What Is A Merchant Cash Advance & How Do They Work?
If your business needs money, but doesn’t qualify for a traditional loan due to poor credit scores or a short business history, you aren’t out of options quite yet: a merchant cash advance (MCA) provider might be willing to advance you money—and fast. A merchant cash advance gives you a lump sum of cash for a share of your future sales.
Read on to learn everything you need to know about merchant cash advances.
Table of Contents
What Is A Merchant Cash Advance?
A merchant cash advance is a sales agreement where the merchant (the “seller”) is selling their future revenue at a discount to the merchant cash advance company (the “buyer”).
Because merchant cash advances are sales agreements, they generally aren’t covered by usury laws that govern loans. This is where they get their dubious reputation. The effective APRs of merchant cash advances can easily crawl into the triple digits.
Aside from technical differences, merchant cash advances vary from traditional loans in a few ways. Instead of charging interest, merchant cash advance providers charge a one-time fixed fee, calculated by multiplying a “factor rate” (sometimes called a “buy rate” or “one-time fixed fee”) by the borrowing amount.
For example, if you have a factor rate of 1.35, and you are requesting $10,000, the merchant cash advance company will collect $13,500 ($10,000 x 1.35). In other words, the fee is 35% of the borrowing amount.
Typically MCA fees range anywhere from 1.09 to 1.6 (or 9% – 60% of the borrowing amount), but you might be able to find fees that are higher or lower. The provider may require other fees, such as an origination fee or closing fee, in addition to the factoring fee.
To collect their money, advance providers usually deduct a percentage of your credit and debit card sales. Because repayment fluctuates with your cash flow, there is no set repayment date; however, most merchant cash advances are calculated to be repaid in 18 months or less.
How Merchant Cash Advances Work
When you get a merchant cash advance, you’re selling your future revenue. What this means is you’ll get a lump sum from your funder much in the same way that you would from a lender with whom you have a loan.
The terms of the merchant cash advance usually kick in as soon as you receive your money. Your funder will begin collecting a percentage of your daily card-based sales every business day or, in rare cases, every week.
Types Of Repayment Structures
The days of cutting a check are over. There are a few different ways to repay a merchant cash advance–all are automated in one way or another.
Typically, merchant cash advances are repaid on a daily basis, but some providers may offer weekly or even monthly repayments.
These days, ACH (automated clearing house) withdrawals are the most common way to repay your advance. ACH withdrawals can be fixed or variable, depending on the agreement. However, even if your withdrawals are fixed, your cash advance provider may be willing to alter your payments if you experience a decline in sales.
If in doubt, it’s a good idea to ask if your merchant cash advance provider is able to alter their payments before entering into an agreement with a fixed ACH payment.
Split Payments Processing
In the past, most merchant cash advances were repaid via split payment processing. The merchant cash advance would team up with your payments processor (or ask you to switch to a partner payments processor). The payments processor would reserve a percentage of every sale for your advance provider before sending you the remainder.
For example, if the merchant cash advance was deducting 15% of every sale, your payments processor would send $150 to the MCA and $850 to you for every $1,000 processed.
Split processing is by far the easiest method of repayment, because it’s completely automated. However because merchants typically have to switch payment processing services to use this method, or use the merchant cash advance provider that works with their current payments processor, there’s a lot of room to wind up in a bad payment processing agreement, a bad advance provider, or both.
While you may still be able to find split processing arrangements, this repayment solution is not as common today as it used to be.
Lock Box Withholding
In a lock box withholding arrangement, the merchant cash advance company sets up a lock box that is in your name but controlled by their company. You will route your sales to this new bank account. Every day, your financier will deduct their percentage of the proceeds and then send the remainder to your business.
Given the numerous problems that can arise—such as money transfer delays—and merchant’s general uncertainty about giving another company direct access to all their proceeds, lock box withholding has never been terribly popular. Nonetheless, you may run into this repayment solution while searching for an merchant cash advance provider.
Merchant Cash Advance Example
Let’s say you get a business cash advance for $10,000 at a 1.26 factor rate. Effectively, your funder has purchased $12,600 of your future card-based profits for $10,000. They start collecting on the next business day. As mentioned earlier, payments can fixed or variable. Let’s assume you’re paying by ACH deduction.
If your payments are variable, the provider will receive a copy of your credit card statement and deduct a percentage of your profits. For example, if the merchant cash advance company is deducting 15% of your sales, and you make $1,000, they will deduct $150. If you make $1,200 the next day, the company will deduct $180.
If the withdrawals are fixed, the provider will simply deduct the same amount of money each payment period. For example, if you make about $1,000 a day, the provider will deduct $150 daily.
This will continue until your funder has collected the $12,600 that they purchased from you.
How Merchant Cash Advances Differ From Business Loans
So since we’ve established that merchant cash advances are not business loans, let’s recap some of the ways they differ from business loans.
- There’s no term length: One of the key traits of term loans is that they, as the name implies, have a term length. Since merchant cash advanced are income-contingent, their terms are variable.
- The funder takes a percentage of your daily card revenue: Loans typically are repaid in fixed installments rather than as a percentage of their revenue.
- It’s not subject to the laws governing loans: Loans are more heavily regulated than advances. While this is changing in some states, you shouldn’t expect the same protections as borrowers have.
Potential Merchant Cash Advance Risks
Merchant cash advances don’t have a stellar reputation. The reasons are pretty straightforward.
They Can Be Expensive
Merchant cash advances, if you compare their APRs to those of most loans, will be much more expensive. It’s not unheard of to see flat rates climb above 40% (and into the triple digits for APRs).
If you do decide to go with a merchant cash advance, make sure you’re not being charged outrageous rates.
They Aren’t As Well Regulated As Loans
The reason merchant cash advances can charge rates as high as they do is because they aren’t generally subject to usury laws. After all, you’re technically not a borrower, and your funder technically isn’t a lender.
You May Be Asked To Change Payment Processors
Though it’s rarer these days, some merchant cash advance providers may still use payment processors to split payments. These funders may only work with certain payment processors. If you’re happy with your current payment processor, or are under contract with your processor, this may not be something you want.
You May Experience Payment Delays
If your merchant cash advance funder uses the lock box method of allocating payments, you’re at the mercy of whatever service the funder is using. Though not common, you run the risk of your funds being held.
Some merchant cash advance providers employ a practice known as double dipping, an issue that also plagues short-term loans. This is a problem when a merchant renews or refinances an advance with a fixed fee.
Because the full fee technically has to be repaid even if the advance is settled early, funders who refinance or renew a advance are essentially paying interest on interest. If you choose an MCA provider who participates in double dipping, you could be losing a lot more money than you would if you had chosen a provider who doesn’t use this practice.
If you think there’s a possibility that you’ll renew or refinance your advance down the line, it’s important to find a funder that does not participate in double dipping. If you’d like to read more, head over to our article Double Dipping: The Hidden Cost Of A Merchant Cash Advance for more information on this practice.
Is A Merchant Cash Advance Right For Your Business?
If merchant cash advances are so risky, why are they so popular? Let’s take a look at when you should and shouldn’t consider getting a merchant cash advance.
When A Merchant Cash Advance Is The Right Choice
Despite their poor reputation, there are tangible benefits to using a merchant cash advance. You should consider a merchant cash advance when you want:
- Low Borrower Qualifications: As stated above, many businesses can qualify for a merchant cash advance, even if they can’t qualify for other types of business financing. As long as you have strong cash flow, you have a good chance of qualifying for an MCA.
- A Fast Application Process: Merchant cash advances generally have a very fast application process. Typically, the application can be completed in a few minutes with a minimal amount of paperwork. After initial application, underwriting and capital dispersal only takes a few business days.
- Variable Repayments: Most merchant cash advances have variable repayments, which means that payments are lower when sales are slow, and higher when sales speed up.
- No Collateral Required: A lack of collateral is not a problem for cash advance providers. You will generally not have to put up any collateral to receive financing.
When You Should Look For Another Type Of Business Financing
Merchant cash advances aren’t the best choice for many businesses. You should consider another type of business financing if:
- You Have Good Credit: If your credit is good, chances are you’ll qualify for financing with much more competitive rates than you would get with a merchant cash advance.
- You Deal Mostly In Cash: Merchant cash advances require a fairly high level of credit card sales for their model to work. If you mostly do business in cash, the model won’t work.
- You Don’t Want Your Revenue Flow Interrupted: Because the merchant cash advance provider is deducting a percentage of your daily sales, you will have reduced profits until you pay off the advance.
- You To Know Exactly When Your Agreement Will Be Settled: The variable nature of merchant cash advances may be a feature for some businesses, and a bug for those who want a more predictable schedule.
Merchant Cash Advance Alternatives
Merchant cash advances are just one form of small business financing. There’s a good chance they aren’t the only option available to you. These alternatives range from short-term loans, to invoice factoring, to traditional installment loans.
For a deeper look at your options, check out our Best Alternatives To Merchant Cash Advances feature.
Tips For Finding & Applying For A Cash Advance
Now that you’re well-versed in what merchant cash advances are, you should have a pretty good idea of whether they’re right for your business. If they are, you may want some tips on how to find and apply for an advance.
- Vet The Provider’s Online Presence: The difference between a reputable and fly-by-night merchant cash advance provider is enormous. Our reviews of merchant cash advance providers are a good place to start. Or check out a comparison of our favorite merchant cash advance companies.
- Calculate The Total Cost Of Borrowing: If you can get your hands on your prospective funder’s rates, you can calculate your total cost of borrowing. Our merchant cash advance calculator can help you out there.
- Check Your Cash Flow: Merchant cash advance providers don’t care about your credit score all that much, but they do want to see that you have consistent cash flow, particularly in credit and debit card sales. The more transparent merchant cash providers will divulge their qualifications upfront.
- See If Your Provider Offers Early Repayment Incentives: If you pay off your merchant cash advance early, you’re technically raising your effective APR. If possible, work with a provider who will slash your flat fee if you’re settling your account ahead of schedule.
- Have Documentation Handy: Your application will go more smoothly if you have the necessary documents handy. This includes things like personal identification, bank statements, and proof that you own your business.