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What’s a merchant cash advance and how does it work?
Merchant cash advances (MCAs), or merchant loans, are a type of short-term financing option available to businesses. In a merchant loan, the lender releases a lump sum of cash to the business, which is backed by future sales. The loan is repaid with regular payments that are calculated by using a percentage of credit card or debit card sales. Merchant cash advances are not actually small business loans, but commercial agreements where the borrower sells future credit card sales to the funding provider.
Payments are made until the agreed amount is paid in full, so the length, or term of the transaction, depends on sales and the amount of money that was borrowed. Typically, a merchant loan will be repaid in less than one year, but many lenders are willing to offer more flexible terms. Merchant loans can include customized financing structures where there is no fixed repayment term, but payments are part of a monthly or daily sales holdback. Instead of charging financing costs through interest rates, MCA providers use factor rates, which determine the percentage of sales that will be collected for repayment. The advance is repaid with daily, weekly, bi-monthly, or monthly payments.
Merchant advances are secured by future debit or credit card sales of the business so they are lower risk for lenders and a great option for businesses that may have been turned down when applying for other financing options. Lenders that offer merchant cash advances work with businesses that have both good credit and bad credit. Since future sales secure the advance, there is no need to offer collateral or a personal guarantee.
Pros and cons of a merchant cash advance
Every personal loan or business financing arrangement comes with pros and cons. Merchant cash advances are no different. There are many advantages to using an MCA to fund your business, but the weight of the disadvantages varies for every type of business and individual entrepreneur’s preferences.
MCA: The pros
Fast funding – Merchant cash advances offer quick funding to approved borrowers. The application process for MCAs is simple and typically available online, which speeds up the approval process. Since MCAs are not like traditional bank loans, most merchant loan companies or online lenders can get borrowers funded within 1 to 3 business days of applying. This can be helpful for small business owners who have immediate working capital needs or operate in an industry with regular cash flow fluctuations.
Better approval odds – The underwriting process for cash advances do not rely as heavily on creditworthiness as other financing applications. In fact, most MCA borrowers do not need to have a good credit score or provide a credit report at all. This is most useful to businesses that may have bad credit or startup entrepreneurs that have not yet established good business credit history. While lenders may request documentation including financial statements showing monthly revenues, income tax returns, personal credit scores, and business bank account statements, eligibility for MCAs is heavily based on sales records and business plans.
Flexible payments – Once a business owner is approved for a merchant cash advance and the factor rate is determined, payments will be taken from credit card sales according to a predetermined schedule. Since the payment amount is set on a percentage of future sales, the amount due is lower when sales are less than expected. In periods where sales exceed expectations, the payments are higher, so the loan is paid off faster.
MCA: The cons
Financing costs – Merchant cash advances are a more expensive financing option than term loans or SBA loans. The annual percentage rate (APR) for an MCA can be as high as 350%, depending on the lender, advance amount, factor rate, origination fees, creditworthiness, and business income. Unlike traditional loan interest rates and fees, factor rates make it much more difficult to figure out exactly how much an MCA will cost you. Since payments are set as a percentage of sales, cash advance borrowers do not benefit from paying down the debt early even though there is no formal prepayment penalty.
Confusing repayment terms – Borrowers of MCAs often find the loan agreement and initial paperwork very confusing. This is especially true when it comes to factor rates and repayment schedules that are based on percentages of your daily sales. Merchant cash advance companies don’t typically provide annual percentage rates in their agreements. This factor makes it challenging to compare MCAs with other types of small business financing.
Lack of regulation – Unlike traditional forms of financing, merchant cash advances, which are considered commercial transactions, are not subject to federal rules. The Uniform Commercial Code of each state governs MCAs. This limited regulation has often led businesses to become the victims of bad actors that leverage questionable marketing and sales tactics that trick people into bad deals. There is also a risk in providing documents and confidential information, like bank statements and social security numbers, to unregulated merchant companies.
7 types of businesses that can use merchant cash advances
Almost any type of small business can consider a merchant cash advance as a source of capital, but MCAs are most frequently used by businesses that:
- Accept payments via credit cards or debit cards – MCAs are repaid through a predetermined repayment schedule, but the funds are taken from credit or debit card sales.
- Do not have a good credit history – New businesses or small businesses without good credit can get approved for a merchant cash advance without a hefty down payment or collateral.
- Need immediate cash – Merchant cash advances fund as quickly as the same day for some applicants.
- Have increasing sales– Growing businesses find merchant loans to work well when their sales are on an upward trend, allowing the loan to be paid off quickly as credit card revenue increases.
While the list of exact businesses that can use MCAs is unlimited, the following list gives examples of some businesses that may benefit the most from a cash advance financing arrangement.
All types of restaurant owners make great candidates for merchant cash advances, including dine-in restaurants, food trucks, franchised fast-food restaurants, cafes, pizza delivery shops, and more. The two primary reasons MCAs work well for those in the food and beverage world are that a large percentage of a restaurant’s annual revenues come from credit card sales and the industry is known for seasonal fluctuations in cash flows. To cover operating expenses during slow months, business owners may rely on marketing strategies, layoffs, and financing options, like the merchant cash advance.
Like restaurants, retail business owners collect a lot of their revenues through credit card transactions. They also experience fluctuations in sales volume because of seasons, holidays, location, inflation, and the type of merchandise. Retailers can supplement working capital by turning to merchant cash advance providers during slow times or use the proceeds from a cash advance to lower operating expenses by purchasing inventory in bulk.
Vacation planning companies and travel agents can use merchant cash advances to keep the business operating during periods of low revenues. The tourism and travel industries are heavily dependent on other factors, like recession threats, weather, large events, and natural disasters. Since businesses can fluctuate, MCAs allow travel agents to continue to network, purchase pre-sale vacation rates, and cover advertising costs even when sales are down.
Similar to travel agencies, owning a hotel, ski lodge, resort, bread and breakfast (B&B), beach condo, or mountain cabin company, can be a very inconsistent source of revenue. However, unlike travel agents, the operating costs for hotels do not decrease as much when business is slow. A cash advance can help hotel and lodge owners pay utility bills, cover salaries and wages, and make monthly mortgage payments.
Seasonal home services
Entrepreneurs that own small businesses that are in demand only during certain seasons also use MCAs to supplement working capital during off-seasons. Some of these seasonal services include landscaping, pool cleaning and repair, snow removal, and swimming schools.
E-commerce businesses have become more and more popular in the last decade. This is in part due to technological advances and social trends. Many entrepreneurs create individual online stores to sell their own products or profit from affiliate marketing arrangements. Merchant cash advances can be used to purchase supplies or inventory, pay web development costs, or launch a marketing campaign on social media.
Salons and spas
Any business owner of a hair salon, nail service shop, spa, barbershop, or other beauty service provider can benefit from an MCA. Most salon customers pay for their services using a credit card or debit card, so arranging a cash advance repayment plan is simple for these business owners. The proceeds from the financing agreement can be used for renovations, expansions, startup costs, or operating expenses.
Alternative business financing options
If the total cost of an MCA concerns you or your business does not yet have the sales volume to make a merchant cash advance work, you may want to consider other funding options. There are several types of traditional bank loans or alternative financing options to consider. Many entrepreneurs, like this software developer, prefer to work with an alternative lender, like Biz2Credit, over a traditional lender because they offer more diverse loan options and a convenient online application process.
Invoice factoring is another type of financing arrangement where a business’s receivables become the collateral on a lump sum payment disbursed to the borrower upfront. With invoice factoring, entrepreneurs can sell their unpaid invoices to a factoring company to secure a business cash advance.
Term loans are a traditional type of financing where the borrower receives a lump sum payment upfront and then repays the loan over time. Term loans can be short-term loans or long-term and may be unsecured loans or secured loans, that require collateral. The financing costs of a term loan include interest, which is determined based on the creditworthiness of the borrower.
The U.S. Small Business Administration facilitates several loan programs where they partially guarantee a percentage of funds for approved borrowers. SBA loans offer low-interest loans with smaller down payments than traditional bank loans, but have stringent requirements and require submission of a business plan. The most common SBA loans for new business owners are the SBA 7(a) loan and SBA Microloans.
Lines of credit
With a business line of credit, the borrower is approved for a maximum line of credit through an online lender, bank, or credit union. They can then withdraw cash at anytime as long as it remains available. The payments on a line of credit are made up of principal and interest, which is only calculated on the amount of funds currently withdrawn.
Merchant cash advances are a great financing resource for business owners that collect credit card and debit card payments. The cash advance works where the borrower sells their future card sales to the merchant cash advance provider in exchange for a cash advance. MCAs offer borrowers fast funding and flexible eligibility requirements, but they have higher financing costs than other loan options. If you’re interested in exploring some great funding options for your business, including the MCA, reach out to Biz2Credit today.