Like the name suggests, a merchant cash advance (MCA) is an advance provided as a lump sum to a business in exchange for future credit card sales. Therefore, it cannot be considered a loan, because it does not have the technical details of a bank account such as collateral and a fixed repayment term. It is more akin to factoring, where a lender gives an advance of cash against an invoice. In fact, the companies that offer financing are very careful not to be referred to as lenders but simply as providers. This allows them a lot of leeway in providing financing to small businesses.
In a factoring business, the one providing funding is buying a portion of a company’s future receivables. In an MCA agreement, the business’s receivables are in the form of credit and debit card sales. This is a riskier approach for the lender because an invoice does not exist. Thus, the interest rates are higher because of the higher risk profile of these cash advances. Despite the costs, there are still circumstances that necessitate taking an advance. To help you navigate the industry and make more informed decisions, this guide will teach you everything you need to know about MCAs.
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How does a merchant cash advance work?
The process for receiving an MCA begins in a similar way to a typical bank loan. Your business applies to receive funding from an MCA provider just as you would apply for a bank loan. Unlike a bank loan, though, merchant cash advances are almost exclusively applied online, because most MCA providers have an online business. Also just like a bank loan, the lender will analyze the details of your business to determine the eligibility of your business to receive the advance.
The most important detail an MCA provider will need to understand about your business is how much you receive in the form of credit and debit card sales. Because an MCA is paid primarily as a percentage of the credit and debit card sales, the lender will need to assess how much of your cash flow is received in this manner. It is from these credit and debit card statements that the lender will determine the rates and terms of the cash advance for your business.
In your application for the MCA, you will be required to provide your business bank statements for the provider to assess how much your business makes from credit and debit card sales. For this reason, an MCA is best for a business that receives most of its revenue from credit and debit card sales rather than cash and other methods. Other documents the provider may require include your credit report and business profile. Your credit report will help them to determine how risky an advance for your business is and to set the factor rate. Meanwhile, the business profile will show how long your business has been in operation. The provider is counting on future sales from your business, which is why they will be interested in knowing whether or not your company will still be active for the duration of the advance. [Are you looking for a small business loan? Check out our reviews and best picks, including our pick for theoption.]
Terms of a merchant cash advance
Once you have received your cash advance, these are some of the terms of the loan that you need to consider.
1. Advance amount and term
The total amount of money advanced will be the advance amount, while the term is how long you will have to pay it all back. Typically, a cash advance ranges from $2,500 to $250,000, while the advance term can be 3-18 months.
2. Factor fee
In a cash advance, the factoring fee replaces the interest rate, although it is essentially the same thing. The average rate is between 1.14 and 1.18 and, when multiplied with the advance amount, shows you what you owe in total. When this factor fee is converted to an annual percentage rate (APR), it becomes equivalent to 15% or more. [Want to know more about? Check out our reviews.]
Every day, a percentage of the daily credit card sales that is deducted from your bank account and sent to the MCA provider. The percentage can be between 10% and 20% and will be charged until the debt is repaid.
To facilitate the daily payments to the lender, an MCA deal is made with the collaboration of a credit card processing company. One way they allocate monies is by deducting the total sales of the day and sending those to the lender, while the rest are processed to your business bank account. The other way is by allowing the MCA provider to access your credit card sales, and they make their deductions before sending the remaining funds to your account. Alternatively, your bank can handle the account, and the provider’s portion is sent to the MCA provider by ACH.
Why are merchant cash advances ideal for small businesses?
At some point, you may need financing for your business. Perhaps you need a boost to expand the business by adding employees, stock or renting business premises. Whatever the need, it is not unusual to be in such a situation. In recent years, MCAs have become more popular for small businesses in particular.
This trend started following the global financial crisis of 2008 that saw the collapse of several major banks and credit unions. Following the collapse of these banks and massive losses by the others that survived, it became a lot harder for small businesses to get loans. Fintech (financial technology) companies saw an opportunity to fill the gap and took it. By 2015, Bryant Park Capital reported that the MCA industry had provided $10 billion to small businesses. By 2018, NBC reported that fintech lenders, including MCA providers, accounted for 25% of all small business loans: about $31 billion worth.
Aside from being more available to small businesses and entrepreneurs than bank loans, MCA providers don’t have strict requirements. To give you a loan, a bank will need to analyze your company’s financial and bank statements. These documents show details about your company’s cash flow and help the bank determine the loan amount to be granted. This automatically eliminates many small businesses that either have a small profit margin or have been in business for a short time. MCAs have more flexible requirements that can serve these small businesses and startups.
Banks also check with credit bureaus to know your credit score and report. If you happen to have a below-average credit score or a blemish on your credit report, it is unlikely that the bank will give you a loan. Although MCA providers will also check your credit score, they only use it to determine the factor rate of your loan – you will get a cash advance nonetheless. Finally, because an MCA is provided with the backing of future credit card sales, you are not required to provide any collateral. For a small business to get a loan, you may have to use the most valuable assets you have as collateral at a bank, which would all be lost in the unfortunate event you’re unable to pay back the loan. As a result, MCAs provide your business with the funding it needs without risking any essential assets.
Considering how any small blemish on your credit report can affect your credit score, these cash advances become ideal for small businesses. For example, a minor mistake like having an overdraft might be enough for a bank to deny you a loan. For a small business owner, it is common to have an overdraft on your business checking account or to go below the minimum operating balance, both of which can lower your credit rating.
There is also the problem of time, where your business may be in need of a quick loan. A typical bank loan for a business will take at least several days as the bank staff analyzes your loan request and weighs their own risks. Merchant cash advances are not loans and are usually applied for online. A typical MCA will be processed and disbursed within 24 hours or a couple of days depending on the situation. That makes it ideal for emergency situations where an immediate influx of cash is necessary for the business to survive.
What is the disadvantage of a merchant cash advance?
The most glaring and obvious problem with MCAs is their high cost. At first, the factor rate makes it seem that the debt would be low, but in actuality, the interest rate is quite high. In some cases, the rate can reach triple digits, which is much higher than a bank loan. Also, considering the daily holdback, your business’s cash flow can be negatively affected.