All sorts of unforeseen circumstances can lead a business owner to need fast access to cash. Perhaps a large order comes in requiring more stock than you have on hand and your outstanding receivables won’t hit your bank account for another 45 days. Not having the cash to buy more inventory can bring your business to a screeching halt. Or perhaps you need to make payroll, but a seasonal slump in sales has put a stranglehold on the funds you need to make your various ends meet.
If a cash flow crunch occurs for any reason and you’re unable to qualify for a traditional bank loan, the next step is to turn to alternative lenders. It’s in these hard times that a merchant cash advance (MCA) can seem like a very attractive solution.
What is a Merchant Cash Advance?
An MCA is an advance secured by future revenue. Noteworthy for the small business owner is the fact that an MCA is not a loan. For this reason, you don’t need collateral like real estate or other substantial assets to get access to funds.
In addition, other factors make MCAs seem like a struggling business owner’s golden ticket. The application process is easy: you can apply online simply by uploading the required documents, such as bank statements and tax returns, and usually, within 24-48 hours you’ll receive a lump sum payment.
While strong personal and business credit scores are requisite for traditional loans, your ability to qualify for an MCA relies more upon consistent revenue generation and how long you have been in business. Therefore MCAs may be available to people with less than perfect credit who don’t qualify for other funding sources, such as a term loan or a business line of credit.
How Do Merchant Cash Advances work?
Here are the broad strokes for understanding how an MCA company provides funding for your business.
- MCA providers will determine the amount of your advance by reviewing three to six months of bank statements and/or credit card processing statements. The advance typically represents 50-70% of average monthly revenue.
- Repayment installment amounts are set based on a percentage of monthly revenue, generally ranging from 5-20%.
- The advance is repaid via automatic transfers from your bank account directly to the MCA company. These amounts are withdrawn from your account on a daily basis.
- Typically, the total cost of the advance is set up front and never changes, as opposed to a loan with a variable interest rate. These costs are included within the daily payments. However, prepayment penalties or late fees can contribute significantly to the actual amount you end up owing the MCA funder.
- Depending on the advance amount, terms may be as short as 90 days or as long as 18 months. Repayment begins immediately after the funds are received.
- The cost of the advance is determined by what’s called a factor rate, expressed as a decimal, and usually ranging from 1.1 to 1.5. So a $100,000 advance at a 1.4 factor rate means a payback amount of $140,000.
Common Pitfalls of a Merchant Cash Advance
The installment payments to your MCA company come directly from your operating account and are automatic, which often causes an immediate cash flow squeeze.
Furthermore, although MCAs purchase a specific percentage of monthly revenue, the repayment amount is fixed, so if sales are down or an unforeseen emergency requires the sudden allocation of capital, the daily repayments have the potential to send your business into the red.
The biggest pitfall with MCAs, however, is the fact that the cost of the advance can heavily outweigh the accessibility and convenience that make them so appealing. Since they are not considered loans, MCAs are not regulated by state and federal usury laws like traditional banks are, and can, therefore, charge much higher interest rates–well over the maximum 20%.
Additionally, factor rates make the “interest rate” of your advance appear much lower than it is. This is the leading cause of confusion with MCAs and makes it nearly impossible for consumers to “compare apples to apples” when shopping around for the best lending option. For a deep dive into how the two compare, check out How Much Are You Really Paying For Your Cash Advance?
So let’s revisit the example above. You receive a $100,000 advance at a factor rate of 1.4, meaning you ultimately owe $140,000 to your MCA company. Paying $40K for your loan seems to reflect an annual “interest rate” of 40%, right? But if your repayment term is only six months, that “interest rate” is effectively doubled to 80%! Coupled with large daily payments going to the MCA funder, you will likely find yourself in yet another cash crisis.
What Happens When You Default On a Merchant Cash Advance
Far too often, when a business owner gets part way toward paying back their MCA, they find themselves so strapped for cash that they take out a second advance to help repay the first one. This is known as “stacking,” and once a company has more than one MCA, it’s a runaway train careening towards bankruptcy. Whether you have one unsupportable MCA or many, when money is tight and your back is up against a wall, defaulting on your advance and stopping the cash flow hemorrhage may seem like the only solution. But beware.
Because there’s no collateral to back a merchant cash advance, MCA companies use other protections in their contracts to decrease their risk. If they sense that you are defaulting on your advance, three things will happen next.
If you signed a COJ (confession of judgment) as part of your contract, your MCA funder will now file it with the courts. A COJ gives your funder legal recourse to empty your bank account without warning as soon as they stop getting paid.
MCA funders can also freeze your cash flow. They do this by serving your clients with a demand letter pursuant to the Uniform Commercial Code (UCC) Article 9 Section 406 (“9-406 Notice”) asserting that your receivables are their rightful property and insisting that all funds must be redirected to them. These actions can hurt your client relationships and cut the legs out from under your business.
If you are in a situation where an MCA advance has led to unsupportable debt or strangled cash flow, your best option is most likely a debt workout with a qualified firm that has decades of experience in business reorganization strategies. Second Wind Consultants offers proprietary solutions that can save you and your company from bankruptcy and guide you toward sustainable success. Learn more and set up your free consultation today.