Merchant cash advance lawyer speaking with client

The Risk of Closing Budget Gaps with Merchant Cash Advances

Companies that provide goods and services often face budget gaps between the time a sale is made and payment is ultimately received. One way to cover these shortfalls is by taking a merchant cash advance (MCA). There are risks, however, not the least of which is defaulting on an MCA agreement. 

What Is a Merchant Cash Advance?

A merchant cash advance is an alternative funding product that is much different than a bank loan or line of credit. Because those traditional sources of funding are demands for payment, they are considered loans and subject to certain rules and regulations. By contrast, an MCA is a purchase of future receivables in exchange for upfront cash. 

Also, MCA agreements typically contain provisions that require the funder to restructure the payment plan if the business experiences a downturn. This means that a merchant cash advance is not a demand for payment, and, therefore, not considered a loan. The fact that MCAs are not loans means these funding products are not regulated like consumer loans; businesses have little, if any, legal protection in the event of default. 

How Does a Merchant Cash Advance Work?

A small business that accepts credit cards is a candidate for a merchant cash advance. Approval for an MCA is based mostly on cash flow rather than a good credit score. The application process is relatively quick, unlike applying for a bank loan that requires borrowers to provide financial statements, business plans, and other documentation.

An MCA provider looks at a company’s daily credit card receipts to determine whether the business can repay the funds on time. In short, the business sells a part of future receivables in exchange for immediate payment. An agreed-upon percentage of daily credit card receipts or “holdback” is withheld to repay the advance. 

Notably, the holdback amount is different from the repayment amount for the entire advance. The holdback percentage is based on:

  • The amount of the advance
  • The term of the MCA agreement
  • The average amount of the monthly credit card sales

In short, the more credit card sales a business has, the faster it can repay the advance.

A business using a merchant cash advance may repay 20 to 40 percent or more of the amount advanced, which is based on a factor rate. This rate is in the range of 1.2 to 1.5 but when converted to an actual annual percentage rate is much higher than rates on traditional loans and lines of credit.

What’s the Catch? 

Because the funder has access to the business’s daily credit card sales, MCAs are often pitched as “no collateral required.” However, a typical MCAagreement includes a provision known as a confession of judgment whereby the business accepts liability for the advance and waives any defenses. 

If the business cannot repay the advance, the funder can obtain a court judgment and begin levying the business’s assets. At the end of the day, relying on a merchant cash advance to cover budget gaps puts a small business at risk of defaulting, which could force the owner into bankruptcy.

The Takeaway

If you are considering taking a merchant cash advance, proceed with caution; don’t take the advance unless you’re confident that you will be able to repay it on time. And if you are already struggling under the terms of an MCA agreement, talk to an experienced debt relief specialist.