Introduction
Merchant cash advances are a form of funding that has become much more popular among small companies particularly those with limited means to get traditional loans This source of funds offers immediate access to capital which can be vital to companies with cash flow issues or other pressing operational requirements The fundamental form of a merchant cash advance or MCA is unlike a standard loan Rather than lending capital with a specified interest rate and stipulated repayment schedule an MCA supplier advances a pool of money to a company in return for a share of its forthcoming sales typically from credit and debit card purchases
This type of financing is meant to be quick flexible and available which makes it attractive to small business owners who cannot secure bank loans because of bad credit insufficient collateral or short business history The qualification process for merchant cash advances tends to be less stringent than the usual financing and companies can get money in a few days This urgency tends to be one of the most attractive aspects of MCAs but also adds to the risks involved that borrowers need to be cautious about
How Merchant Cash Advances Work
In order to better know why merchant cash advances are dangerous first one must understand how they work When a company submits an application for an MCA the lender considers its average monthly credit card sales or total daily revenue After approval the lender disburses a lump sum which is usually a fraction of the companys average monthly sales Repayment is not made in the form of periodic fixed payments Instead the lender takes a fraction of the companys daily or weekly sales until the advance is fully repaid
This percentage termed as the retrieval rate typically will fall in a range of five to twenty percent and will automatically be drawn off from the merchant account of a business or deposited into a bank on a daily basis The total to be reimbursed is made up of the original advance coupled with a certain fee that depends on a factor rate For example if a company receives an advance of twenty thousand dollars using a factor rate of one point four then it will be required to reimburse twenty eight thousand dollars whether or not they ever make this payment
Unlike interest-bearing loans the factor rate is paid only once and is not based on time This implies that even if the advance is settled within a couple of months the amount owed does not change As such the effective annual percentage rate or APR of an MCA can be very high in certain instances more than one hundred percent
Reasons Businesses Turn to Merchant Cash Advances
Most business owners resort to merchant cash advances due to the perceived advantages of speed and convenience Bank or credit union traditional loan applications may take weeks or months to process and usually involve a lot of documentation collateral and a good credit history For businesses with an immediate cash deficiency such as paying payroll buying inventory or covering an unforeseen expense an MCA can provide a near-instant solution
Yet another reason companies get attracted to MCAs is because of the repay flexibility Since it is calculated against a percentage of daily sales amount repaid varies as per business cash flow flow This is a very attractive point for businesses who have revenue shifts during seasonal intervals like restaurants, retail outlets and service-based enterprises In slower revenue months payment terms are reduced hence the burden decreases
Also merchant cash advances are usually unsecured that is the business is not required to pledge assets as collateral This makes it less risky to lose precious property in case of default Though this might appear to be a positive aspect the absence of collateral usually means that the borrower will have to pay more since the lender is remunerating the higher risk
The Exorbitant Fees Involved with Merchant Cash Advances
One of the biggest dangers of merchant cash advances is the exorbitant size of the cost involved in this type of funding Unlike traditional loans that are controlled and do contain required clear APR disclosure MCAs are technically not loans This permits lenders to express costs in forms that seem more beneficial upon approval at first glance but create very high effective interest rates when computed over a period of time
The application of factor rates can be deceptive to borrowers who might not realize the actual cost of the advance For instance a factor rate of one point five may not raise alarm until it is realized that it is a fifty percent increase on the initial amount received Since the repayment time is usually short often less than a year the effective APR can shoot well into triple digits
This excessive cost can lead to a cycle of dependency for certain companies Finding it difficult to cope with day to day activities while paying back a large amount of daily income can result in cash shortages and more borrowing To survive some companies end up borrowing more MCAs to settle earlier debts a situation that is similar to a debt trap
The Absence of Regulation and Consumer Protections
Another concern in merchant cash advances is the restricted regulation in the area Unlike credit unions and banks that are governed by federal and state regulations MCA providers fall under a partially unregulated situation This absence of regulation implies that providers do not have to give terms in a uniform way such that business owners cannot compare rates or know the complete financial aspects of an advance
Additionally since MCAs are facilitated as acquisitions of future receivables and not loans they escape conventional lending statutes This difference excludes them from usury statutes that limit the rate of interest and from truth-in-lending rules that require plain disclosure of terms
This legal loophole can expose borrowers to predatory abuse and confusing contracts Some MCA contracts have confessions of judgment clauses that enable lenders to get a judicial judgment against borrowers without a trial in the event they fail to meet the terms of the contract This can lead to instant asset confiscation or bank account garnishment with minimal notice or relief for the business
Cash Flow and Business Operations Impact
The weekly or daily payment structure of merchant cash advances can put a substantial burden on a businesss cash flow While monthly payments on a loan provide some cushioning between transactions MCA payments are pulled right out of daily revenue As a result, all sales made by a business go towards paying back the advance ahead of paying operational costs
This constant outflow of funds can hinder the businesss ability to invest in growth initiatives pay staff or manage unexpected costs For businesses that experience seasonal or inconsistent sales the rigid repayment structure can be especially challenging During low revenue periods the fixed percentage still applies reducing the cash available for other critical needs
With time this financial stress can create a vicious cycle whereby the company must reduce expenses hold back payments to suppliers or even explore other sources of financing which can further add to the situation The short term relief of ready funds can easily turn into long term financial duress
Possible Legal and Credit Impacts
Even though merchant cash advances are sold as not impacting a businesss credit score this is not always so While most MCA providers do not report to credit bureaus a default on an MCA can still result in collections lawsuits and other legal proceedings that ultimately affect the creditworthiness of the business and possibly the owner personally depending on the agreement terms
In addition because most MCA agreements contain personal guarantees the business owner could be held personally responsible for repayment even if the business does not survive This puts personal assets at risk and introduces yet another stressor for owners already struggling with operational and financial issues
The legal issues of MCAs can get out of hand fast If a company misses payments the lender can record a confession of judgment or start lawsuits to retrieve the money This can lead to frozen bank accounts property liens or even closure of the business if it fails to satisfy the monetary requirements
Alternatives to Merchant Cash Advances
Since merchant cash advances come with risks business owners need to look for alternative options of financing that can provide better terms Traditional business loans though slower to process tend to have lower interest rates and more defined repayment methods For well-established businesses with good credit histories this is a much cheaper route to funding
Lines of credit are another choice that enables businesses to draw on funds as they go and pay interest only on the amount that is utilized These can be very helpful for covering short term cash flow shortfalls without paying the excessive fees of MCAs
Invoice factoring and equipment financing can also be alternatives to businesses with particular requirements Invoice factoring gives businesses cash immediately against outstanding invoices while equipment financing enables businesses to acquire equipment needed via reasonable installment payments
Peer to peer lending and crowdfunding grants are also options that should be considered based on the nature of the business and objectives Every one of these will have certain requirements and benefits but many have lower costs and more transparency than merchant cash advances
Teaching Business Owners Financial Literacy
One of the root causes of the dangers of merchant cash advances is the absence of financial savvy among small business owners Too many entrepreneurs concentrate on the day-to-day operation of their company and lack the training or access to funds necessary to properly scrutinize sophisticated financial instruments Because of this they can be susceptible to making choices based on short term exigencies instead of long term viability
Enhancing access to financial education has the ability to enable business owners to make more discerning decisions about financing opportunities Having knowledge of the real cost of financing knowing how to assess proposals and the potential legal implications of varying agreements is vital to ensuring financial wellness
Organizations that assist small businesses like chambers of commerce small business development centers and nonprofit financial counseling services may hold a vital role in filling this gap By providing resources mentorship and workshops these organizations can assist entrepreneurs in becoming more confident in navigating the financial arena
