Business owners often need quick access to working capital to cover payroll, expand their businesses, or pay unexpected expenses. Merchant cash advances may be a solution to cash flow shortages, but there are risks, not the least of which is defaulting.
A merchant cash advance (MCA) is a financing agreement in which a percentage of future receivables is used to repay the advance. In the event of default, the owner’s business and personal assets may be on the line. Let’s look at the reasons to avoid this alternative funding option.
Thinking About a Merchant Cash Advance? Think Again
There are several drawbacks to merchant cash advances, such as:
High Cost of Funding
The APR (annual percentage rate) for an MCA after converting the quoted cost of funding or “factor rate” could be in the triple digits. The APR is the total annual borrowing cost, including fees and interest, which depends on the size of the advance, fees, how long it takes to repay the advance, and the strength of the business’s credit card sales. Because merchant cash advances are not loans, state usury laws don’t apply.
The Higher the Sales, The Higher the APR
Merchant cash advances are repaid with a percentage of the business’s receivables. The APR depends not only on the amount, fees, and factor rate but also on how quickly you repay the advance. Weak sales mean payments are spread out over a longer time; therefore, the APR is lower. Higher sales mean you repay the advance faster, but the APR goes up.
No Benefit In Prepaying
Traditional business loans often allow you to make prepayments without a penalty and pay less interest over time. By contrast, there is no benefit to prepaying an MCA. You must repay a fixed amount of fees. So you receive no interest savings from early repayment and may incur a prepayment penalty.
No Federal Oversight
The merchant cash advance industry is not subject to federal regulation because MCAs are commercial transactions, not loans. While the Uniform Commercial Code (UCC) in each state regulates MCAs to some degree, the UCC does not provide businesses with legal remedies if something goes awry. However, the Federal Trade Commission enforces truth-advertising laws applicable to MCAs, and several states have adopted disclosure requirements.
Debt-Cycle Danger
Taking a merchant cash advance can put your business in a debt cycle if you need another advance soon after taking the first one. For example, a daily payment of several hundred dollars could cause cash-flow problems and put your business at risk of default.
Confusing Contracts
The repayment structure and costs make MCA agreements hard to understand. Such agreements often contain unfamiliar terms, including:
- The “holdback amount” (the percent you repay out of credit card sales)
- The purchase price (the amount you receive)
- Receipts purchased amount (total payback amount)
MCA providers don’t disclose annual percentage rates (APRs) unless state laws require them, making it impossible to compare with other financing products. Finally, the MCA agreement may require you to sign a confession of judgment whereby you accept liability for the advance and waive any defenses if the funder takes you to court for nonpayment.
The Takeaway
Merchant cash advances sound like a good option if your business needs quick access to working capital. However, the high cost of funding, risk of default, and predatory lending practices in the MCA industry are good reasons to avoid taking a merchant cash advance. And if your business is already in an MCA-induced debt cycle, talk to an experienced debt relief specialist at ReconcileMyMCA.com.