If you own a small business that takes credit cards and need access to working capital quickly, a merchant cash advance might seem like a good solution. If your restaurant or auto repair shop needs new equipment, this kind of funding solution might offer a way to access funds quickly and then repay the advance based on a percentage of future sales.
However, once you learn about how the merchant cash advance industry really works, you might find that there are better and cheaper ways to access funds. Take a moment to consider some of the pros and cons of using this kind of funding for your business.
Table of Contents
How Does the Merchant Cash Advance Industry Work?
Companies that offer this kind of funding say that they are not really in the business of offering loans. Instead, they offer to provide funds in exchange for some percentage of future sales. In that way, the transaction may be more like a sale than a loan. Your company buys the advance and repays the balance and fees later.
This sort of funding might appeal to companies that take a large portion of their sales with credit cards. Since the advance companies base repayment upon a percentage of sales, the transaction can get repaid more slowly if revenues are lower than expected. However, it’s important to really understand how the merchant cash advance industry works in order to decide if this is a good way to fund your company.
It still can seem a bit tricky, so below is an outline on the way that companies in the merchant cash advance industry typically work:
- The company offers funding in return for some portion of future credit card sales.
- These funders may work with a card processor to withhold their portion of receipts.
- They keep taking their portion until the advance gets paid off.
- The total to get paid back includes the original advance of any fees charged for the advance.
Understanding Merchant Cash Advance Fees
Like many other kinds of funding companies, the advance companies base their fees upon a risk assessment. Riskier companies get charged higher fees. Typically, these fees are based upon a factor that ranges from 1.2 to 1.5. In order to figure out how much has to get paid back, you simply multiply this factor rate by the amount of the cash advance.
To understand the cost of merchant cash advances, it might help to consider some examples:
- If you have a factor of 1.5 and borrow $50,000, you’ll have to replay $75,000.
- If your company gets assigned a factor of 1.2, you still have to repay $60,000 for that original advance.
- In other words, repayment for this example transaction could include fees that range from $10,000 to $25,000.
Certainly, some business owners might find this kind of transaction tempting. Since the cash advance isn’t technically considered a loan, the business doesn’t have to have a high credit score. They just need to have consistent revenue from credit cards sales. Obviously, riskier businesses that have to pay the original advance and an additional 50 percent in fees have to assume even more risk in the form of their obligation to replay the balance. The factors may look like small numbers, but they actually multiply out to expensive fees.
This kind of funding can actually equate to a higher APR if it’s paid back faster. The merchant cash advance industry bases the percentage on estimates of how quickly the loan can get paid back. For instance, they might take 10 percent of sales and predict the advance can get paid back in six months. If your business revenues are higher than expected, you will actually pay the balance back faster than they anticipated. This won’t reduce your fees, so they actually would compare to a much higher APR than if your sales were slow.
Merchant Cash Advance Alternatives
Consider the kinds of companies that might consider a cash advance for their business. These companies rely upon credit card sales, so restaurants and online shops might be good examples. Since they may not have high credit scores from credit bureaus, the businesses might not think that traditional lenders will consider them. In any case, it can take weeks or months to qualify for a loan from a bank or similar finance company, and merchant cash advance companies can usually fund quickly.
An online lender can provide many of the advantages of merchant cash advances without the drawbacks. Online lenders also use alternative information, like sales receipts, to approve applications for funding. Companies may get approved for a loan without having established great credit if they can provide information about their sales to the lender. Business owners also get to enjoy online applications, rapid approvals and very quick funding.
Fees from online lenders compare favorably to typical cash advance fees. Online lending platforms can offer transparent fees that may be much closer to interest rates from a traditional lender. In other words, online lenders actually provide loans with set fees and a set repayment period. A business can include these kinds of loans in their credit management strategy because they know exactly how much money to pay back within a certain time frame.
Is a Merchant Cash Advance the Best Funding Solution for Your Business?
The same kinds of companies that might turn to a merchant cash advance might also consider an online working capital loan. It’s a good idea to compare the repayment terms, risk and fees associated with both methods of funding. It’s also important be completely honest with yourself when assessing your business’s risk level. In many cases, an online loan can provide a cheaper and more transparent solution than a merchant cash advance. However, if you still would like to choose the merchant cash advance as your source of funding, keep the information above in mind.
The Kabbage Team is here to not only fund the small business loans you need but to help you grow your business through free marketing tips, webinars, tools and more. Kabbage empowers small businesses through straightforward, flexible access to capital. We’ve extended more than $2 billion directly to small business owners and powered automated funding for other organizations all over the globe – all while maintaining a remarkably high laughter quotient.