At first glance, the concept of merchant cash advance sounds noble and overly-generous. Someone may even look at the promises of various merchant cash advance companies as dangerously close to those of dubious enterprises that sell services such as 100% secure loans or 100% guaranteed loan match. The idea is that the legal enterprises known as MCA (merchant cash advance) companies loan finances businesses that cannot qualify for bank credit.
The creditor then gets his money back by receiving a pre-arranged portion of the subsequent sales that the merchant carries out. The borrowers who benefit from merchant cash advance loans the most are predominantly small businesses, startups with small cash flows, and businesses with bad credit scores. And while this is an option that undoubtedly sounds appealing, the coin has two sides and merchant cash advance, like many other financial tools, can sometimes be a double-edged sword for the debtor.
How does a business merchant cash advance work?
The mechanism behind merchant cash advance is relatively simple. We can use the example of a small local bookshop that desperately needs to raise $15,000. Unfortunately the owner is unable to apply for a business credit since the bookstore is brand new and he cannot afford to put up a collateral. As an alternative, he turns to the services of a company that offers merchant cash advance loans. The MCA company decides to make a lump-sum payment to the applicant in exchange for $18,000 from his future credit card sales.
Note that the company does not give the bookstore a specific period of time in which it should return the debt. Instead, they calculate a percentage of the future customer credit card payments and this percentage is to be transferred from the bookstore to the MCA company until the advance is fully repaid. Whether the payment is to be made on daily, weekly, or monthly basis depends on the arrangement between the bookstore and the merchant cash advance firm.
So instead of setting a fixed payment term, the MCA company collects the agreed portion of credit card sales until they get their funds, plus the interest back. Typically, this happens within a time span shorter than 12 months. However, there is the exception where the businesses do not go as well as planned and the advance turns into an inescapable burden that keeps draining the merchant’s cash flow. Having your business not go exactly as planned is just one of the many considerations that should be taken into account before rushing into the doors of the nearest MCA firm.
Disadvantages of a merchant cash advance
Times of financial instability and credit crises are when the business of merchant cash advance business usually booms. What happens is that in an environment where credit terms become more unappealing for small businesses and banks tighten their loan regulations, entrepreneurs in need of a quick financial boost readily embrace the idea of merchant cash advances. Unfortunately, in their enthusiasm, a lot of them choose to turn a blind eye to the possible negative impacts that a financial strategy like that would have on their business.
The devil is in the detail. In the case of merchant advance loans, the devil is in how this type of cash advance is treated by the law. The catch is that, although a merchant cash advance sounds strikingly similar to a typical banking loan with just slightly unorthodox payment terms, it is actually not a loan. From a legal perspective, that is. Instead of business credit, the merchant cash advance is considered a sale of future debit/card sales, or more simply put, a sale of future income with interest attached to it. What this means for the firms that offer merchant cash advance for small business is that they function in an area that is considerably unregulated.
Therefore, in setting the terms and interest rates on their lump-sum payments to merchants, the MCA companies do not have to abide by any kind of usury laws. As a result, the interest rates in the industry can triple the usual interest rate charged by, for example, credit card companies. A situation where the merchant has to pay 50% over the borrowed sum in exchange for the MCA service is not something unusual. Since they are not bound by government’s laws that limit interest rates, merchant cash advance enterprises are free to operate in whichever way they deem fit. History has shown that it is always going to be small business owners with insufficient equity as well as businesses with poor credit history that would desperately use the financial stimulus. Those who are considering taking out a merchant cash advance loan should think twice before signing up for one.
What you need to know about merchant cash advances
In conclusion, merchant cash advance loans are definitely not everybody’s cup of tea. Although the service may initially look tempting for small business owners, there are a lot of things that should be taken into account.
One of the most important is the fact that small businesses usually operate with small cash flows. And since MCA companies take their percentage off the merchant’s cash flow, the abnormally high interest rates that they charge compared to other forms of financial credit services may end up doing more harm than good for the business. So, if you have decided that the merchant cash advance loan is a good financing option for you, be sure to do your homework. Always insist that the MCA firm gives you an estimated A.P.R. for your merchant cash advance. Always familiarize yourself with the payment terms. And always explore as many merchant cash advance companies as possible before making the final decision.