Introduction
Merchant cash advances represent a type of alternative business capital that provides business owners the option to gain an influx of funds upfront for an agreed-upon percentage of future credit card revenue or overall profit. Traditional merchant cash advances unlike loans are not subject to having a set rate of interest charged per month or over any determined time. Instead, repayment is set according to daily or weekly deduction relying on the revenues of the company, thereby attracting those firms whose sales are significantly dependent on credit cards but cannot readily get the normal loan
This funding option initially picked up popularity during the early 2000s when small businesses were finding it increasingly hard to qualify for the tight lending standards of banks after economic recessions and financial legislations. Consequently merchant cash advances turned out to be a go to option for immediate access to money. This funding option has particularly been popular with retail restaurants e commerce and service oriented companies that deal with frequent credit card transactions
How Merchant Cash Advances Work
The basic structure of a merchant cash advance is fairly straightforward. A business applies for an advance from a provider. If approved the business receives a lump sum payment which is typically less than the total amount that will be repaid. The repayment typically is made using one of two options either as a percentage of daily credit card receipts or daily debit from a business bank account also referred to as Automated Clearing House withdrawals
The company repays until the entire amount due including the original advance and the fee charged by the provider typically denoted as a factor rate has been paid. Factor rates are commonly between 1.1 and 1.5 i.e., if a company is given an advance of 10000 dollars at a factor rate of 1.4 it will be required to pay back 14000 dollars throughout the duration of the advance
This model is attractive to businesses due to the quickness and ease of the approval process. Several merchant cash advance companies can approve an application in a day and transfer cash between 24-48 hours and hence prove to be extremely attractive to businesses that have immediate working capital needs
The Advantages That Attract Small Businesses
One of the most appealing aspects of merchant cash advances is the quick funding process. Conventional bank loans may take weeks or even months to be approved with extensive financial documentation and credit checks. Merchant cash advance providers, on the other hand, usually need little paperwork and are more concerned with sales performance especially credit card sales than credit score or collateral
Also the repayment cycle is adjustable to a degree. Due to payment being made on a percentage of daily or weekly turnover, companies repay more in good sales seasons and less in bad seasons. This serves to ease the financial burden on companies that have seasonal fluctuations or irregular cash flow
Merchant cash advances also provide a solution for businesses rejected by conventional lenders. For business entities with bad credit histories lack of collateral or brief operating history merchant cash advances can be the sole available financing option
The Hidden Costs of Fast Funding
While attractive and easily available quick finance merchant cash advances usually involve some heavy risks and negatives especially relating to expense. Among the primary concerns is total amount of repayment. Although a notion of factor rate may look easy in application it leads to real annual percentage rates that end up being greatly high at times above 100 percent or higher
This expensive cost of capital can take a big toll on a business’s cash flow particularly when daily or weekly payments accumulate. With regular loans, interest is simply compounded over time and the balances can be prepaid early in order to avoid paying interest merchant cash advance contracts generally demand payment of the contracted amount in full regardless of the speed the balance is reduced
Additionally merchant cash advance contracts can be opaque. Conditions and terms can be intricate and confusing causing some business owners to sign contracts without fully comprehending the long-term financial consequences. This industry lack of standardization makes it simple for predatory lenders to exploit desperate or ignorant business owners
The Effect on Cash Flow and Operations
Regular daily or weekly deductions from a business’s revenue can be a major burden on operations particularly if sales go down. Because the repayment is automatic and takes precedence it can cause businesses to struggle with fulfilling other financial commitments like payroll rent inventory purchases and utility bills. Over time this can create a vicious cycle where the business must take on additional advances just to cover basic expenses leading to a debt trap that is difficult to escape
This cycle of debt is aggravated when companies resort to stacking which is borrowing a series of merchant cash advances simultaneously or in close proximity. Although this may grant short-term relief it creates overlapping payment liabilities that continue to deplete the business’s cash flow. Most businesses who practice stacking end up struggling to cope with daily debits and cannot function efficiently
Legal and Regulatory Issues
Merchant cash advances are in a regulatory limbo. Because they are not technically loans, they are not held to the same standards and laws as traditional lenders. This means that they are not subject to usury laws which cap the amount of interest that can be levied. Because of this, some providers are resorting to aggressive collection practices and deceptive contract wording to trap companies in high-cost repayment schemes
The legal uncertainty encompassing merchant cash advances also complicates matters for businesses seeking to have claims or recourse in the event of a dispute. While several states and federal agencies have started examining the industry and implementing regulatory steps there is still significant inconsistency in the way merchant cash advances are regulated
A number of recent legal cases and lawsuits have highlighted the predatory tactics of some providers. But without regular regulation, many of the dubious tactics continue and unsuspecting business owners are still at risk of financial injury
Alternatives to Merchant Cash Advances
Due to the dangers and excessive prices of merchant cash advances most professionals advise businesses to seek alternative financing before they sign up for an advance. A number of alternatives have more advantageous terms and less expense depending on the business’s needs and qualifications
Conventional bank loans remain an option for solidly credit businesses and a clean financial record. Although the process of applying can be slower, these loans tend to have lower interest rates and longer repayment terms
Lines of credit are yet another flexible facility option that enables business to borrow what they need, repay what they borrow, and reuse it for future draws. This facility of financing is particularly beneficial to tackle cash flow highs and lows as well as short-term operational demands
Invoice finance can prove very suitable for business that face high payment periods by customers. This facility enables the business to unlock cash tied within unpaid invoices to enhance liquidity without incurring fresh debt
Small Business Administration loans are also available at good terms and government support and hence are a good alternative option for qualifying businesses. They are longer to process but tend to offer substantial financing at reduced rates compared to merchant cash advances
Crowdfunding and peer-to-peer lending sites have also become attractive choices for companies looking for nonconventional financing. These sites allow companies to link directly with individual investors who typically provide more favorable rates and terms than merchant cash advance lenders
Questions to Ask Before Accepting a Merchant Cash Advance
Prior to entering into a merchant cash advance agreement business owners should thoroughly review the terms and conditions of the transaction. Some of the most important questions to ask are the total amount to be repaid the factor rate the amount to be repaid daily or weekly and how it will affect overall cash flow
It is also essential to know if there are any charges for early repayment and how the provider treats overdue or missed payments. Providers might charge fees or modify repayment terms in ways that cost the business further
Business owners must also inquire if the provider needs access to their bank account and to what extent and type of monitoring or control the provider will exert over their business operations. The information is necessary to know the impact of the advance on routine business activities.
Seeking advice from a financial consultant or lawyer prior to signing the agreement will ensure that the terms are understandable and manageable. Professionals can offer advice on whether the merchant cash advance is indeed the most suitable option or if other financing would be more appropriate
Best Practices for Managing Merchant Cash Advances
If a company decides to proceed with a merchant cash advance there are a number of best practices that can assist in reducing risks and controlling the repayment process more effectively. Firstly it is imperative to have proper and current financial records. This will ensure that cash flow is tracked repayments deducted and discrepancies detected early
Second businesses need to allocate emergency funds or reserves to assist with repayment in lean revenue times. This can help minimize the chances of default and the necessity of further advances
Third open and continuous communication with the merchant cash advance provider is essential. In case the business is facing financial challenges or foresees difficulties in meeting repayment terms it is advisable to proactively approach the provider instead of falling behind
Lastly business owners ought to regularly review their financing requirements and seek refinancing or consolidation options for existing advances into better terms. This strategy can minimize overall costs and free up cash flow for other areas
The Bottom Line for Business Owners
Merchant cash advances can be a lifeline for companies with an immediate need for capital especially those with little access to traditional credit. But the convenience and rapid funding frequently come at an expensive price and include serious risks. Entrepreneurs have to balance the advantages against the prospect of long-term financial stress cash flow interruption and legal issues
It is essential for every company that is contemplating a merchant cash advance to do proper due diligence read the small print and take the advice of professionals. If the real cost and the ramifications of this form of funding are known, then business owners will be able to make more-educated choices that benefit the long term health and viability of their business
