Merchant Cash Advance: Is It Right for Your Business?
A merchant cash advance (MCA) is a type of financing that allows a business to borrow money against its future credit and debit card sales. Merchant cash advances can be an option for small businesses that need quick and easy access to capital.
However, they aren’t right for all businesses in all circumstances — so it’s important that you understand how they work and what the pros and cons are before deciding if this is right for you.
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What is a merchant cash advance?
A merchant cash advance is an easy way for businesses to borrow money against their future credit card sales. When a small business takes out an MCA, the lender gives them a lump sum of cash. In exchange, the lender takes a percentage of the business’s daily credit and debit card sales.
The business doesn’t need to have good credit or put up any collateral to get a merchant cash advance. This can be helpful for businesses that need money quickly for things like inventory or repairs.
How does a merchant cash advance work?
A merchant cash advance is a type of business financing that’s actually an advance against your future sales. Because of this, repayment works differently than it does with a traditional term loan.
Merchant cash advance companies will often partner with credit card processors. And rather than making monthly loan payments, the merchant cash advance company takes a predetermined percentage of your business’s sales each day (or week) until the loan is paid in full. This percentage is known as the “holdback rate,” and is usually anywhere from 10% to 20% of the daily credit card sales.
Payments might come right off the top of your daily credit card sales or be taken in direct ACH withdrawals from your business’s checking account.
Rates and fees
Merchant cash advances charge a factor rate rather than an interest rate. This means that the merchant cash advance company will multiply the amount of the advance by the factor rate — usually between 1.2 and 1.5 — to determine how much interest is owed. For example, if you borrow $10,000 and the factor rate is 1.5, you will owe $15,000, including principal and interest.
Factor rates can be high compared to interest rates on traditional loans, which usually run anywhere from 3% to 7%. As such, it’s important to make sure you understand all the costs involved before deciding if a merchant cash advance is right for your business.
There are a few things that can impact the factor rate that a merchant cash advance company charges, including:
- The industry your business operates in
- How long you’ve been in business
- Your average monthly credit card sales
- The amount you want to borrow
As with other types of financing, the higher the risk for the lender, the higher your factor rate will be. Plus, in addition to the factor rate, merchant cash advance lenders may also charge fees, such as an origination fee.
How to calculate the borrowing cost of a merchant cash advance
When taking out a merchant cash advance, it’s important to understand how much it’ll cost you. This is calculated by multiplying the amount of the advance by the factor rate.
For example, say a business wants to borrow $100,000 using a MCA, with a 1.2 factor rate. Here’s how you would calculate the total borrowing costs.
| Merchant cash advance details | Total borrowing cost |
|---|---|
| Cash advance amount: $100,000 Factor rate: 1.2 | $100,000 * 1.2 = $120,000 |
For the purposes of this example, fees aren’t included — it’s more about illustrating the point of how factor rates work with MCAs. However, you should include fees when calculating your borrowing costs, as this is how you calculate your annual percentage rate (APR).
To calculate the APR, you:
- Multiply the number after the decimal point in the factor rate by 365. So for the example above, the calculation would be: 0.2 x 365 = 73
- Divide the result by the repayment term. If the repayment term is 120 days, your calculation would be: 73 / 120 = 0.608
- Convert the result into a percentage: 0.608 x 100 = 60.8% APR
As you can see, an APR of 60.8% is quite high compared to what you’d get from a traditional bank loan.
In the example above, the business has to pay back $120,000. Let’s assume that the merchant cash advance company takes 10% of monthly credit card sales. Because sales aren’t consistent from month to month or from business to business, repaying a $120,000 MCA looks differently for businesses with different volumes of sales. Here’s two examples of how repaying a MCA might look:
| Total borrowed with a merchant cash advance: | $120,000 |
| Monthly credit card sales: | $50,000 |
| Payback amount per month: | $5,000 |
| Daily payback amount: | $166.67 |
| Time to repay full amount: | 24 months |
With monthly credit card sales of $50,000 and a 10% holdback rate, it would take Business A two years to repay the full MCA plus the factor.
Now, let’s look at the difference for Business B, which does $100,000 in credit card sales each month.
| Total borrowed with a merchant cash advance: | $120,000 |
| Monthly credit card sales: | $100,000 |
| Payback amount per month: | $10,000 |
| Daily payback amount: | $333.33 |
| Time to repay full amount: | 12 months |
With twice the monthly credit card sales volume, it takes Business B half the time to repay its MCA.
Pros and cons of a merchant cash advance
Merchant cash advances can be useful for some business owners, but they’re not for everyone. Here are some pros and cons to consider.
| Pros | Cons |
|---|---|
Good for seasonal businesses: Because a MCA is paid back with a percentage of sales, it provides more flexibility than traditional term loans with set monthly payments. This makes them a good option for seasonal businesses with fluctuating cash flow as they won’t have to pay as much during slow times of the year. Accessible to businesses with poorer credit: MCA lenders don’t usually require good business credit. Unlike traditional lenders, their willingness to lend is based primarily on your cash flow. Automatic payments: MCA lenders automatically withdraw payments from your merchant account or checking account, so you don’t have to worry about scheduling monthly payments. This can help busy small business owners avoid late fees. Fast funding: Getting a loan from a bank can take weeks or even months. With a MCA, however, you can often get approved and funded in under a week. No additional collateral required: MCAs are an advance against future sales, so they typically don’t require any other collateral. This makes them a good fit for business with few assets or assets that are already being used as collateral on other loans. | No prepayment options: Because payments are automatic, you typically don’t have an opportunity to make extra principal payments to pay off a MCA early. You won’t save money even if you do pay the loan off early since the factor rate and repayment amount are determined upfront. Confusing rates and terms: Because MCAs are not technically considered loans, MCA lenders aren’t required to adhere to the Truth in Lending Act, which requires lenders to provide clear loan cost information so that you can comparison shop. This often means you’re on your own when trying to decipher loan rates and terms. Limits your authority to make business decisions: MCA contracts may also include restrictions that limit your authority to make business decisions during the contract term. For example, you might not be allowed to change your credit card processing company, change your business hours, change locations or offer customer incentives for non-credit card payment while you have an outstanding MCA. An expensive form of small business financing: When you convert an MCA’s factor rate into an annual percentage rate, it could wind up being an APR as high as between 60% and 200%. This makes them an extremely expensive form of small business financing. Can harm cash flow: MCA lenders usually deduct repayment from your daily sales. If you’re already having cash flow problems, having an MCA eat into your revenue every day can make the problem even worse. |
Alternatives to a merchant cash advance
A merchant cash advance can be a costly way to borrow money, so it’s important to consider the following alternatives before going to an MCA.
- Short term business loans: Short term business loans typically have shorter terms than merchant cash advances, making them a good choice for businesses that need the money for a specific purpose and don’t want to be locked into repaying a MCA for months or years.
- Line of credit: A small business line of credit can be used for any purpose related to your business. It’s also unsecured, so you don’t have to put up any collateral and you only need to pay interest on the amount you actually borrow.
- Working capital loans: Working capital loans are unsecured business loans that are designed to help businesses cover short-term expenses, such as payroll, inventory and accounts receivable. They’re typically smaller than merchant cash advances and the terms are more forgiving, making them a more affordable option for businesses that need access to quick capital.
- Equipment financing: Equipment financing allows you to borrow money specifically for the purchase of equipment, rather than borrowing money for general business purposes. This can be a great option for businesses that are growing and need new equipment to keep up with demand, but don’t have the cash flow to purchase it outright. Equipment financing typically offers lower interest rates and longer repayment terms than merchant cash advances. You can also spread the cost of your new equipment over several years, making it more manageable for your business budget. And since the equipment is used as collateral, you can typically get approved for a loan even if your credit score isn’t perfect.
- Business credit cards: Business credit cards can also be a good alternative because like a merchant cash advance, there is no need to provide any collateral. In addition, small business credit cards usually come with reward programs that allow you to earn points, miles or cash back for every dollar you spend. This can be a great way to save money on future business expenses.
Frequently asked questions
A MCA can be a good idea for small businesses that need quick access to cash, as they provide businesses with a lump sum of cash in exchange for a percentage of their future sales. MCAs are relatively easy to obtain and can be a great option for businesses that need fast access to capital.
However, some drawbacks with MCAs are that the interest rates on MCAs can be high, so it’s important to compare rates from different lenders before settling on an MCA. Second, MCAs can be expensive to pay back if your business’ sales don’t meet projections.
In order to qualify for an MCA, a business must be in good standing with its credit card processor and have a high volume of credit card transactions. The business may also be required to provide detailed financial information, including recent bank statements, tax returns, accounts receivable aging reports and a current profit and loss statement.
In general, merchant cash advances are legal in most jurisdictions. This is because they’re seen as a form of business financing, rather than a loan, and as such are not subject to the same regulations as loans.
Businesses may be able to get a merchant cash advance with bad credit, since MCA lenders are usually more concerned with cash flow and volume of credit and debit card transactions rather than credit. For this same reason, MCAs may not be ideal for startup businesses, since they may not have a steady cash flow yet.
If you find yourself in a situation where you want out of a merchant cash advance, you may be able to refinance the MCA with a small business loan. Keep in mind that refinancing will likely come with additional fees and may extend the length of your repayment period.
If you default on a merchant cash advance, the lender can sue the business for the money you owe. Some MCA companies also require a personal guarantee, which means they can hold you personally responsible for repaying the advance if the business is unable to repay it.