Merchant cash advances (MCAs) are popular alternative business financing options for many small business owners. Unfortunately, there remains a lot of misinformation about MCAs. I’m going to clear up four of the most common myths about MCAs so you can dig into your options with confidence.
- High APRs Mean Taking a Merchant Cash Advance is Like Borrowing from a Loan Shark
Let’s just start with the biggest, ugliest myth about Merchant Cash Advances. You can read in a lot of places how high the APR (annual percentage rate) of an MCA is compared to average APRs on conventional small business loans. This makes it seem like an MCA is usurious (a la the loan shark loan), and is meant to scare you away from investigating MCA options. Comparing the APRs of a business loan and an MCA is bit like comparing apples and oranges.
An APR is meant to express the total cost of money as a percentage rate. The purpose of an APR is to help you compare which financing option is more expensive.
Now there is no question that generally, an MCA is going to be more expensive than small business loans. Some of the reasons for this are the reasons that MCAs have different advantages over a business loan – like not having to put up any collateral to secure the loan, not having fixed payments that can be onerous if your sales dip, or not having to pay any late fees.
However, if you have difficulty paying off a business loan on the original schedule, the costs of that business loan will go up. Depending on how long it eventually takes to repay the loan – or worse, if you default and lose your collateral – the cost of the business loan can be painfully expensive.
These differences between an MCA and small business loans stem from one of the most critical distinctions between the two: the cost of an MCA never changes from what’s set out in the original agreement; while the actual dollar-amount cost of a business loan can’t be fixed at the outset. There are too many variables on a business loan. This is why the APR was set up in the first place. To give borrowers a single number they could compare among business loans to gauge relative costs, but not actual costs.
The truth is while an APR is a useful metric to compare the terms of different business loans, it’s not a useful metric when comparing an MCA to a small business loan. One way we know this is because the APR of an MCA actually becomes higher the quicker you repay the MCA, but goes higher the longer it takes to pay off a business loan. In these situations, your out-of-pocket cost on the MCA hasn’t gone up from what was originally agreed, but your costs on the business have.
Let me step back a minute to explain why this is so.
The single most important fact to remember about an MCA is that it isn’t a loan of any kind. Most of the myths about MCAs follow from the confusion that it’s a loan. It’s not.
The cost of a loan to the borrower comes in the form of interest, fees, and other potential costs. If you take out a business loan, it will come an annual interest rate (this is not the APR). For example right now, SBA interest rates range anywhere from roughly four to eight percent.
The interest rate on a business loan can be fixed or variable, meaning it can change based on market conditions over the course of the loan. The business loan’s fees are usually fixed, unless you need to refinance or renegotiate the loan down the line because current payments are too difficult. This is one way your cost to repay a business loan can increase over the course of the repayment period.
In contrast, the cost of an MCA is called a factor rate. Say you take a $15,000 MCA with a factor rate of 1.3 (factor rates generally range between 1.0 and 1.5). Your cost to get the $15,000 cash advance is $4500 ($15,000*1.3= $19,500/ $19,500-$15,000 = $4500). Your MCA will always cost $4500, whether you can pay it back in six months or 18 months.
Let’s say you agreed to pay back the MCA at 5% of your daily credit card receipts, and you typically average $20,000 a month in credit card sales. If your credit card sales stick to this average, you’ll pay off the MCA in around 19 months. Under this scenario, the MCA has an APR of 34.25%.
But let’s say the new equipment you were able to buy with the MCA lets you take on more business and so increased your credit card sales. They went up to $25,000 on average per month. You were able to repay in your MCA in just around 15 months. Under this scenario, the MCA has an APR of 42.82%.
In both scenarios, your cost for the MCA is still $4500. That doesn’t change. But if you look at the APRs the way you would for a business loan, the APR numbers tell you that the MCA paid off in 15 months was more expensive. It wasn’t. This is why an APR isn’t a useful number to compare the relative cost of an MCA.
I want to be clear – an MCA usually does cost a bit more than a small business loan. You may decide the extra cost is worth it to you because of the advantages an MCA does have over a small business loan. You may decide the MCA is not. Do your research and make an informed decision. But don’t get distracted by comparing the APRs between MCAs and APRs.
- Merchant Cash Advance Funders Are Predatory and Unethical
Because Merchant Cash Advances are often presented with having such high APRs, some people complain that MCA funders are unethical. They make the same charge because since MCAs aren’t small business loans, they aren’t as highly regulated.
However, according to the Federal Reserve’s “2015 Small Business Credit Survey,” merchant cash advances and business loans have similar approval rates – 71% of merchant cash advances to 69% of small business loans. There is likely some self-selection going on here, as business owners who may have poor credit, or want cash faster and with less paperwork than a business loan requires, may opt to go straight to the business cash advance.
This point is, that MCA funders, as an industry, aren’t approving everybody in search of up-front fees and late fees on people who can’t keep to the business loan’s repayment terms. That’s because an MCA doesn’t have these kinds of fees. MCAs only get repaid as fast as the business owner has credit card revenue coming in. That’s where the MCA funder earns its money.
An alternative finance industry group, the Small Business Finance Association (formerly the North American Merchant Advance Association) has established best practices for MCAs. The goal is to clarify what’s good practice and to keep any individual funder from using abusive tactics or tacking on hidden fees.
Just like you would with any business agreement, do your due diligence into who you’re getting into business with. Most MCA funders are more than reputable. Here at United Capital Source (UCS), we pride ourselves on working with each client to determine what finance option makes sense for each one’s specific situation. We never encourage our clients to take out more cash than they actually need. And our clients can reach their UCS reps and talk to them throughout the repayment period of whatever financing option they’ve chosen.
- Only Failing Businesses Need a Merchant Cash Advance
I hear this one a lot. Merchant Cash Advances have a bad reputation as the finance source of last resort. Nobody would get an MCA if they had other options, is how this thought goes.
This thinking is wrong.
The origin of this thinking is since MCAs are an option for businesses with bad credit, that business must be failing. Having bad credit doesn’t mean your business is failing. In some cases, a small business owner hasn’t created enough separation between their personal and business credit. As the new business was finding its feet, the owner’s personal credit took a hit as she financed her business with her credit cards. Not a good option.
Or it may be that the business is healthy, but you’re looking for extra cash to fund that back-burner project you’ve been putting off and don’t want to risk your working capital. The business’s computers need an upgrade. You’ve been thinking about adding a new line of inventory to the shop. Every business has its “someday” projects. This restaurant owner used an MCA to refill his operating capital coffers when the construction project expanding his space overran its budget.
Even if you and your business have a good credit score, you may prefer an MCA to a small business loan. There are many good reasons to take an MCA instead of a small business loan. You don’t want to risk putting up collateral, which any bank would require. Maybe you want to protect your balance sheet and don’t want to add another liability to it. Remember – MCAs aren’t loans, so they don’t show up as negatives on your account ledger.
Whatever the reason – considering an MCA isn’t some sort of sign that your business will be closing up soon. If it’s the option that makes sense for you, look into it.
- Taking a Merchant Cash Advance Hurts Your Credit Rating
Taking a Merchant Cash Advance will not hurt either your personal or business credit rating. It won’t help them, but it won’t hurt them either.
Your credit report and score are only affected by the information reported to the credit reporting agencies. Credit card companies and banks report to credit reporting agencies. If your business has its own credit file, some of your larger suppliers may report your record on paying their invoices. MCA funders do not make reports to credit reporting agencies. They’re not trying to hide anything. It just that an MCA isn’t a loan (you’ve heard that before).
An MCA is repaid by the funder taking a cut off the top of your credit card receipts. This cut is the retrieval rate you agreed to in the deal. Typical retrieval rates range from five to 12%. So your restaurant does $5000 a day in credit card receipts, and you agreed to an 8% retrieval rate. The MCA funder automatically gets $400 sent to their bank account. You get the other $4600 straight into your restaurant’s bank account.
Because the fund transfer happens automatically between your credit card processor and your MCA funder, you never have to worry about late fees on your MCA. Since repayment doesn’t depend on your ability to pay on time, there’s nothing to report to a credit agency.
This is also why MCAs are a valuable financing option for business or business owners with bad credit. It doesn’t rely on your ability to make timely payments. An MCA funder looks forward to your future credit card sales. The only backwards look that interests an MCA funder is your most recent average inflow of credit card sales.
An MCA funder will usually want to see at least your last six months of credit card volume to see how much your business typically processes in credit cards. This information helps the funder determine how much cash they’ll advance your business and under what terms.
Clarity Brings Confidence
Merchant Cash Advances get you cash fast. They’re available regardless of your credit score. These are all great positives about an MCA.
But an MCA’s greatest advantage is its clarity. You know from the start exactly how much this cash is going to cost you. That will never change. You know your repayments will never outpace your revenue or your ability to make that any given payment.
Look past the myths about MCAs and you’ll see just how crystal clear an MCA really is.