixed repayment term. Instead, a percentage of daily credit card sales will go directly towards repaying the advance. If the company processes thousands of credit card transactions per day, the advance may be paid back quickly. But if sales flag, and only a few transactions are processed per day, the advance will take longer to repay.
If this sounds too good to be true, that’s because it is. Merchant Cash Advances are not a license to print cash. Loans from the Small Business Administration (SBA) have rates as low as 5.5% in November of 2021, but an MCA equivalent can be as high as 40-350%! Technically, since MCAs aren’t loans, we aren’t talking about interest rates. Instead, the phrase to use is “factor rate.” When you take advantage of an MCA, your repayment will be based on a factor rate typically ranging from 1.2 to 1.5. So, if the above business received a $5,000 MCA at a 1.2 factor rate, they would have to pay back $6,000 ($5,000x 1.2). If their MCA was at a 1.5 factor rate, they would owe $7,500.
How does that compare to an SBA loan? Well, right now SBA loans under $25,000 have an interest rate of 7.5% if the loan is paid off in less than 7 years (the rate increases to 8% if the repayment will occur over 8+ years). That means you would have 7 years to pay off just over $6,400 at current rates, which is the equivalent of a 1.228 factor rate.
But that’s only one piece of the equation. The factor rate gives you the total amount owed, but there’s another number you should pay attention to. And that’s the percentage of sales that will be deducted. This is often called the “holdback” or “retrieval rate” and frequently ranges from 5-20%.
As with any type of business financing, it is important that you recognize positive ROI from the transaction after all the costs are paid for. For MCAs, you must take into account both the factor rate and the holdback. Remember, an MCA means that instead of all the money from sales going into your bank account each business day, a portion will be going to the MCA provider.
Pros and Cons of a Merchant Cash Advance
If after reading all this you’re still contemplating a merchant cash advance, here are a few pros and cons that can help you decide:
Unlike loans from traditional lenders, where borrowers must wait 1-6 months to get a decision, with an MCA, you can often get a decision in a week or so. This means that if you need cash fast to take advantage of an opportunity, an MCA might be right for you.
MCAs are unsecured
With a traditional loan, you will frequently have to put up collateral that might include business or even personal assets. With an MCA, however, you typically won’t have to put up collateral since you made the purchase with your future sales. Of course, you should always carefully read any agreement before you sign to make sure you understand what you are agreeing to.
MCAs are available to companies with bad credit
Businesses with bad credit history often struggle to get traditional loans, but creditworthiness isn’t an issue with merchant cash advances since repayment is automatic. As a result, MCAs can be attractive as a last resort option for struggling owners with significant cash flow problems or business needs.
High effective interest rates
While MCA providers don’t require a personal guarantee for your financing (or a good credit score), they find other ways to make money. A high factor rate may not make the total loan amount seem that much different than a traditional loan. But the daily, weekly, or monthly cost may be much higher since repayment is based on your sales. In other words, your effective interest rate may be much higher than a traditional loan.
No deferred payments
With a traditional loan, you may be able to defer a payment if you run into unforeseen circumstances. But if you default on payment for an MCA, it may put you in breach of contract and lead to a lawsuit. While some MCAs are based on actual sales, so you pay when transactions occur, others are based on projected sales, with the result that you have to pay regardless of whether or not your credit card receipts match up with expectations. This can exacerbate your cash flow problems rather than solving them. As such, this type of agreement should be examined with the greatest scrutiny before accepting.
So, if the MCA isn’t right for you, what is an alternative? Let’s look at other types of small business financing.
Alternatives to Merchant Cash Advances
Small Business Loans
There was a time when getting a small business loan meant jumping through a lot of hoops and navigating red tape (this is what led to the creation of MCAs in the first place). But today, there are multiple options for companies that need financing, even companies with less than stellar credit. These range from loans for equipment and real estate to inventory and bridge loans. You can read more about all the various loan types here, but one in particular that we’ll dig into is the microloan.
Microloans are small, government-backed loans of up to $50,000 that can be used for starting or expanding a business. Uses include:
- Working capital
However, you can’t use a microloan for real estate purchases or to pay down debt.
Because these microloans are backed by the Small Business Administration (SBA), you can expect a lower-than-average interest rate, when compared with non-SBA loans or MCAs. Of note, microloans are not granted by the SBA. Instead, the SBA works with banks and online lenders who provide the actual loans, while the SBA acts as a guarantor should your business fail to meet the required payments. This makes the loan safer for the lenders, hence the lower interest rates. SBA microloans have a maximum term of six years.
Business Credit Card
Another alternative to an MCA is a business credit card. If you are running a small business already, chances are you regularly receive invitations to apply for one of these cards in the mail. If you don’t already have a dedicated card for your business, I strongly recommend getting one, for no other reason than to clearly delineate between your business and personal finances. This will make tax season much easier and help prevent accounting errors. Other advantages include building your business credit so you can take out business loans with lower rates in the future, as well as better rewards and perks. For example, many business cards offer discounts or money back on business-related purchases, and when you’re still getting started, every dollar counts.
A word of caution, however: Business credit cards come with a high interest rate (just like personal credit cards), and if you fail to make payments, it can have a negative effect on your credit score, so make sure you think twice before carrying a balance month to month.
Business Line of Credit
Another alternative to an MCA is a business line of credit. Like other types of funding, a business line of credit provides access to needed capital. But instead of giving you a lump sum up front, the lending institution will qualify you for a maximum line of credit that you can draw against as needed. You can think of it as similar to a debit card: If you have $50,000 in your bank account, you can withdraw up to that amount as needed. In the same way, if you have a $50,000 line of credit, you can access up to that amount of funding. Unlike a loan, with a business line of credit, you only pay interest on the cash you use. So even if you qualify for a $50,000 line of credit, if you only access $10,000 of it, you would only pay interest on the funds you withdrew.
If your business needs access to cash, there are plenty of ways to get it. When evaluating your options, whether a merchant cash advance, a microloan, or a business line of credit, make sure you understand what your business needs are, and that the solution you engage in will ultimately allow you to create a positive return on investment.