One thing that most small business owners have in common is that, at some point, they need cash quickly in order to meet a short-term need. The purpose of this article is to show you how these loans work – and how to figure out whether they are right for you and your business.
What is a merchant cash advance?
A merchant cash advance (MCA) is a lump sum of cash that a company receives up front from a lender in exchange for a fixed dollar amount of receivables in the future, generally in the form of credit and debit card receipts. For example, a business might get a sum of $50,000 up front for $60,000 of debit and credit sales in the future.
The target audience of the MCA is a small business that makes a lot of its money from debit and credit card sales. Most commonly, independent retailers and restaurants take out MCAs. While these do bring fast money and do offer advantages, the cost of the financing is quite high.
How do MCAs work?
There are 3 main aspects of an MCA that need to be worked out:
Advance amount: How much will your business receive up front?
Factor rate: This is the multiplier that determines what you have to pay back. If you have to pay $60,000 back for a $50,000 advance, you’re looking at a factor rate of 1.2.
Retrieval rate: The percentage of your debit and credit card receipts each month that return to the MCA provider. If your retrieval rate is 10%, for example, if you sell $24,000 in credit and debit card transactions in a particular month, you would pay the provider $2,400 to the MCA provider that month.
Once the MCA provider have set the terms together, your company gives the provider permission to deduct the payments through your bank or through your credit card processor. You keep making payments until you have paid back the agreed amount (the advance amount times the factor rate).
How long is the payback period?
An MCA differs from a term loan because you don’t have a set time period in which you have to pay back the loan. This is helpful for many businesses because they don’t face a set monthly payment but instead can pay less when receipts are down. When receipts are up, of course, the payment goes up as well. Most providers, though, plan retrieval rates so that they can get their money back between six and 18 months.
What is a typical factor rate?
The range is from 1.15 to 1.45. This depends on the sales of the company, the size of the advance and the credit profile of the business and the owner.
What is a typical retrieval rate?
Expect a retrieval rate between 5 and 15% — again, depending on the same factors.
What are the benefits of MCAs?
The approval rate for MCA loans are north of 80% with some lenders and upwards of 95%. The big banks only approve about 20% of loan applications from small business, while smaller banks and credit unions tend to approve about half of their applications. However, a lot of small businesses who get denied by the big banks won’t go back to the smaller banks and credit unions, so that rate might be a little misleading.
You’ll also find out the credit decision quickly. Approval can come as quickly as a business day or two, and you don’t have to send in a ton of documentation. A typical application contains 3 months of bank statements, 4 months of statements for credit/debit card receipts and a copy of the business’ lease. Ideally, it is best to provide 12 months to ensure all options can be considered. The business owner’s personal credit score does not have to be good for his business to get approval for an MCA.
If your business goes through a cold phase, you still only pay at that retrieval rate. If a catastrophic event shuts down your business for a couple weeks, or even a month, you only pay 10% of what you take in. Even if that amount is zero, you don’t owe any low payment fees. Of course, business owners are not permitted to push clients to pay in cash or by check instead of with a card, but no matter how high or low your receipts are, you only pay at that set percentage.
If your business goes bankrupt, you don’t remain personally liable for paying back the balance.
What are the drawbacks of MCAs?
If you take out an MCA, you can end up paying an effective interest rate of 80% — or even more. You could argue that an MCA is not comparable with a loan – after all, if the business goes under, the obligation goes away; there aren’t set monthly payments; and there’s no set term for repayment. However, you should be sure that MCA providers make detailed calculations about the amount of money they will bring in, and the time frame in which they will receive it. If your business takes off, there’s no benefit for early repayment, so if you do well, so does the provider.
Consider the example from earlier: you get $50,000 in a cash advance and have to pay back $60,000, suggesting a factor rate of 1.2. The provider sets your retrieval rate at 10%, and you project monthly card sales of $20,000.
Each business day, you would pay an average of $66.67 to the provider, with an APR of 15.26%, and you’d pay the loan back in about 900 days – or almost 2 ½ years, well above the typical average.
But what if you end up making $40,000 a month in card sales? You’ll pay it back twice as quickly, but you pay back the same amount. So your APR almost doubles, to 30.47%.
Now if your business explodes – and you jump to $60,000 a month in sales – then you’re paying 45.68% in APR, and you pay the note back in about 10 months.
What should you do if you need an MCA?
You have 2 options…
Option 1 – Go to each provider earn your money – go to at least two providers and let them know that you are shopping out the loan. Many MCA providers provide loans and want to earn your business, however shopping too much can also make your business look desperate and backfire. Some MCA funders will decline a file simply based on this fact.
Option 2 – Get in touch with a business loan broker that is able to match the business criteria with the funder that would be best suited for what it is you are seeking.
In both cases, as you negotiate your loan, ask for a retrieval rate as low as possible. Even if your factor rate goes up a bit, retrieval rate is the bigger factor when it comes to effective APR.