Merchant cash advances (MCAs) are a popular alternative to getting a small business loan. They provide access to needed capital to small business owners that wouldn’t otherwise be able to invest in expanding their business or find a bridge to carry them through a rough patch.
Like any financial obligation, an MCA has its own collection of advantages and disadvantages that must be considered while deciding whether to take it on. So you can best appreciate the list of MCA pros and cons, I’m going to go over the basics of an MCA first.
When a business owner gets a Merchant Cash Advance, they’re getting a cash advance against future credit card sales. The MCA is paid back by a fixed portion of credit card sales revenue going to the lender. But what do the details look like?
Key Terms Used in a Merchant Cash Advance DealFirst, the business owner in a MCA deal gets an advance amount. This is the actual cash in hand that goes into the business owner’s bank account. This is the money she can now use to buy new equipment, cover payroll, or use however her small business needs it.
The factor rate is the number that sets the total amount the business owner has to pay back for the MCA. Last, the retrieval rate is the fixed percentage taken out of credit card sales to pay back the MCA.
Let’s say a restaurant needs to upgrade some kitchen equipment. Restaurants have a high volume of daily credit card sales, so they are typically good MCA candidates. Restaurant owner “Richie” enters into an MCA deal. His advance amount is $50,000. So he has $50,000 to spend on the new kitchen equipment.
The factor rate on his MCA deal is 1.3 (factor rates generally range between 1.12 and 1.5). That means restaurant owner Richie will have to pay back $65,000 (50,000 x 1.3 = 65,000). He agreed to a retrieval rate of 10%. If he does $2,000 a day in credit card sales, $200 of that will go to his MCA lender until he pays off the full $65,000 ($2,000 x 0.10 = $200). Retrieval rates can range between 5% and 15%.
Most MCAs are repaid within six to eight months, although repayment periods can run anywhere between 4 to 24 months depending on the specific terms.
All right, keep restaurant owner Richie’s MCA deal in mind as I breakdown the pros and cons.
- Available to people and businesses with bad credit
Business loans typically require the business owner and business have good credit ratings. This means personal credit scores above 650. An MCA looks forward to future sales, not backwards. So a bad credit rating, which is based on past history, isn’t relevant to the lender. This is why MCAs have higher approval rate than small business loans, and this doesn’t even take into account the volume of people not bothering to apply for business loans because they know they don’t meet the criteria.
- Merchant Cash Advances are easier to qualify for overall
In addition to being available to people with bad credit, a Merchant Cash Advance’s other underwriting criteria are also easier to meet than those for typical small business loans.
An MCA lender is going to look at whether you can show that your business is averaging a certain amount in monthly credit card sales over a specified period of time. Different lenders will have different requirements, which can also vary by deal. One example criteria set would require the small business to show an average of $5,000 in monthly credit card sales over the past six months.
Depending on the advance amount sought, the variables of average amount of monthly credit card sales over what period of time will vary. Note the credit card variable being weighed is the average dollar amount, not the number of transactions. So a business such as a construction company, that may have only a few credit card transactions a month, may still qualify if the dollar amount of these transactions meets the average amount requirements.
What could disqualify you from an MCA deal?Having a prior bankruptcy, not currently processing credit card sales or enough in credit card sales, or being in business less than six months.
- Applying for an Merchant Cash Advance is simple
Small business loans take a long while to process, and require large amounts of paperwork, meetings, and signings. In contrast, an MCA requires much less documentation and takes less time. Because they’re done mostly online, the entire process is streamlined. A business loan application process with a bank can take months. Not helpful if you need money to manage immediate cash flow needs. An MCA application requires minimal paperwork — just what’s needed to verify you meet the credit card transaction requirements.
Usually, the only paperwork the MCA lender wants are a few months of your past credit card statements and bank statements. The lender will also want to see a copy of your lease just to make sure your business will be there for the expected repayment period.
The low friction in applying for an MCA lets you respond to quickly changing events. It also reduces your administrative costs to applying. Instead of needing hours of your time (or your accountant’s time) preparing the business loan documentation, the statements needed by an MCA lender are quite easy to put together.
- Receive cash fast
Because process is faster and done mostly online, the business owners get the cash much faster. In some cases, a business owner can have cash in their bank account in 24 to 48 hours. If Restaurant owner Richie has opportunity to buy his new kitchen equipment at advantageous rates, he can close that deal quickly because an MCA will get cash to him fast.
- Get a smaller business loan than bank business loans may require
Banks don’t generally write business loans for small amounts. It costs them the same to service a $100,000 business loan as a $1 million business loan. Banks are incentivized to prefer larger loans. Even the average SBA loan in 2015 was $371,628.
Most small business owners are looking for anywhere between $5,000 and $25,000. An MCA deal works for both business owners and lenders in these lower amounts, so there’s no need to take on more debt than necessary.
- Amount owed never grows because there’s no interest
A Merchant Cash Advance isn’t a loan. There’s no interest. The business owner pays the factor rate, but it’s not interest. The bottom line of this distinction is that the total amount you would owe on an MCA doesn’t change. Restaurant owner Richie owes $65,000. If he has a slow period during which his repayments are lower than usual, that doesn’t increase the overall cost of his MCA.
If he had that same situation with a bank business loan, his total repayment amount would probably change, as he’d be paying interest on the loan longer.
- No late fees – repayments are made automatically
With a Merchant Cash Advance, the lender gets paid directly from the business owner’s credit card sales via the credit card processor. The business owner never has to worry about making a payment on time, so payment is never late. That means no late fees.
MCA repayment terms can be structured differently. It’s very common for the MCA lender to get their retrieval rate on a daily basis.
- No collateral required
A Merchant Cash Advance is secured by your future credit card sales. If restaurant owner Richie sees lower credit card sales than expected, it will take longer for him to pay off the MCA. He doesn’t have to worry about the MCA lender taking his new kitchen equipment. Nor does he have to worry about having any personal liability to repay the MCA.
Taking on the financial obligation of an MCA inspires less stress than business loans that require personal guarantees and collateral to secure them.
Pro/Con: Repayment amounts are fixed percentage of sales
A key feature of a Merchant Cash Advance is the retrieval rate. Since it’s a percentage of actual sales, it fluctuates with your sales volume. If sales are high, you’ll repay the MCA quickly. If sales dip, you’re not on the hook for a fixed, high repayment that doesn’t care if your revenues and cash flow are low.
You’ll never get slammed by high debt payment in a slow month. That’s a serious “pro.”
But there’s a reason there aren’t late fees on an MCA – because you never get the portion you owe the MCA lender into your bank account. It goes straight from your credit card processor to the lender. The percentage it takes will never vary, so you’ll always get 85% to 95% of your revenue, depending on your retrieval rate, into your bank account. Yet the MCA cut off the top will always get taken.
The MCA lender has first priority on your credit card revenue, which means in a down month it may be more challenging for you to meet your other financial obligations.
Pro/Con: No fixed repayment term
This triggers the related pro/con of having no fixed repayment deadline. If sales go down this may extend the repayment period. That’s a con. Of course, it may not if your business experiences an upswing within the expected repayment term that balances out the low period.
Regardless, taking longer than expected to repay an MCA won’t increase the overall total of what you owe, such as having to negotiate a business loan extension would entail.
You can mitigate both these pro/cons by negotiating a lower retrieval rate, as opposed to factor rate.
- Merchant Cash Advance money is more expensive than a business loan
Restaurant owner Richie is paying $15,000 to borrow $50,000 on his MCA deal. If he qualifies for a business loan and could find a bank that would write him a loan for $50,000 he would probably pay much less than $15,000 to get that money.
Interest rates on a business loan can range between 6.25 and 12% (roughly). As long as you make each loan payment on time, avoid late fees, and pay it off within the original term, the APR (annual percentage rate) will be less on the business loan than on an MCA. If you run into another cash crunch, and only make interest payments and take longer than planned to pay off the business loan, the cost of that money goes up.
The higher cost on an MCA deal covers the higher risk the lender takes on. This is the trade-off for many of the advantages of an MCA deal, particularly the more flexible qualification criteria.
If you want to mitigate the overall cost, rather than the daily/monthly repayment amount, then focus on bringing down the factor rate. Although you may have to live with a higher retrieval rate instead because that brings down the risk to the financing lender.
- Is it solving your business need?
Because a Merchant Cash Advance is a more expensive option, you need to consider how well the MCA is solving your business needs. In our original example, restaurant owner Richie needs the money to invest in kitchen equipment, which is presumably something that will ultimately increase his revenue. This is good.
But let’s say restaurant owner Richie doesn’t want the money to invest in something that will boost future revenue. Instead, he’s just in a cash flow crunch and needs the cash as operating capital. Well, if his restaurant has cyclical high and low periods that are predictable, then using an MCA to get through the low period may make sense.
If the cash flow crunch is not part of a normal business cycle, then it’s prudent to take a closer look. Is the MCA cash going towards buying more inventory, which can be turned into revenue? Or is to going to pay rent or other overdue bills?
You repay an MCA based on future revenue. So the best use of an MCA deal should be towards those things that can directly impact revenue.
- Merchant Cash Advances aren’t regulated
An MCA isn’t a loan. A factor rate isn’t interest. As such, it’s not regulated by lending laws, including usury laws. This is why lenders can charge factor rates that create high APRs – even though it’s not really an APR.
The general lack of regulation on MCAs leaves business owners open to risk of taking an MCA deal with a less-than-scrupulous lender. There are ethical lenders and predatory lenders out there. A predatory lender will encourage and approve you to take more cash than you really need.
An MCA is a financial contract. The application process may be fast, but that’s what’s happening after you decide where you want to apply for an MCA. Before that, you need to do the due diligence and learn about the differences in terms offered, and reputation of the lender. Know who you’re going into business with before signing any financial obligation.
- MCA may have limitations put on how you operate your business
It’s common for MCA deals to include terms that give the lender some control over how you operate your business. For example, the lender can include a term in the MCA contract prohibiting you from taking any steps to discourage your customers from paying with credit cards. You couldn’t offer a discount for cash payments that’s not also available to those paying by credit card. So Restaurant owner Richie can’t offer free desserts if diners pay in cash.
Another common term is to prohibit the business owner from switching credit card processing companies while money is still owed.
It makes sense that lenders want to protect credit card revenue stream. They provided the advance amount based on credit card volume.
Some MCA lenders may include other terms that limit your ability to make operational changes. Other such terms can include preventing you from closing the business for an appreciable time (so no sabbaticals), changing locations, or taking out a business loan while the MCA is still being repaid.
Not all these terms are standard, so review any potential MCA deal carefully to see what it includes. Then you can make a determination if those are operational controls you can give up for the repayment period. An MCA deal is a contract, so if you violate any of these terms, you can be sued for breach of contract.
So does an MCA make sense for restaurant owner Richie? In his case, it looks like the pros definitely outweigh the cons. Never forget that an MCA is a financial obligation. So if you’re thinking about it, review this list to see where the pros and cons fall for your business.