The Pros and Cons of Merchant Cash Advances

In the world of business financing, securing the right funding can be a significant challenge for small businesses. Traditional small business loans often come with stringent requirements, leaving many entrepreneurs in search of alternative financing options.

One option that has gained popularity in recent years is the merchant cash advance (MCA). Ten percent of small businesses that sought financing in 2022 sought out a merchant cash advance, according to a survey published by the Federal Reserve.

While MCAs offer small business owners quick access to capital, they come with their own set of advantages and drawbacks. Let’s delve into some of the pros and cons of merchant cash advances, how they work, their impact on credit and viable alternatives.

Pros of Merchant Cash Advances

Easy to qualify for. One of the most significant advantages of an MCA is the ease of applying. Traditional lenders often require a lengthy application and approval process, including a thorough review of credit history, financial statements and collateral. In contrast, MCAs offered by merchant cash advance companies are based primarily on the volume of credit card sales. This can make them accessible to businesses with bad credit scores or those without substantial assets to offer as collateral.

Fast funding. Speed is another major benefit of merchant cash advances. The application process is straightforward, and once approved, funds can be disbursed quickly — sometimes within 24 to 48 hours. This rapid turnaround is ideal for businesses facing immediate cash flow challenges or unexpected expenses.

No collateral. Unlike traditional loans that often require collateral (such as property or equipment), MCAs do not. This reduces some risk for businesses, as there is less danger of losing valuable assets if the business struggles to repay the advance amount.

Payments are based on your sales. Repayment of an MCA is usually tied directly to the business’s daily credit card sales. This means that payments fluctuate with sales volume, making it easier for businesses to manage during slower periods. Instead of a fixed monthly payment, the repayment amount adjusts according to the revenue, providing some flexibility in cash flow management.

Cons of Merchant Cash Advances

Expensive cost. One of the most significant downsides of MCAs is their cost. The factor rates (the equivalent of interest rates in MCA terms) can be extremely high, often ranging from 1.2 to 1.5. This means that for every $1,000 advanced, the business must repay $1,200 to $1,500. When annualized, these costs can translate to APRs (annual percentage rates) well into the triple digits, making MCAs one of the most expensive financing options available.

Hurts cash flow. While the flexibility of repayments based on sales can be an advantage, it can also be a drawback. During periods of low sales, the daily or weekly deductions can strain the business’s working capital, making it difficult to cover other essential expenses. This can create a cycle of dependency on MCAs, where businesses continuously need new advances to maintain operations.

The industry is largely unregulated. The MCA industry operates in a regulatory gray area, meaning there is often less oversight compared to traditional business loans. This lack of regulation can lead to predatory practices, hidden fees and less transparency in terms and conditions. Businesses must be diligent in understanding the terms of the agreement and should seek out reputable merchant cash advance providers.

It’s a temporary solution. MCAs are typically designed as short-term solutions for immediate cash flow needs. They may not be suitable for long-term financing and can become a costly burden if used repeatedly. Businesses relying on MCAs for ongoing financing may find themselves in a debt cycle, struggling to keep up with the high repayment costs.

How does a merchant cash advance work?

A merchant cash advance is often structured around the future credit card sales of a business. Here’s a step-by-step breakdown of how the process works:

Application. The business applies for an MCA by providing basic information about its operations and daily sales history. The MCA provider evaluates the application and determines eligibility based on the business’s daily credit card receipts.

Approval. Once approved, the provider offers a lump sum of cash. The amount is typically a percentage of the business’s average monthly credit card sales.

Agreement. The business and the provider agree on a factor rate and the percentage of daily credit card sales that will be withheld for repayment.

Funding. The agreed amount is deposited into the business’s bank account, often within a few days of approval.

Repayment. There are usually no set repayment periods with MCAs. Instead, the provider deducts the agreed-upon percentage of daily credit card sales until the advance and fees are fully repaid. This continues until the total repayment amount, calculated using the factor rate, is met.

Does a merchant cash advance impact your credit?

Merchant cash advances generally do not directly affect a business’s credit score because they are not traditional loans and do not typically report to credit bureaus. However, if a business defaults on the advance, the MCA provider may take legal action to recover the funds, which can then affect the business’s credit. Additionally, the impact on cash flow from high daily repayments can indirectly affect a business’s ability to meet other financial obligations, potentially leading to credit issues.

Alternatives to a Merchant Cash Advance

Given the high costs and potential pitfalls of MCAs, businesses should consider alternative forms of financing:

Traditional business term loans. Though sometimes harder to qualify for, business term loans often offer lower interest rates and longer repayment terms.

Small Business Administration (SBA) loans. SBA loans are government-backed and provide favorable terms and lower interest rates for small businesses.

Business lines of credit. A line of credit offers flexibility similar to an MCA but typically at a lower cost. Businesses can draw funds as needed and repay based on what their cash flow allows.

Invoice factoring. This type of financing involves selling unpaid invoices to a factoring company at a discount. Invoice factoring can provide quick cash and be less expensive than an MCA.

Crowdfunding and peer-to-peer lending. These funding options can connect businesses with investors willing to fund their operations, often at lower rates or different terms than traditional loans.

Equipment financing. If the need for cash is related to purchasing equipment, equipment financing can be a viable option. It uses the equipment as collateral, often resulting in lower interest rates.

The Bottom Line

Merchant cash advances offer a quick and relatively easy way to secure funding for businesses, especially those with poor credit or urgent cash flow needs. However, the high costs, potential impact on cash flow, and lack of regulation can make them a risky option. Before opting for an MCA, businesses should carefully weigh the pros and cons and explore alternative financing solutions that might offer more sustainable and affordable options for their specific needs.