Are Merchant Cash Advances Good for Startups?

merchant cash advanceMerchant cash advances (MCAs) have been gaining popularity in recent years as a short-term business financing tool. Also known as cash advances or ACH loans, MCAs promise to provide easy access to funding for entrepreneurs who need it.

While getting an MCA is easier than getting any other type of funding, this ease comes at a cost. Literally. This type of financing is very expensive.

The expense and short-term nature of this product makes it very dangerous if used incorrectly. But if used under the right circumstances, it can also provide access to many opportunities. From this article you will learn:

  1. What a merchant cash advance is
  2. The pros and cons of this solution
  3. When an MCA makes sense
  4. When an MCA is a terrible idea

What is an MCA?

Originally, an MCA was a product that allowed you to sell future credit card sales in exchange for an immediate payment. The product was originally aimed at retailers and companies that only had credit card sales. The product has now evolved and can finance almost any type of future sales revenue.

Given how the product has evolved, calling it a “merchant cash advance” is almost a misnomer. The name “ACH loan” or “business cash advance” is more appropriate.

The business model is an interesting one. Cash advance companies claim that an MCA is not a loan because they are not loaning you money. They claim they are purchasing future assets (sales) and are subject to different underwriting rules. For more details, learn about business cash advances.

How does a cash advance work?

Cash advances are fairly simple. The cash advance company reviews your company sales and determines how much they can give you and how much you have to pay back. The payback is often calculated using a “factor” that is multiplied against the funds provided.

Factors range from 1.09 to 1.50. However, these values vary greatly. For example, if you get $100,000 with a 1.09 factor, the payback is $109,000 ($100,000 x 1.09).

The next step is to calculate the payback time. Payback can range from three months to 15 months. From what I am told, longer paybacks have “higher factor rates.” However, risk is still the most important variable in determining the factor rate. Therefore, you could potentially have a 1.50 factor rate and a three-month payback.

In reality, the combination of factor and payback time determines how expensive this solution is for you. Here is an example. A 1.20 payback factor sounds really expensive, right? You must pay back 20% more than what you got.

Well, maybe.

If you had a payback of three months, it would be very expensive – if calculated on a yearly basis. But if you had a payback of 36 months (three years), it would be much more reasonable. That is why the combination of the factor and payback time is important.

How do you repay a cash advance?

The way you repay cash advances varies based on the type of sales you are financing. You have a couple of options.

If you are financing credit card sales, the cash advance is paid by splitting your daily revenues with the cash advance company. The rate of payment is called the “retrieval rate,” which can range from 3% to 15% of your sales (this rate varies). In other words, 3% to 15% of your daily sales go to pay the cash advance until the debt is satisfied.

If you are financing general sales, the cash advance company gets paid by making a daily debit from your business bank account. Unlike revenue shares from credit card sales, the payment amount is fixed.

Pros and cons

Cash advances have a number of pros and cons to consider before choosing them as a way to finance your startup.

Pro #1: They are easy to get

The most important advantage is that cash advances are very easy to get. This advantage is what makes advances attractive to new startups and businesses that have no credit and minimal assets. However, this advantage also makes the product dangerous because it’s easy to use it incorrectly. More on this later.

Pro #2: You can get them quickly

Another benefit of cash advances is that you can get them very quickly. You can get this type of funding in few days, and often in less than a week. This quick turnaround can be useful if your business or startup has a unique opportunity or an emergency.

Pro #3: They require minimal collateral

Unlike a conventional line of credit, you don’t need collateral to get this type of funding. All you need is a good track record of sales. By the way, cash advance companies encumber your assets with a UCC lien, just as any other business finance company would. However, this lien counts as secondary protection for them.

Con #1: They are expensive

The biggest problem with many merchant cash advances and ACH loans is that they are very expensive, especially if you compare them to conventional loans or lines of credit. I think that few businesses truly understand just how expensive these products are. And, as discussed in the next section, this expense can be a serious problem.

Con #2: They are only a short-term solution

This product offers a short-term cash solution. The problem is that many businesses owners try to use this product to solve long-term  problems. As you can imagine, a short-term solution may not fix a long-term problem.

Con #3: They may not be suited to solve your problem

Although not term loans, these products operate much like them. You get an immediate cash infusion and then make regular payments until the funds and interest are paid back. This structure may work great for some types of problems but do little to help if you have cash flow problems. Here is an example.

Let’s say you get a $100,000 cash advance with a six- month payback and a factor of 1.15. So, you get $100,000 now and need to repay $115,000 in the next six months. Three months after you get the advance, you will have paid $57,500. In other words, your actual availability of funds is $42,500 ($100,000 – $57,500). That’s a far cry from the original $100,000.

It gets more challenging. By the fifth month you will have repaid $95,833.33 – almost the whole amount. Basically, you have little, if any, availability. This diminished availability leads to problems, as companies often need to get a new cash advance (by the way, here is another good read about this issue).

Con #4: Selling future sales is risky

Perhaps the biggest problem of this model is that you are selling future sales performance. As you know, the future is unpredictable. No one knows what is going to happen. This is one of the reasons by many conservative business investments (including the safest government security-based mutual funds) still have the warning that “past performance is no guarantee of future performance.

If you borrow too much, or if your sales don’t realize, you and your business are done. Period. In this product’s defense, this is true for any type of financing. However, the high cost and short-term nature of this solution leaves you very open to this risk.

When would a cash advance be a good idea?

I recently asked a colleague in this industry if a cash advance would ever be a good idea and make sense. He came up with a good example. He told me of a pizza store owner who had a growing business. The tenant who occupied the space next door moved out and the landlord gave this restaurant owner the chance to rent that space.

However, he needed to make a quick decision.

In his case, using bank financing was out of the question. The approval process was too slow, and he did not meet banking criteria anyway. But he was certain that with an MCA he’d be able to refurbish the place and expand his growing restaurant.

From his perspective, this situation represented a unique opportunity to grow. The owner was willing to make less profit, or even take a short-term loss, to be able to grow the business. This type of calculated risk may make sense if it is carefully thought out.

Here is another example. Let’s say that one of your suppliers is clearing its products and gives you an incredible discount if you buy a whole bunch of inventory right now. Assuming the product sells well and the supplier’s discount is deep enough, an MCA or ACH loan may make financial sense.

When would a cash advance not make sense?

Generally, a short cash advance would not be a good solution if your company has ongoing cash flow problems. In these cases, a revolving product (like a line of credit) is a better solution.

For example, let’s say you run a commercial cleaning business and your clients are paying you in 30 days. However, you can’t afford to wait for payment because you need to pay employees every week. This problem is very common.

Unfortunately, a cash advance would only solve this problem temporarily (see Con #3) because of how it is structured. It may actually leave you worse off by using your profits. This loss can lead you to get another cash advance and go into a financing spiral.

Look for alternatives

If you are looking for financing, always examine multiple options. This approach allows you to make an educated choice. One option I like is the SBA’s Microloan program. This product is designed to help small business owners and often comes bundled with consulting and business courses. Unlike many conventional funding solutions, Microloans do not require good credit and are ideal for small business owners.

If you are looking for other options, consider these sources of funding for small businesses.

One piece of important advice

If there is one piece of advice I’d like to leave you with, it is this: get real, professional advice before getting a Merchant Cash Advance or ACH loan. Frankly, this advice applies to any type of business financing. You can get solid advice from a local CPA and from the SBA’s Score Program.

Sure, your CPA may charge you $150 to $300 an hour. Trust me, that cost is far cheaper than getting the wrong type of financing and putting your business at risk.