Introduction
In small business financing, there are plenty of options for owners of businesses who require rapid access to capital. One of the more recent popular options is the Merchant Cash Advance (MCA). Merchant Cash Advances offer a seemingly simple means by which businesses can obtain funds without the complicated approval procedures associated with traditional loans. Yet, while they may look appealing because they are so quick to fund and have fewer barriers to entry, they have great risks associated with them that may outweigh the advantages. In this article, we will analyze what Merchant Cash Advances are, how they function, and why they are dangerous for small business owners even though they are easily and quickly available.
What is a Merchant Cash Advance?
A Merchant Cash Advance is a form of financing in which a company is paid a lump sum of money up front in return for a percentage of future credit card sales or daily bank deposits. This implies that companies do not have to undergo the usual loan application process, which involves credit checks and extensive paperwork. Rather, MCAs are founded on the amount of transactions a company makes through credit card payments and thus are very attractive for companies with high sales but maybe not an impeccable credit score. It is an easy process: the owner of the business is offered the terms of the MCA, often a factor rate that will dictate the amount that the business will pay back in total. Payment is then taken on a daily or weekly basis from credit card sales or bank deposits of the business. Because the amount of repayment is based on the business’s sales, this is an adaptable one for when sales change.
How Does a Merchant Cash Advance Work?
Knowing how an MCA works is key to understanding its potential advantages and disadvantages.
When a company applies for an MCA, they are basically selling some of their future credit card transactions or bank deposits. This implies the lender gives the company a sum of money as a lump payment, and as a repayment, the company repays the money in installments over time from a percentage of the daily or weekly sales. The factor amount the company will repay is decided based on the factor rate, which can be many times the interest rates for standard loans. For instance, if a company gets an MCA of $50,000 and the factor rate is charged at 1.3, the company would repay $65,000. The payments are not static but vary with the sales, implying that the quicker a company gets sales, the quicker it pays back the advance. If sales are slow, the company would pay smaller amounts.
The repayment structure is among the major aspects that make MCA so attractive to businesses whose cash flows are irregular. In months where sales are high, the company can settle its MCA in a short while, but during slow months, the repayment term lowers to match the reduced sales, which helps the company survive more comfortably.
Quick Access to Capital: The Seductive Charm
One of the most appealing aspects of an MCA is how quickly business owners can obtain the funds they require. Conventional loans take months of paperwork, a thorough examination of a business’s financial condition, and several approval rounds. For small business owners who require quick funds to pay bills, capitalize on an opportunity, or fill a cash flow shortfall, the Merchant Cash Advance offers a much quicker option.
In most instances, companies can access the money from an MCA within a few days, or even 24 hours. This is a far cry from traditional loans that take weeks or even months to approve. Because of this, companies that require immediate capital can avoid the lengthy and often tedious processes of obtaining traditional loans, placing them at a huge advantage in a competitive marketplace.
No Collateral Required
Unlike traditional loans that often require collateral, an MCA does not require the business owner to put up personal or business assets as security. This can be a major benefit for businesses that do not have significant physical assets to use as collateral. In this sense, an MCA offers a level of flexibility that other financing options might not.
But even though there is no collateral involved, the lender still has a claim on the future business revenues. If the business defaults on the repayment of the advance, the lender can sue the business owner, which can result in dire consequences for the business owner.
The Risky Nature of Merchant Cash Advances
Though the flexibility and velocity of an MCA may sound attractive, understand that this financing is fraught with risks. The following are some of the principal reasons why an MCA might be a risk for small business owners:
High Factor Rates and Total Repayment Costs
The greatest danger of Merchant Cash Advances is the expense. Even though MCAs are usually advertised as an effortless and speedy source of capital, they have factor rates that are very high. Factor rates, which dictate the amount a business must pay above what it borrows, vary from 1.1 to 1.5 or even more, based on the lender and the condition of the business.
For instance, if a company takes a loan of $50,000 at a factor rate of 1.4, the amount to be repaid can be as much as $70,000, which means the company has to repay $20,000 more than what it borrowed initially. Compared to conventional loans, where interest rates tend to be lower and the amount to be repaid is certain, the factor rates of MCAs can result in significantly higher overall expenses.
The large repayment figures of MCAs can rapidly become burdensome for companies, particularly if they fail to realize the anticipated revenue growth to accommodate the repayments. Consequently, company owners can end up in a vicious borrowing cycle to reimburse earlier advances, and thus find themselves in a “debt spiral.”
Daily or Weekly Repayments
Another MCA risk is the repayment schedule. In contrast to conventional loans, which are normally repaid monthly, MCAs are paid back daily or weekly as a percentage of sales. This poses considerable cash flow problems for businesses since they will struggle to sustain consistent cash flow and at the same time pay back daily or weekly.
For companies whose sales are subject to fluctuations, the weekly or daily repayment strategy may prove to be difficult. When there are low sales months, the company can fail to meet repayment obligations, and this will be financially burdensome. Moreover, the constant repayments will deplete the company’s working capital very fast, and it will find it hard to cover other running costs like payroll or inventory.
Lack of Regulation
The MCA industry is not heavily regulated, so the owner of a business is not always sure about the terms of the agreement into which they are entering.
Though the industry has expanded quickly, not many regulations exist to offer protection to the owner of a business from predatory lending practices. This can result in businesses losing out on the true costs and obligations of the MCA until after they have committed themselves to repaying the advance. There are some lenders who practice unscrupulous behavior, including charging concealed fees, providing unrealistic repayment schedules, or employing coercive collection methods if payments are not made. In these situations, companies can end up in legal battles or financial bankruptcy because of the absence of regulation in the MCA market.
Potential for Debt Spiral
As stated earlier, one of the most risky elements of Merchant Cash Advances is that there is a danger of falling into debt trap. Because of the high payback amounts and the weekly or daily payback format, companies might struggle to make their repayments. In case a company gets behind in its repayments, it will be forced to obtain another MCA to settle the outstanding debt, which just creates more trouble.
This cycle of repayments and borrowings can soon become a cycle of debt entrapment. Entrepreneurs could find themselves always borrowing in order to repay earlier advances, and this can result in mounting levels of debt, which in turn can imperil the financial soundness of the business.
Impact on Credit
Even though MCAs do not need a credit check, they can become detrimental to a business’s credit in the long term.
The lender might report the payment history to credit bureaus, and in case the business fails to comply with its payments, it could lead to an injured credit score. This may make it harder for the business to obtain financing in the future, either from conventional lenders or other alternative funding sources. ### Alternatives to Merchant Cash Advances
Since MCAs carry risks, entrepreneurs should opt for other funding sources before opting for this funding. Some of the alternatives include the use of traditional bank loans, Small Business Administration (SBA) loans, or other business finances such as lines of credit or invoice factoring.
Each of these options has its own advantages and disadvantages, but they might have more predictable terms and lower fees than a Merchant Cash Advance. And by using a financial advisor or considering several financing alternatives, business owners can be assured that they are making a well-informed choice regarding their funding requirements.
Conclusion
Merchant Cash Advances can be a convenient and speedy source of capital for small businesses, but they are risky.
Steep factor rates, irregular repayment terms, and the possibility of debt cycles make them a risky choice for most business owners. Before applying for an MCA, business owners should carefully consider the costs and risks involved and seek out other financing alternatives that may have more attractive terms. Although quick funding can be tempting, it is important to know the long-term financial consequences of an MCA in order to keep a business healthy and stable.
