If your business is looking for extra financing, you’ve probably thought about both a merchant cash advance (MCA) and unsecured business loan. They each come with their own set of advantages and disadvantages. Which advantage or disadvantage means the most to your business – only you can decide. Here’s a review of the key distinctions to help you in your research.
LET’S DEFINE OUR TERMS
You probably have a good working idea of what an MCA and unsecured business loan are. Even so, let’s include a quick review here, just to make sure we’re all on the same page.
An MCA isn’t a loan; it’s a business cash advance secured by future credit card sales. The total cost to get the business cash advance is set up front and never changes. If your $50,000 MCA is going to cost you $5,000 (for a total repayment due of $55,000), it will always cost you $5,000. It’s repaid via regular, automatic transfers from your credit card processor directly to your MCA lender.
Payment installment amounts are set by a percentage you agreed to when putting the MCA together, typically anywhere from 5 to 10% of credit card sales. So the actual dollar amount paid in a given installment can go up and down, but keeps the same proportion relative to your overall revenue. This is why there’s no fixed due date by which the entire MCA must be paid back.
In contrast, an unsecured business loan is, in fact, a loan, but isn’t secured by any sort of collateral, such as your house, inventory or equipment. The cost of an unsecured business loan is primarily the interest rate on the loan, which can vary over the course of the loan for a number of reasons. Interest rates on unsecured business loans are generally higher than on a secured business loan exactly because no security is required to get one.
There are other fees with unsecured business loans, such as origination and set up fees, as well as late payment fees. There is also a firm due date for the entire amount borrowed, which can be a few months or a few years depending on how much is borrowed. If troubles with the business make meeting the repayment schedule difficult, you may be able to renegotiate the terms. This will most likely mean additional fees and a higher interest rate.
WHICH OPTION IS BEST FOR YOU AND YOUR BUSINESS?
You need to consider your business needs and priorities, along with what risks you’re willing to take in the context of how a Merchant Cash Advance and unsecured business loans each operate. Then, in consultation with an experienced financial counselor regarding what deals are available to you, you can make a decision.
Start your analysis by answering these questions:
HOW MUCH OF YOUR REVENUE COMES FROM CREDIT CARD TRANSACTIONS?
The average dollar volume of your monthly credit card transactions is really a threshold issue. The entire structure of an MCA relies on repayment via direct transfers from your business’s credit card transactions. If your company can’t show a strong, recent history (typically the past three to six months) of average monthly credit card sales, your business isn’t a good candidate for an MCA. In such cases, an unsecured business loan may be a viable option instead.
A few more points to keep in mind: The relevant number is the average dollar amount, not transaction number. Businesses like restaurants and spa/salons are great MCA candidates because they do a high amount of daily credit card transactions. Yet, a flooring contractor or general contractor may be a good MCA candidate as well even though their number of credit card transactions would be fairly low. The average dollar amount of transactions in the construction industry is higher than your average dinner or mani/pedi bill. So when you’re considering whether an MCA may be right for your business, focus on the average dollar amount, not transaction count, of your credit card revenue.
Second, your credit card average will impact how much cash your business can get via an MCA. While your credit card transaction history may qualify you for an MCA, it may not qualify you for the size of the cash advance you need.
Look at all your payment methods – what percentage of your revenue is coming in via credit card? If at least 40-50% of your monthly revenue comes in via credit card transactions, you may be a good MCA candidate.
DO YOU HAVE A GOOD, OK, OR BAD CREDIT SCORE?
Your personal and/or business credit score may also be a threshold issue. An unsecured business loan is still a loan, unlike an Merchant Cash Advance. Many business loan lenders will at least require a borrower have OK credit (in the 650-690 range), while other lenders will accept a poor credit score (between 600-649). If you have a credit score below 600, getting a small business loan may not be an option.
In contrast, because an MCA is repaid based on future credit card sales, it doesn’t consider credit scores when qualifying a company. As discussed above, it’s concern is a business’s credit card revenue.
If your credit score will qualify you for an unsecured business loan, you should give this finance option a look. In many cases, the overall cost of the money you’re borrowing will be less expensive than a business cash advance. There may be repayment disadvantages when compared to an MCA (more on that later), but these other terms may be acceptable to you in exchange for the overall cheaper rate to get the money in the first place.
DO YOU WANT TO IMPROVE YOUR PERSONAL OR BUSINESS CREDIT SCORE?
If improving your personal and/or business credit score is important to you, an unsecured business loan can help you, whereas an MCA won’t. Most MCA lenders don’t report your MCA deal to credit bureaus, so the MCA doesn’t impact credit scores. They don’t report them because repayment of an MCA happens automatically via your business’s credit card processor. The MCA lender doesn’t have to rely on you to remember to make your payments or have the cash flow to make the payment. Thus, not much credit-worthiness is involved in the MCA.
In contrast, your repayment history on unsecured business loans is reported to credit bureaus. That’s the good and bad news. If you keep up your payments and pay it off on schedule, the unsecured business loan will improve your credit score. Of course, if you find yourself in a pinch and miss a payment, then it may hurt your credit score.
So when deciding whether to pursue an MCA or unsecured business loan, make a decision how important repairing or improving your credit score is, and whether you want this transaction to impact your score.
HOW MUCH FLEXIBILITY DO YOU NEED TO MAKE REPAYMENTS?
If your business revenue is cyclical or unpredictable, you may have trouble meeting a fixed small business loan repayment. One of the benefits of a Merchant Cash Advance is that repayments are fixed as a percentage of your revenue. If you have a bad day or a bad month, your MCA repayment for that period is lower than the days and months when your revenue is higher.
Having this sort of flexibility on your repayment amount can be very helpful, but it does come with other risks. Since the MCA repayment is made directly by your credit card processor to your MCA lender, it has first priority. Meaning, the MCA repayment can cause a cash flow squeeze elsewhere since you’re not getting 100% of your credit card receipts into your bank account.
If your weekly or monthly revenue is predictable and stable, making the fixed, scheduled repayment on an unsecured business loan may make more sense for you. If you’re worried that payments may get missed because of administrative oversight, set up your own automatic payment via your bank.
HOW LONG HAVE YOU BEEN IN BUSINESS?
While MCAs have generous qualifying criteria, they do require a business have a history of credit card payments. A new business may not have enough history to qualify. If so, an MCA may simply not be an option.
Lenders of unsecured business loans do look at qualifying criteria such as revenue and time in business, which presume you’ve been in business for at least a minimal amount of time. However, they also look to other criteria that show credit-worthiness, such as your personal credit score, to gauge whether making an unsecured business loan to you is an acceptable risk.
HOW DO YOU WANT TO USE THE MONEY?
When gauging the risk to making an unsecured business loan, some lenders will require a declaration of how you’ll be using the money. You’ll be held to use the loan for that purpose. Not all unsecured business loans must be for specified purposes, but it’s not unusual that the borrower may be restricted in how the money can be used.
An MCA doesn’t have any such constraints. If your intention is to use the advance to buy more inventory, but a great deal for new equipment presents itself – you can use the MCA to buy the equipment instead. The only caveat is that you should never use business financing for personal reasons.
WHAT HAPPENS IF YOU DEFAULT?
Technically, you can’t default on a Merchant Cash Advance because it’s not a small business loan. Putting semantics aside, the point is – what happens if you can’t continue to repay an MCA? As long as you have any credit card revenue, the MCA is getting repaid at least a little. Since there’s no fixed end date on an MCA, you’ll keep paying it off bit by bit, as long as you have credit card revenue.
To protect themselves, most MCA funders include provisions in the MCA contract that restrict the business’s ability to change credit card vendors or change their operations in certain ways that could reduce credit card transactions. These types of provisions are all intended to keep the stream of credit card revenue flowing. If the business violates any of these provisions, the MCA funder may have a legal case for breach of contract. In practice, this isn’t usually such a good use of resources for the MCA funder unless you’ve taken a large advance and haven’t paid much off yet.
If you default on an unsecured business loan and don’t renegotiate repayment terms, the good news is that you haven’t risked any collateral. The bank can’t come in and seize inventory or equipment. Keep in mind, though, that many lenders will require a personal guarantee on the unsecured business loan. So while the bank can’t come in and seize your property, you may still be personally liable to repay the loan. In some cases, MCA funders will also ask for a personal guarantee. Be sure you know whether a personal guarantee is part of the deal you’re putting together, regardless of what type of finance package it is.
HAVING LOTS OF OPTIONS REQUIRES DUE DILIGENCE
Here’s a quick and dirty recap of some of the threshold differences between a merchant cash advance and unsecured business loan:
- A merchant cash advance will likely cost more than an unsecured business loan, but will have more flexible repayment terms.
- If you don’t have sufficient dollar volume in credit card sales, you probably won’t qualify for an MCA, but may qualify for an unsecured business loan.
- On the other hand, if you have bad credit, you probably won’t qualify for an unsecured business loan, but may qualify for an MCA. Although some lenders may lend to someone with poor credit, but on more expensive terms.
The growth in alternative business financing market is a great boon for small businesses seeking financing options. Still, signing an agreement for any type of funding is a serious business and must be taken seriously. It’s worth it to invest the time into understanding your own priorities and needs, and researching your options among lenders and packages.