Introduction
Merchant Cash Advances, or MCAs, have emerged as the trendy alternative financing solution for small companies. As opposed to traditional loans, which come with fixed repayment schedules, MCAs give entrepreneurs rapid access to funds tied to their upcoming sales. Though this may seem like an attractive option for businesses requiring immediate cash, there are some caveats that should be taken into consideration carefully. Knowing how MCAs operate, their advantages, and disadvantages is essential for entrepreneurs seeking financing.
What is a Merchant Cash Advance?
A Merchant Cash Advance is essentially a type of business financing that gives a business an upfront lump sum of money. Repayment of the cash advance is not done in the conventional loan manner. Rather, the business commits to repaying the MCA by permitting the lender to collect a portion of the business’s daily credit card sales or a set daily or weekly withdrawal from their bank account. This repayment structure is often referred to as a “holdback” and is usually a percentage of the business’s daily sales, small in nature. The higher the sales the business generates, the quicker it will repay the MCA.
In contrast to traditional loans, MCAs do not need specific collateral, so they become available to businesses which may not be eligible for a bank loan because of low credit ratings, lack of assets, or other factors. The repayment schedule is not fixed, but it depends on the sales of the business. Businesses with increased sales can repay the advance faster.
The Allure of Merchant Cash Advances
The greatest advantage of MCAs is the quickness with which they advance funds. Bank loans can take weeks or even months to approve and disburse. On the other hand, an MCA can be approved and funded within a matter of days, which makes it a great choice for companies that require immediate cash. This quick funding can be utilized for a variety of reasons such as buying inventory, paying payroll, or expanding business.
Additionally, companies that may not possess the ideal credit record or high collateral to back a loan find MCAs more within reach. Since repayment is based on sales, companies with irregular income are able to more easily afford repayment than they would with a monthly fixed loan payment.
For companies with unpredictable cash flows, the variable repayment terms of MCAs are highly appealing. Rather than being tied to inflexible repayment schedules, companies can modify their repayment levels according to their immediate sales volume. This is a great way for business owners to avoid the anxiety of failing to make a payment or being behind on their loans when times are slow.
How Merchant Cash Advances Work
Obtaining an MCA is a fairly easy process compared to other business loans. First, the business will submit an application with a lender or MCA provider. The lender will generally review the business’s sales history, mostly reviewing daily credit card sales or bank deposits, as the repayment mechanism is based on these sales amounts. Most MCA providers do not conduct a hard credit inquiry, and thus the application process is easier and quicker for firms with poor credit.
After approval, the company gets a lump sum payment ranging from a few thousand dollars to several hundred thousand dollars, depending on the company’s volume of sales and the provider’s requirements. The company then needs to repay the advance in the form of daily or weekly deduction from their sales or bank account. The repayment percentage is usually 5 to 20 percent of daily sales.
One of the most characteristic things about MCAs is that there is no repayment schedule. The amount to be repaid depends on the sales of the business. When sales are high, the business will repay the MCA sooner. When sales are slow, the repayments will be lower, offering some breathing space to the business. For this reason, most small business owners view MCAs as a flexible form of finance.
The Risks Involved in Merchant Cash Advances
While Merchant Cash Advances can offer quick and easy access to funds, they also come with significant risks that business owners need to be aware of. The most notable risk is the high cost of borrowing. The interest rates and fees associated with MCAs are typically much higher than those of traditional business loans, which can make repayment difficult for businesses in the long run.
The cost of an MCA is typically represented as a factor rate, which is a multiplier that calculates the total amount that the business will be required to repay. Factor rates are usually between 1.1 and 1.5, so for each dollar borrowed, the business would actually repay $1.10 to $1.50. While this might seem possible at first, the steep price of repayment will quickly accumulate, particularly for companies that use MCAs for more than one round of funding.
The factor rate might complicate companies’ ability to know precisely the amount they would eventually pay. Since the repayment is based on sales, businesses cannot determine with certainty the full repayment amount. Such uncertainty makes it challenging for business owners who attempt to calculate their finances.
Burden of Accelerated Repayment
Another attribute of an MCA is that it has a speedy repayment profile. Yet this can also be a significant disadvantage for companies that have seasonal variations or other inconsistencies in their sales. Since repayments are based on daily sales, a company can find itself in a position where it is unable to make its repayments during slow periods. In certain situations, companies can even get into a vicious cycle of borrowing more money to pay off current debt, resulting in a constant financial struggle.
In cases where sales are significantly lower than expected, the percentage taken by the MCA provider can be a financial strain, leaving the business with insufficient funds to cover operating costs or other obligations. For businesses that depend on consistent cash flow, this can create serious financial instability.
Hidden Fees and Terms
Most MCA providers promote their products with favorable terms and simple approval. The fine print, however, usually shows additional charges that make the advance costly. These concealed charges may include application fees, origination fees, and administration charges that sum up fast and make the MCA’s total cost much more than initially expected.
Another issue with MCAs is the transparency lacking in the factor rate and terms of repayment. While the factor rate might appear to be reasonable at first sight, business owners need to know how it operates and how much they will repay. Some MCA providers employ coercive sales tactics to make the products look cheaper than they actually are, and hence business owners sign agreements without knowing what they have committed to.
The Effect on Business Cash Flow
Merchant Cash Advances can greatly affect the cash flow of a business. Since the repayment is based on daily or weekly sales, the cash flow of the business will be directly influenced by the repayments. Companies with high daily sales can manage their repayments, but companies with low or inconsistent sales will find it difficult to keep up with the regular deductions. This can result in a scenario where the company is perpetually struggling to make up for payments, and hence experience cash flow issues and possible financial distress.
In some cases, businesses may have to take out additional MCAs to cover their existing debt, leading to a cycle of borrowing that can be difficult to escape. This cycle can leave business owners trapped in a never-ending cycle of debt, with little hope of ever achieving financial stability.
The Risk of Default
If a company cannot maintain its MCA repayments, the lender may initiate legal action against the company. Though MCAs do not involve conventional collateral, certain MCA providers offer conditions within the agreement that grant them the authority to take possession of the company’s assets should the company fail to repay the loan. This includes gaining control over the company’s bank accounts or even filing legal proceedings to reclaim the debt.
For cash-strapped small businesses, the threat of default can be a major issue. Defaulting on an MCA can not only hurt the financial well-being of the business but also hurt its reputation, making it harder to obtain financing in the future. This can lead to a vicious cycle that is hard to escape.
Alternatives to Merchant Cash Advances
Although MCAs might be an easy way to deal with cash flow issues, business owners do have a number of other options they can turn to before opting for this kind of financing. Bank loans, credit lines, and Small Business Administration loans tend to have better terms and lower interest rates than MCAs. They are longer to obtain, but they can offer more stable and cost-effective financing in the long run.
Business owners must also consider other types of alternative financing, including invoice factoring, equipment financing, or crowdfunding. These alternatives offer funding without the exorbitant costs and risks of MCAs.
Conclusion
Merchant Cash Advances can be a source of immediate access to capital for businesses that need quick cash. Yet the high expense, concealed fees, and risk involved in MCAs make them a potentially hazardous choice for business owners. It is essential for the owners of the business to wisely evaluate their funds, the condition of the contract, and whether it will reflect on their money flow before looking into an MCA. Alternatively, business owners can look for other financing models and study MCAs extensively before making a judgment.
