Introduction
Merchant cash advance is another kind of business funding that entails receiving a large sum of funds from a provider in return for part of its upcoming credit card receipts or a portion of everyday earnings. The contrary to having conventional loans carrying predetermined terms of interest and set monthly payments the merchant cash advance will be serviced in the form of a percent of daily weekly or sometimes twice-daily gross revenues usually charged directly by the funder itself. This product is widely provided to small businesses especially those in the retail food service or service sectors that make frequent credit and debit card transactions. The ease and quickness of approval render merchant cash advances attractive especially for business owners who do not qualify for traditional loans based on poor credit or lack of collateral. But these benefits have underlying complexity and financial threats that cannot be ignored.
The Mechanics of Merchant Cash Advances
In order to better see why merchant cash advances are enticing and dangerous let us explore the way they function. When a company requests a merchant cash advance the lender weighs the company’s daily income based usually on credit card sales. On the basis of this evaluation the provider advances an initial sum of capital usually between a few thousand dollars and several hundred thousand dollars. As repayment the company commits to sending a percentage of its daily or weekly sales until the total amount plus fees and charges is repaid. This percentage is referred to as a holdback and usually varies between five and twenty percent. The repayment period will vary with the sales volume with greater sales allowing for faster repayment while slower sales will lengthen the repayment period.
Factor Rates and Overall Repayment Charges
Another characteristic of a merchant cash advance is the use of factor rates rather than regular interest rates. The factor rate is a set multiplier usually between 1.1 and 1.5 which is multiplied into the cash advance amount. If for instance a company is advanced a ten thousand dollar advance and the factor rate is 1.3, then it must repay thirteen thousand dollars in all. This calculation of the borrowing cost can be misleading to many business owners who might not so quickly recognize how costly the advance actually is. Although the provider might sing the praises of the ease of access and quick funding the effective annual percentage rate or APR in some instances can be well over triple digits rendering this type of financing one of the most costly on the market.
Velocity and Ease of Merchant Cash Advances
Perhaps the most significant advantage of merchant cash advances is the speed at which they are offered. Providers routinely approve and make funds available in twenty four to forty eight hours a time that is almost impossible for conventional banks to match. This makes merchant cash advances highly attractive to those businesses that require immediate access to funds whether to meet payroll buy inventory or offset unforeseen expenditures. In addition the application process is quite simple typically only requiring simple financial information like credit card processing statements and bank statements. Credit scores are less involved in the approval process which provides an opportunity for companies with less than stellar credit histories to qualify for funding.
Lack of Regulation and Oversight
In contrast to more conventional loans that fall under federal and state lending regulations merchant cash advances tend to fall outside of such regulatory systems. Because they are technically more sales of future receivables than loans providers are not necessarily required to be restricted by the same disclosures requirements interest rate caps or consumer protection statutes. This is a legal gap that can render the situation a difficult one for borrowers who could be unaware of the terms and conditions of their contracts. There is also vulnerability to predatory activity such as bullying collection methods misleading advertising and unclear disclosure of expenses. Consequently a number of firms that engage in merchant cash advance contracts end up with unforeseen financial obligations and legal conflicts.
The Debt Cycle and Renewal Traps
Perhaps the greatest danger of merchant cash advances is the possibility of falling into a debt cycle. Since repayment is based on daily sales cash flow can become tight in a hurry particularly during lean business times. This lower liquidity may compel business owners to obtain additional advances simply to stay in business or cover current obligations. Most providers have so called renewal or refinancing plans that entail borrowing a new advance to settle the old one usually with additional fees and increased repayment terms. This vicious cycle can quickly spiral into one where the firm continues to repay advances without making significant headway towards becoming financially stable. With time the total cost of successive advances can greatly surpass the initial sum borrowed eventually threatening the sustainability of the business.
Effect on Day-to-Day Operations and Cash Flow
Payback of a merchant cash advance in the form of daily deductions can significantly affect a businesss operations and well-being. In contrast to conventional loans where merchants make set monthly payments merchant cash advances take a percentage of daily sales irrespective of whether the company makes a profit on the day. During lean months these can tightly limit available cash inhibiting the ability to pay suppliers staff or cover other necessary outlays. This constant financial strain can decrease the business’s flexibility and restrict its capacity to adapt to shifting market conditions. In addition the psychological weight of being aware that part of each sale is going towards repayment can become oppressive to business owners causing heightened stress and lower morale.
Transparency and Understanding of Terms
One of the merchant cash advance’s criticisms of wide appeal is that their costs and terms are not disclosed clearly. Since providers do not have to adhere to standardized disclosure procedures many contracts have complicated or obtuse language that borrowers find very hard to grasp. Factor rate holdback, retrieval rate are some of the terms with which non-finance people are not familiar. In addition, the overall amount of the advance plus fees and interest is not always made transparent. Such lack of transparency can result in great misunderstanding and remorse after signing the deal. Entrepreneurs are highly advised to consult with attorneys or financial planners prior to any merchant cash advance deal to be sure they are making an educated decision.
Comparison to Traditional Business Loans
Compared to conventional business loans merchant cash advances are different in a number of important respects. Conventional loans generally have lower interest rates fixed monthly payments longer repayment periods and more transparency. But they also come with stricter eligibility requirements such as higher credit score requirements collateral and extensive financial documentation. For companies that qualify conventional loans are generally a less expensive and more sustainable choice. By contrast merchant cash advances provide convenience and speed at the cost of greater expense and risk. Recognizing these trade-offs is crucial for any business owner looking to consider financing alternatives.
Alternatives to Merchant Cash Advances
Due to the risks involved in merchant cash advances it is wise to look at alternative financing options. Business lines of credit are one such alternative with flexible access to funds with interest only on the amount drawn. Equipment financing and invoice factoring can also offer targeted funding for specific purposes without the hefty price tag of merchant cash advances. Further some community development financial institutions and not-for-profit lenders provide small business loans with good terms and lower entry barriers. Peer to peer lending and crowdfunding websites have also become viable sources of capital particularly for startups and niche businesses. All of the alternatives have their own positives and negatives but tend to be more transparent and predictable than merchant cash advances.
When a Merchant Cash Advance Could Be Suitable
Merchant cash advances can be suitable despite their risks in some situations. For businesses with limited access to credit that need immediate funding and are confident in their short term revenue projections a merchant cash advance may serve as a useful stopgap. Seasonal businesses with predictable cash flows or companies facing temporary emergencies may also find value in the quick turnaround and ease of access. Yet these benefits must be balanced well against the cost over the long term and risk of financial stress. Prior to proceeding, it is crucial to have a complete cost benefit analysis and explore all that can be found as alternatives.
Role of Due Diligence and Planning Financially
Due diligence is essential for any business contemplating a merchant cash advance. This entails closely going through the terms of the agreement computing the amount to be repaid comparing factor rates and effective interest rates and determining the effects on a day-to-day cash flow. A meeting with a financial advisor accountant or attorney can be beneficial for further advice and to steer clear of expensive errors. Additionally companies should know a definite plan regarding usage of the funds and repayment management. Responsible planning will assist in moderating some of the risk associated with merchant cash advances and can ensure that the funding is going to long term growth instead of short term survival.
Legal Recourse and Dispute Resolution
When disagreements occur with a merchant cash advance provider businesses have limited legal recourse because of the non loan structure of the arrangements. But depending on the jurisdiction and particular terms there could still be avenues available to challenge unfair practices or pursue relief through arbitration or litigation. Business owners ought to keep copies of all agreements correspondence and payment records and note any issues which arise during the repayment period. Where deceptive practices or breaches of contract occur legal advice should be sought to pursue possible remedies.
Conclusion
Merchant cash advances are a quick and convenient source of capital for small businesses but they have some serious risks and potential drawbacks. The expense of borrowing lack of regulation effect on day-to-day cash flow and risk of debt cycles make them less than perfect for most companies. Though they might be appropriate in cases of emergencies or companies with few other options it is important to know all the terms and conditions before signing up for such a deal. Investigating alternative financing sources performing extensive due diligence and taking professional advice can enable business owners to make better and sustainable financial choices. In the dynamic business finance environment, preparation and knowledge are the best weapons for guaranteeing long term success and stability.
