Are merchant cash advances worth it? The short answer is, maybe.
There’s a lot of chaos in small business financing right now. Many lenders have tightened up their loan qualification criteria or flat out stopped lending—but there are still options. A merchant cash advance (MCA) is one of those options, but they’re different from a business loan or line of credit and shouldn’t be approached lightly.
What’s different about a merchant cash advance?
For starters, an MCA isn’t a loan. It’s a cash advance based upon the credit card sales deposited in your merchant account. So if you don’t take credit card payments in your business, this isn’t an option for you.
If you do take plastic, the application process and subsequent approval is pretty easy and you can have access to funds fairly quickly—sometimes as quickly as within 24 hours after approval.
MCA providers look at your risk and credit history differently than a banker or other lenders. They look more at your daily credit card receipts to determine if you have the cash flow to pay back the advance in a timely manner. In other words, even if your personal credit score is below 600 (sometimes as low as 500 depending on the lender), you may be able to qualify for an MCA.
Although it’s pretty easy to get approved, the cost of an MCA can get high. Much higher than other financial options, so it’s critical you understand the terms you’re being offered to make sure an MCA is a good fit for your situation.
Further Reading: Building Business Credit (11-Step Guide)
A merchant cash advance can get complicated
Unlike bank loans or a line of credit, there’s more to an MCA than an interest rate or an APR. Repayment terms are not what you would expect from a traditional loan at the bank. One big difference is something called a “holdback.”
If you’ve never used a merchant cash advance before, this is probably an unfamiliar term. The holdback amount is the percentage of daily credit card sales applied to the repayment of your advance. The holdback percentage is usually somewhere between 10% and 20% (but does not reflect the agreed-upon interest rate or APR, that’s something different) and is usually fixed until the advance is completely repaid.
Repayment is based upon a percentage of the daily balance in your credit card merchant account, and direct-debited from your banking account via an electronic funds transfer every day. The more credit card transactions you have, the faster you’re able to repay the advance. In other words, if you have a day where you have fewer transactions than expected, the draw from your merchant account will be less, but will be greater on those days when you have more activity in your account.
What’s the difference between interest rate and holdback?
It’s easy to confuse the interest rate you’re being charged for the advance and holdback amount. The holdback is the daily draw from your account until the advance (including the agreed-upon interest) is paid in full. So holdback applies to your daily payment while the interest rate, which is typically a factor rate, is the cost of the financing.
For example, if you borrow $10,000 at a factor rate of 1.5 ($10,000 x 1.5 = $15,000)
The cost of borrowing the $10,000 would be $5,000, plus any fees the provider may charge in addition to the factor rate.
If the holdback percentage was 15% and $5,000 was deposited to your merchant account today, your payment for today would be $750. If you received $8,000 in your merchant account tomorrow, your daily payment would be $1,200.
Is a merchant cash advance really worth it?
Because an MCA is very expensive financing, they may be too costly for most small businesses that are looking to borrow for working capital needs, like making payroll. Whether or not an MCA is worth it will largely depend on the need a business owner is trying to fill, the discipline they have in leveraging borrowed capital, and how well they can maintain their cash flow.
Because the costs associated with an MCA can sometimes include triple-digit interest rates, it’s not considered a multi-purpose financing option. For a business owner focused on leveraging financing to generate more ROI, an MCA could be a vehicle for doing that. For example, an opportunity to purchase quick-turnaround inventory at a sizable discount could be a reasonable use-case where an MCA could be successfully used (provided the cost of the MCA when added to the cost of the inventory still allows the business to make a profit).
We recommend treating a merchant cash advance as part of the cost of goods sold in this scenario.
An MCA could make sense for a business that needs cash quickly in an emergency, but the expensive nature of an MCA shouldn’t be taken lightly. Make sure you understand what the factor rate will be, any fees that may be included, and what the daily holdback will be and how that could impact your cash flow. If your cash flow fluctuates a lot during the month, this might not be worth it to you. You’ll more likely be successful with an MCA if you have a consistent flow of credit card receipts flowing through your business every day of the month.
Most MCAs are considered short-term financing options, so they likely wouldn’t be a great fit for a longer term need for capital like expanding the dining area of a restaurant, or financing a new location across town. What’s more, because they are so expensive, you need to be pretty disciplined financially to successfully leverage the advance. In other words, in chaotic times like we’re experiencing right now, proceed with caution—a merchant cash advance has the potential to wreak havoc on your cash flow, despite the possibility it could help a business capture additional ROI.
Because an MCA is relatively easy to qualify for, they might be approached as the financing option of last resort. In other words, if a borrower can’t find money anywhere else, they might turn to an MCA to access additional capital. Without a full appreciation of the cost, this could overburden the business and actually cause more financial stress.
With that being said, there are many business owners who are able to successfully leverage this option to access capital for their businesses.
Are there alternatives to a merchant cash advance?
Yes, there are several alternatives to an MCA.
Business credit cards, short-term loans, and business lines of credit immediately come to mind. Like a merchant cash advance, a business credit card can provide quick access to cash, are easier to qualify for than a typical small business loan or line of credit, and aren’t as expensive as a merchant cash advance.
Although card issuers have updated lending restrictions, tightened (and even closed) new account applications for some business credit cards, there are still some issuers approving customers for business credit cards that could help your business access cash to meet budget shortfalls during the health crisis. But the majority of issuers doing that now are only accepting applications from those businesses with an exceptional credit profile.
As we face uncertainty over the coming weeks and months, I would suggest not waiting to make sure you have adequate capital to meet your cash flow needs in the midst of the health crisis. Investigate all your options sooner rather than later, apply for the credit you need, but keep an eye on how the payment burden could impact your cash flow.