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Updated on Thursday, January 17, 2019
When you need cash personally, you probably try to steer clear of payday loans. These short-term loans are risky, providing small amounts of money at a high cost. The speed at which you could receive funds may be tempting, but the risk involved in taking out a payday loan should make you think twice before doing so.
On the business side, cash advance funds or merchant cash advances, present the same dilemma. Merchant cash advance companies hand over a set amount of money in exchange for a portion of your business’ future receivables, such as credit card sales. A cash advance gives you cash on hand almost immediately, but it can have long-term effects on your finances.
Although merchant cash advances represent less than 1 percent of the financing products available to small businesses, here’s how to feel prepared to make an informed decision when you consider taking this option.
What is a merchant cash advance?
Unlike an actual loan, a merchant cash advance typically doesn’t require collateral, a personal guarantee or liens. Cash advances also do not have a fixed payment schedule, whereas traditional loans do.
When you take on a merchant cash advance, the advance provider purchases a portion of your credit card sales or other receivables in exchange for a lump sum of money. Going forward, the cash advance provider receives a percentage of your daily sales until you pay off the debt. Because the repayment schedule is based on a percentage rather than a fixed amount, the cash advance provider receives a larger payment on days when your sales are high.
Business owners tend to use merchant cash advances to cover working capital needs, such as new equipment purchases, seasonal inventory, expansions or remodels, debt payoff or emergency expenses.
Cash advance providers may include a performance guarantee when you sign a contract. Generally, there is no obligation to repay a cash advance. That’s different from loans, which require various guarantees and have a promissory note of repayment to ensure borrowers pay back the funds. Companies use performance guarantees to give a cash advance the appearance of a loan and borrowers an added push to repay the debt. A performance guarantee would require you to agree not to take any action that would undermine your business performance, such as selling the business or filing for bankruptcy.
Repayment depends on the business continuing to receive credit card payments or other receivables, which means the obligation to repay the advance is conditional, exempting merchant cash advances from state usury laws. These laws regulate traditional loans that are unconditionally repayable and the laws usually put a cap on the rates that lenders can charge. Usury laws do not apply to merchant cash advances.
How a merchant cash advance works
After applying for a merchant cash advance, you could see funds in your bank account in a matter of hours or days after approval. Repayment starts automatically and could begin as early as the next day.
While some merchant cash advance companies specifically purchase your future credit card receivables, other companies may accept a range of receivables, Catherine Brennan, partner at Maryland-based law firm Hudson Cook, told MagnifyMoney. Instead of taking a portion of your daily credit card sales, a cash advance company may make a daily withdrawal from an account that holds your receivables. This type of funding is similar to revenue-based financing, in which a company purchases a percentage of your total revenue rather than just your receivables.
Several companies use the Automated Clearing House Network (ACH) to set up direct electronic transactions between bank accounts. Companies that use a fixed ACH program collect a set amount of money from your business checking account each day. Some merchant cash advance contracts allow you to adjust the company’s daily withdrawal if business temporarily slows down, Brennan said.
“One of the key benefits of this [feature] is it’s supposed to be based on what you generate,” Brennan said.
If the merchant cash advance provider wants to collect part of your credit card receivables, the company may require you to switch to a credit card processing system of their choice to collect money.
Because repayment is based on your daily credit card sales in this situation, the more card transactions your business does, the faster you pay off the advance. However, if sales are slow, you still have to fork over a portion of your daily transactions.
Cash advance companies use factor rates to determine the cost of the advance instead of annual percentage rate, or APR, which is used to calculate interest on traditional loans. A factor rate is written as a decimal figure rather than a percentage and is multiplied by your funding amount. For example, a $10,000 merchant cash advance with a factor rate of 1.25 would cost $2,500, and you would owe the company $12,500 in total. When shopping for a cash advance, look for the lowest factor rate, Brennan said.
The pros and cons of cash advance funding
- Fast cash. The underwriting process for merchant cash advances is less involved than the process for traditional bank loans, which contributes to the speed at which you receive funds, Brennan said.
- Lenient eligibility requirements. Cash advance companies often target business owners with poor credit who may not qualify for other types of funding. However, a reputable merchant cash advance provider will have criteria that customers must meet, Brennan said. Watch out for companies that don’t have any eligibility requirements.
- No obligation to repay. A merchant cash advance contract obligates you to keep your business running so the company can continue collecting receivables, Brennan said. If the business fails despite your best efforts, you’re not on the hook for a cash advance.
- High cost. Because the underwriting process is so quick, the cost of merchant cash advances is high, Brennan said. Underwriting typically puts your credit history under a microscope to reduce the risk for the lender. Without going through that process, cash advance companies don’t reduce any risk, which leads to higher prices.
- Your debt could build. Because cash advances are expensive, some business owners end up taking out more than one advance to cover the costs of their current advances, which is known as “stacking.” Cash advance companies may include contractual provisions that prevent business owners from stacking, Brennan said.
- Fluctuating payments. It could be difficult to forecast how much will be taken out of your sales each day, and it may be difficult to plan around the payments.
- Deceptive marketing. Some cash advance companies are deceptive when advertising their products. It’s important to look for fees or penalties that are not disclosed up front, which could make the cash advance more expensive.
Merchant cash advance FAQs
When you sign a contract for a merchant cash advance, you agree to continue operating your business to the best of your ability to ensure the cash advance company will receive a portion of sales.
Many merchant cash advance companies approve businesses for funding within a few hours and funding is delivered the next day.
A merchant cash advance company may collect a fixed percentage of daily credit card transactions or make a pre-scheduled withdrawal from your business account for a bank-to-bank transfer.
You could typically use your merchant cash advance to cover any business expense.
Where to get a merchant cash advance
Merchant cash advance companies operate online, and both the application and underwriting processes are completed digitally.
Some companies are direct lenders, which means they directly supply the capital to your business. When working with a direct lender, the name of the capital provider on the application should be the same as the name on the contract for the cash advance. If you work with a company that is not a direct lender, the company may send the information from your application to several different funding companies, which may all pull your credit. When a potential lender checks your credit, it’s considered a hard credit pull. Multiple hard credit pulls in a short amount of time could bring down your credit score. A direct lender only pulls your credit once, making minimal impact on your score.
Merchant cash advances are also available from independent sales organizations, or ISOs, that act as brokers for cash advance providers, Brennan said. They may work with a variety of companies and be able to provide you with information on a range of products. However, ISOs generally rely on commission and may push you toward a product that isn’t suited for you and your business.
“As a merchant, buyer beware is a good frame of mind,” Brennan said.
Alternatives to merchant cash advances
If you’re uncomfortable with the premise of a merchant cash advance but need capital quickly, online business lenders can offer fast short-term funding that traditional banks are hesitant to provide, Brennan said. Here are a few alternatives to merchant cash advances:
Working capital loans
Working capital loans are short-term products used to cover day-to-day business expenses. They typically must be paid off quickly and often come with high interest rates. You may need collateral to secure the loan, but the application process is less demanding than other loans and you could receive funds within a week.
Business line of credit
Instead of borrowing a lump sum of money, a business line of credit allows you to draw from a set amount of funds as you need it. You only pay interest on the amount you borrow. A business line of credit may require a personal guarantee and collateral, and your personal credit may be a determining factor. But you could use a business line of credit to boost cash flow and cover daily costs, building up your business credit at the same time.
If you need to purchase specific materials for your business, equipment financing could help you cover those expenses. These loans tend to have low rates, as the piece of equipment acts as collateral. Credit history may be a deciding factor and you could be required to contribute a down payment, but payments on equipment loans are generally manageable.