If you’re a small business owner in need of emergency funding, merchant cash advances are an option you might be considering. MCAs are one of the many alternative financing options available to small businesses apart from traditional bank loans.
While MCAs may seem like a saving grace for millions of small business owners, they also come with their share of pitfalls and could put your business in further debt. Keep reading to learn more about Merchant Cash Advances, how they work, and the potential risks of using an MCA for your business.
What is a Merchant Cash Advance?
If you’re getting into the murky waters of merchant cash advances for the first time, you might be under the common misconception that an MCA is a loan. While merchant cash advances are a form of external financing for small businesses, they are technically not a loan.
Technically, MCAs are considered “purchase of future receivables,” which means that your lender is purchasing a certain percentage of your business’s future debit and credit card sales. This is one of the many reasons why lenders evaluate your business credit card receipts to determine if you can repay the funding based on your business’s daily credit card sales.
So, when you take out a merchant cash advance from a merchant cash provider, you’ll receive cash advances upfront in exchange for a percentage of your business’s future revenue. Your lender will have the right to receive a certain percentage of your business debit or credit card sales until the advance has been repaid.
How Do Merchant Cash Advances Work?
Historically, MCAs have been for small businesses whose revenue comes mainly from debit and credit cards sales, such as restaurants, retail shops, and tourism-centered businesses. However, it is now common for companies who do not rely heavily on credit and debit card sales to take out merchant cash advances to fund their business needs.
Typically, when applying for an MCA for your business, your lender will provide you with an MCA agreement that you must sign before receiving the up-front cash. An MCA agreement is based on the following factors:
Advance Amount
- The advance amount is the total up-front lump sum you receive from a merchant cash advance provider. The amount you receive is usually based on the strength of your business’s daily credit and debit cards sales.
Payback Amount
- The payback amount is the total amount due that you must pay back to the lender or MCA provider. The payback amount you may have to pay is calculated based on the amount you receive plus other fees referred to as a factor.
Holdback
- The holdback or retrieval rate is the agreed percentage of your business daily or weekly credit card sales you have offered to the MCA provider in exchange for the upfront lump sum.
The cash advance you are qualified to receive will largely depend on your business average debit and credit card sales. Depending on your business financial needs, lender, and the amount of cash advance you qualify for, your MCA can be as low as 50% of your business monthly credit card sales or as high as 250% of your monthly sales.
In terms of MCA repayment, a small percentage is calculated and withheld by the MCA provider on each of your credit card sales until the cash advance is paid off in full. The percentage or holdback rate can be anywhere from 5% to 20%, depending on the advance amount, lender, daily credit sales, and the repayment period.
In addition, the amount you receive as a cash advance plays a considerable role in determining your cash advance repayment period, which can be anywhere between 90 days and 18 months. Although, if your business is doing great and receiving enough credit card transactions, you might be able to pay off the cash advance sooner than expected.
An Example of How MCA Works
Jim owns an event management business in West Virginia and has a major city event to cater within the next two weeks that could make or mar his business. Due to a recent upgrade of the business office, Jim has little funds in his business accounts.
Now Jim is desperate to find external financing to fund the purchase of more equipment, pay his decoration supplier, and support staff on the day of the event. He doesn’t qualify for a traditional small business loan since he is already paying down several debts. So, he opts for a merchant cash advance.
So, Jim approaches a merchant cash advance provider for a cash advance of $30,000 with a factor rate of 1.25%, which means that Jim owes a total of $37,500. The terms of the merchant cash advance agreement are such that the provider will hold back 10% of Jim’s daily credit sales. And the provider estimates that he will have the advance repaid within 8 months.
So, if Jim’s business generates an average of $2,000 in credit card transactions per day and 10% automatically goes to the MCA provider, he’d pay about $200 each day toward that $37,500, and his advance would be paid off in just under 8 months.
Feature
Value
Advance Amount
$30,000
Factor rate
1.25%
Total repayment amount
$37,500
Retrieval rate
10% of daily credit card transactions
Estimated term
Eight months
What Are the Requirements for MCAs?
Unlike traditional business loans, the requirements associated with MCAs are different across lenders. While some MCA providers may require that you maintain at least $7,000 in monthly credit card sales, others may be fine with monthly credit card sales of $3,000. It is also common for different providers to require different operating histories and credit scores.
However, the general minimum qualifications for an MCA are:
- 1+ years in business
- $50,000+ in annual revenue
- 500 minimum credit score
More importantly, most MCA providers are focused on the consistency of business sales volume instead of lengthy operating history or credit score.
Qualifying For a Merchant Cash Advance
Qualifying for a merchant cash advance is fairly straightforward. These days, it is standard for MCA providers to offer an easy online application with a faster turnaround time. So, the application only takes a few minutes, and you can receive an approval letter within 2-3 business days.
Generally, you’ll need to provide your lender with the following information:
- Loan amount
- Company name
- Company address
- Contact number
- Annual gross revenue of your business
- Monthly credit card volume
- Number of years in business
- Business owner’s full name
- Business owner’s SSN
- % Of ownership
- Business owner’s home address
Once you’ve accepted the terms of the merchant cash advance agreement, you’ll need to provide your lender with documents, such as:
- Business ID
- Credit report
- Financial statements
- Recent credit card processing statements
- Recent business tax returns
During your application, the provider will assign you a loan officer to guide you through the entire process. If approved, a credit card processor will be set up. Sometimes, your MCA provider may request that you switch to a designated credit card processor.
Once the processor is set up, you will receive the cash advance within a day or two in your business bank account. Please note that the repayment starts immediately after the funds hit your business bank account.
Why Merchant Cash Advances Are Not the Answer
Although it may seem like a merchant cash advance can help your business; there is a downside and it comes with significant risks. Without a proper understanding of what you are getting into, it could put your business further in debt and leave you in a worse position than you started.
Let’s take a closer look at some of the reasons why you should not finance with a merchant cash advance and why it’s recommended to search for better financial alternatives to help your business.
- No federal oversight. Since MCAs are regarded as commercial transactions and not loans, they are not subject to federal regulations. And since the Truth does not regulate loan terms, providers can take advantage of desperate business owners by offering exorbitant retrieval rates.
- Businesses may end up in a debt cycle. The ease that comes with getting an MCA can put your business in a continuous debt cycle, especially if you fail to qualify for other forms of funding. It is common for business owners to need another cash advance before even paying off their existing cash advance.
- More expensive than traditional loans. Since repayments are tied to a business’s future revenue, lenders don’t have to follow the same regulations on interest rates. Typically, business loan rates hover between 6.25% and 12%. With merchant cash advances, retrieval rates can range between 5% and 20%. In fact, according to Leonard C. Wright, CPA and Money Doctor columnist, the annual percentage rate (APR) for a merchant cash advance fee can range between 60% and 200%.
- Shorter Repayment timeline. While we mentioned that the average repayment timeline for MCAs is usually between 90 days and 18 months, most MCA providers will require business owners to offset their debt within six to eight months. This can be a drawback for businesses dealing with other forms of debt repayment.
A Better Financial Solution For Your Business
While the low requirement and ease of approval make an MCA attractive for business owners in dire need of cash, it is one of the most expensive financing options available to small business owners. Yes, MCAs may fulfill your short-term business financial needs, but be careful because they can destroy your cash flow and leave you in a severe debt spiral.
Before taking out a merchant cash advance, you should consider discussing your situation with financial management professionals like our team here at Reorganization Management Group to see if there might be a better option for your business.
With over 50 years of experience in debt restructuring and unique background in turnaround services, the experts at Reorg Group can help your business end financial hardship, find solvency and profitability and thrive while planning for the future.
If your business is in need of capital or suffering challenges due to severe debt, our commercial debt management solution might be your best option. Contact us today to find out how we can help reduce your debt burden and help your business thrive.
