Avoiding Common Pitfalls When Using Merchant Cash Advances

You may have heard of a special type of immediate financing called the merchant cash advance, or MCA. An MCA is different from other types of financing. In fact, it’s legally not considered a loan. But, there are some merchant cash advance best practices you can adhere to. 

Let’s look at how to avoid some common MCA challenges.

Understanding Merchant Cash Advances

An MCA is an agreement where a lender “purchases” future sales. Merchant cash advance repayment is drawn directly from your card transactions. 

Instead of an interest rate, an MCA has something called a factor rate. This factor rate is multiplied against the principal amount to arrive at the outstanding total repayment amount. This amount will not change, even if you pay it off early.

The unique nature of an MCA necessitates avoiding some merchant cash advance pitfalls. There are certainly merchant cash advance risks, and you may have heard of merchants with an MCA horror story. However, as long as you avoid MCA mistakes, an MCA can actually be a very helpful tool for bridging gaps in your cash flow.

Minimizing MCA risks involves the strategies we’ll outline below. Merchant cash advance pros and cons should be weighed against other forms of financing. Choosing the right MCA provider, understanding MCA terms, and gauging MCA’s impact on cash flow are all important. 

Common Pitfalls of Merchant Cash Advances

Though merchant cash advances can be a valuable tool to immediately aquire funds, even with poor credit, it still have some pitfalls to be aware of.

High Cost

One of the most important considerations any borrower must research when shopping for a loan is the annual percentage rate (APR). Consumers would never want to get a credit card with an APR above 24%, as anything higher would be considered punitive. Typically, higher interest rates are assigned to individuals with no established credit or bad credit history.

Business owners usually enjoy better interest rates than consumers. For example, the nationwide average for an SBA(7) loan between $50,000 and $250,000 is 14.5%, and 11.5% for loans over $350,000. One reason business owners can enjoy lower interest rates with an SBA loan is because these loans are backed by the Small Business Administration, which wants to stimulate the small business economy.

Typically, merchant cash advances have higher interest rates than other forms of business financing. They are riskier for the lender because there is no backing from the SBA. Business owners can declare bankruptcy to avoid repaying the MCA and other debts. In many cases, it’s even easier for them to take this route than a personal bankruptcy because their business assets are legally separated from their own via an LLC and/or S-Corp.

Cash Flow Concerns

Another risk is that an MCA is also not alone in the traditional sense but rather the “sale” of future receivables. What if sales don’t pan out as expected due to a business mistake or unforeseen circumstances in the greater economy?

For all these reasons, the effective “APR” of an MCA is typically much higher than any form of traditional financing—credit cards included. The average factor rate of an MCA ranges between 1.1 and 1.5, although it is not unheard of for factor rates to go higher.

A merchant must carefully consider their cash flow when shopping for an MCA. Merchant cash advances typically have set repayment timeframes. By contrast, a loan with an APR allows the borrower to make lower payments and extend the life of the loan—allowing for better management of their monthly cash flow.

If cash flow is tight one month, the merchant can simply make a minimum payment instead of paying more to accelerate the payoff. However, with an MCA, they are locked into paying it all off with a fixed timeframe. Can you afford periodic MCA payments while remaining financially solvent to address overhead and operating expenses?

APR vs. Factor Rate Considerations

Although the factor rate is not an APR, for the sake of illustration, let’s compare an MCA to a traditional business loan—both at $50,000, and assuming that both will be paid off in the same time frame of 12 months.

A $50,000 business loan with a 14.5% interest rate will yield approximately $4,037 in interest payments if paid off in one year. By contrast, an MCA of the same amount with even the “lowest” average factor rate of 1.1 would yield $5000 “interest.” If the factor rate was 1.5, this would be $25,000.

Another factor that must be assessed is the actual term of a typical business loan. These loans must usually be paid back between 3 to 10 years. That is going to yield a much different set of numbers. The same $50,000 SBA loan with the same interest rate would yield over $12,000 in interest payments. Yet, this amount is still much lower than the effective “interest” demanded by an MCA because any factor rate above 1.12 surpasses this.

Lastly, a business must consider its debt cycle. A business turning to a merchant cash advance may not be able to get a more normative loan with favorable terms. If things don’t go as expected, they may attempt to take out a second MCA to pay off the first one. This becomes a catch-up that can be hard for some merchants to climb out, particularly if sales start declining.

How to Avoid Merchant Cash Advance Pitfall

Now that we know the pitfalls, let’s take a look and see what you can do to avoid them.

Research MCA Providers

The first line of defense against MCA pitfalls is to research MCA providers. You may already work with a payment processor that helps you accept debit and credit card payments—and if you have a good relationship with that company—you could start by asking them if they also offer MCAs. If they don’t, it’s time to look around and see what’s available.

If your payment processor does not offer MCAs themselves, they may have a good referral for you with a lending partner. Your payment processor will be very reluctant to disrupt a successful working relationship with you, so they are unlikely to refer you to anyone who would be problematic.

Ask fellow merchants if they have had success working with anyone in particular. They may be able to put you in touch with an MCA broker who can help you. Similarly, merchants in your professional circle will be very reluctant to sour any potential relationships by referring you to a bad lender. 

Nevertheless, check out reviews of your referred lender on Google, Trust Pilot, and the Better Business Bureau website. Don’t expect the total sum of reviews to be sparkling, as there will always be problems with anything…and some of them may not be the fault of the lender. Reviews out of five stars and above are strong, while anything above 3.5 is still fair.

Assess Business Financials

In addition to conducting your research about the lender and reviewing the terms, you need to assess the financials of your business. Cash flow is the most relevant factor, as the MCA will be repaid from your incoming debit and credit card sales. You may also want to explore alternative types of loans.

Many credit cards offer a 0% interest introductory period of 12, 18, or even 24 months. These offers are not common on business cards, but they are on consumer credit cards. However, consumer credit cards may have lower limits than you need. If you were looking at a small amount of credit for a small purchase, this could work. 

Some financial institutions will facilitate balance transfers, which consolidates debt at very low introductory rates. They may even be able to use what is called a direct deposit promotion to place funds from the credit line in your business checking account at this promotional rate.

If you have time to finance what you need, you may also explore a business loan or SBA. These types of loans take a lot longer to originate than an MCA. But they are much better suited to long-term investments like the purchase of property, equipment, or anything else that is not time-sensitive.

Case Study: A Business That Faced MCA Challenges

Let’s look at a hypothetical example of small business owner who took out a merchant cash advance. 

Suppose a contracting company with five vehicles is looking to expand business operations in the neighboring county. They hoped to obtain a traditional bank loan to purchase a satellite garage and 5 more vehicles. 

Race Against the Clock

Unfortunately, their access to funding was running up against a clock, as a competitor was moving into the same county. The owner tried to explore some other funding ideas like a business line of credit. However, every lender he spoke with said it would take at least 30 days to originate a loan. The owner already had a property in sight, and waiting a month would allow the competitor to make significant advances in the housing market.

Our handyman hero began to get desperate, giving long-term goals precedence over his immediate financial situation. Without thoroughly weighing the pros and cons, he sought out a merchant cash advance. He figured that within a few months, he could refinance the property and vehicles to something with a more affordable interest rate.

Lack of Research

He did not bother researching merchant cash advance companies, but simply went with the first one he found on Google—which happened to be a paid advertiser. It seemed reasonable to make daily or weekly payments from his sales volume. Unfortunately, there were some disruptions of significant impact on his cash flow management.

Cash Flow Concerns

Competition in the neighboring county was fierce. Moreover, the owner did not consider the seasonal fluctuations in cash flow. He took this MCA in the fall. As winter approached, demand for construction slackened, as it always does. But our handyman hero did not consider this, as seasoned as he was.

Without a thorough examination of his finances, he assumed he could “wing” the repayment each business day. Suddenly, he found himself unable to cover his overhead after the MCA repayment had been automatically deducted from the transactions. He had to let some of his contractors go, and some of them even went to his competitor.

As it turns out, this particular MCA lender did not have a good reputation. They were inflexible about changing the agreement and leveraged a COJ to seize his five new vehicles and the new satellite location. Remember, it pays to ask people in your social or professional circles for references. Networking is the best form of equity, they say.

Mistakes Made

Let’s look at some of the mistakes our contractor made: (1) he did not consider the year-long picture of his cash flow or MCA cost management, (2) he did not properly research an MCA vs. traditional loans, (3) he did not do his due diligence in navigating MCA contracts, resulting in the COJ, and (4) he did not properly vet his lender.

MCA financial planning must also take into account big-picture concerns, such as seasonal fluctuations. Of course, some things will be outside your control (such as the recession in our example), but there are still ways of avoiding MCA debt traps within your control.

Best Practices for Managing an MCA

It is important to make a very structured plan to repay an MCA. Remember, an MCA must usually be paid off within a specific timeframe that is much shorter than a traditional loan. There is room for flexibility with a traditional loan that has an APR month-to-month. However, you cannot make these adjustments with an MCA repayment plan.

Monitor your cash flow carefully, even day-to-day, more so than you would normally. Consider setting aside a portion of your sales every day to meet your repayment timetable. In some cases, repayment for the MCA will happen every day (instead of weekly or monthly). Even if it does not, you may consider setting aside a fixed portion or percentage of incoming sales to cover your repayment at the end of the month, just in case things don’t pan out as planned.

Make sure your MCA is a clear, immediate revenue-generating expense. This would include things like rapidly liquidatable (e.g., “hot”) inventory. Overhead—such as payroll—can also be considered an immediate revenue generator. You cannot stay open for business if nobody is manning the ship. All the same, before exploring MCA, you might see if you can make any ethical cutbacks (e.g., reducing employee hours).

Some types of expenses are not immediate revenue generators, even if, in the long term, they will significantly improve your revenue. Renovations are one clear example of this. Although, in the long run, improving the look of your footprint will generate more revenue and probably increase customer lifetime value, this may take months or even years to fully pay off. Marketing campaigns fall into a gray space—some might say they are immediate revenue generators, while others might say they are more of a long-term practice.

Legal and Compliance Considerations

Because an MCA is technically not a loan but rather the right to receive a portion of future sales, it evades some of the legislation that is aimed at reducing the impact of predatory lending. The effective interest rate of a merchant cash advance from the factory rate may exceed the usury cap of your state’s laws. Lack of legislative parameters also means that the marketing of an MCA or presentation of the terms can lack transparency when compared to traditional forms of financing.

Make sure you understand the terms of the MCA before signing it. The lender should be willing to explain these terms and answer any questions you might have. If they are unavailable or unwilling to explain the terms, this is a red flag.

You may also want to contact your local Chamber of Commerce to inquire about certain laws in your state. One of these is called confession of judgment or COJ. A COJ will effectively forfeit your legal rights if you default on the MCA. 

The lender will essentially have the same legal rights as a court-ordered judgment against you. They’ll have tools at their disposal, such as wage garnishment or asset seizures, such as money or property. Do not be afraid to reach out to your lawyer to discuss an MCA and review its terms.

A retainer can help you understand any merchant cash advance fees that aren’t readily apparent and/or buried in the legalese beyond the origination fee (if applicable). This is one way to avoid MCA’s hidden costs. In summary, having good legal counsel is an understated but important merchant cash advance strategy.

When to Consider Refinancing or Renegotiating

Refinancing is one of the greatest tools available to borrowers in any situation. Lenders are motivated to refinance because they will make money on fees and on collecting interest that you would pay to other lenders.

If you are struggling to repay an MCA, you might first inquire if you can renegotiate the terms of the contract with the MCA provider. In most cases, this will be unlikely. But refinancing is typically more available than you might think. 

You should definitely avoid using a second MCA to pay off the first one. Rather, you should seek a long-term loan with a lower interest rate. As mentioned earlier, there are credit card issues that provide balance transfers to consolidate debt at a 0% rate for up to 24 months.

Earlier, we mentioned that it is important to select an MCA provider who is transparent and recommended. You want the lender to be approachable and someone you can work with. That means, for starters, that someone with decision-making power picks up the phone when you call. Do not be afraid to approach them with full transparency if you are struggling to repay the MCA.  

Conclusion

MCA financial management is important to avoid an MCA becoming a debt trap. Merchant cash advances (MCAs) can be an excellent tool for short-term cash flow issues or jump-starting immediate revenue-producing activities.

Curious about MCAs and if they are right for your business? Caught in an MCA with an unfavorable lender and looking to get out? Perhaps it’s time to reexamine the broader context of how you accept payments. Reach out, and we’d be happy to answer any of your questions.

Frequently Asked Questions About Merchant Cash Advances