Merchant Cash Advances (MCA) have become a great new source of financing for smaller businesses that don’t qualify for traditional bank financing. But businesses should be cautious when raising capital with this product.
An MCA technically is not a loan. The financing company purchases from the business future credit card sales. The financing company gets repaid from future credit card receipts, typically based on a fixed daily amount or a fixed percentage of credit card transactions. For example, a financing company may offer to buy $25,000 of future credit card receipts for $20,000 with the repayment amount set at $100 per business day. Payments are typically automatically deducted from the business’s merchant or checking account.
There are now over 50 companies that provide MCAs. One very attractive feature is that a business can get approved in minutes via a simple online application and get funded within days by many of these providers. The small daily repayment amount is also attractive. But there is a big difference between attractive and affordable, and the implied interest rate can vary from 10% to above 150%. Here are the key issues to consider with an MCA.
Since an MCA is not a loan there is no stated interest rate. The implied interest rate can be calculated using the following formula:
((Purchase Amount – Funding Amount) / Funding Amount) x (365/# of days to repay purchase amount)
In the example above, this would be:
(($25,000 - $20,000)/$20,000) x (365/250) = 36.5%
Suddenly the very attractive $100 per business day repayment looks more expensive than most credit card borrowing rates. Recently the APR4SMEs campaign was started to call on the UK government to require financing sources to disclose the annual percentage rate (APR) of their products so businesses can understand the true cost of capital.
We have seen an enormous difference in the implied interest rates quoted to the same business by various financing sources. Since the online application process is so easy, a business can save thousands of dollars by rate shopping. The Kaplan Group has created a simple Implied Interest Rate Calculator where all you have to input is the amount of money you get, the amount of future sales sold, the daily repayment amount and the number of repayment days per week to find out the cost of money from a particular vendor. APR4MEs has an APR calculator for other financial products such as Invoice Discounting, Factoring, and Overdraft Protection so you can compare the cost of different financing quotes.
While some MCA providers require a fixed daily repayment amount, others base repayment as a percentage of credit card receipts. This is the best approach for a business, because if sales unexpectedly drop, so does the repayment amount. Let’s say the business that was offered the $20,000 MCA in the example above has average daily credit card sales of $1,000 seven days a week. The $100 fixed daily repayment amount is equal to 10% of daily sales which may appear affordable from a cash flow perspective. But what happens if bad weather or any other event suddenly causes average daily sales to drop to $600? Not only is the business without 40% of its revenue, the fixed $100 payment is now 16% of actual daily receipts. However, if the rate of repayment is set at 10% of actual credit card sales, the daily repayment amount would only be $60 during the unexpected downturn.
We have seen repayment rates set at 10% to over 30% of expected revenue, so it makes sense to compare this as well. Another word of caution: some MCA providers will tout that the repayment amount will decline if sales decline, but the fine print in the contract shows that you have to make the fixed payments all month long and then request a refund at the end of the month if sales were lower than expected. Obviously, this puts the business under much more financial pressure than an MCA where repayment amount adjusts automatically based on actual sales.
Many MCA providers require a personal guarantee but many don’t. We have also seen MCA contracts where the personal guarantee only applies if the business violates certain legal provisions of the contract but not if the business simply stops operating.
Many MCA contracts have large liquidated damage clauses. For example, $2,500 if you default, another $2,500 if you block ACH transfers, and collection agency and attorney fees if the vendor has to seek professional assistance to get repaid. We have seen cases where the business only has $10,000 of the MCA provider’s money but the amount owed has ballooned to over $25,000 due to these liquidated damage clauses.
Some MCA providers specialize in financing businesses with horrible credit. In these cases, the implied interest rate is at least 50% and regularly above 100%. Unless the financing is going to help your business make more profit (not just revenue) than the cost of the money, you are only digging a deeper financial hole. If you can’t justify the cost of financing from a business perspective, then you probably should not take the money.
A Merchant Cash Advance is one of several new financing products. It may or may not be the best approach for your business. You can search the internet for alternative financing companies to compare rates and terms. Or use the searchable Alternative Financing Directory which has over 500 vendors offering nearly a dozen different financing products to identify possible capital sources.