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Are you a business owner? If so, you’re well aware of the daily stress involved to keep things running smoothly. Problems can arise without warning – and as the owner, the responsibility ultimately falls on you to solve them.

Cash flow shortages are particularly problematic. When cash becomes scarce, you can quickly find yourself in a dicey situation. If you’re unable to secure a loan, you may grow desperate, seeking alternative sources to cover your shortfall. That’s when you may discover merchant cash advances (MCA).

How Does A Merchant Cash Advance (MCA) Work?

A merchant cash advance is an alternative form of financing for businesses that have poor credit and for those who need cash quickly. Unlike a traditional business loan, a merchant cash advance works by lending a lump sum of cash in exchange for a percentage of a business’s future sales.

In general, there are three terms to understand when getting a merchant cash advance:

  • The advance amount – This is the amount of money you borrowed
  • The payback amount – This is the amount of money you and your lender agree you’ll pay back. This is also called the factor rate which is basically the interest rate you’re paying on the loan.
  • The holdback percentage – This is the percentage of your credit card transactions that will go towards paying back your loan.

For example, if you borrow $20,000 (the advance amount) at a factor rate of 1.3 (30%), that means you’re payable amount is $26,000. If you agree you’re business will pay 15% of its credit card sales towards the loan until it’s paid off, that would be your holdback percentage.

The holdback percentage typically ranges between 10% – 20% and is determined based on your credit card sales revenue and how long it would take you to repay the loan.

What Makes Merchant Cash Advances A Risky Solution For Businesses?

While there aren’t laws prohibiting firms from offering MCAs, that doesn’t mean it’s necessarily safe to do business with them. You can find yourself in severe financial trouble if you accept MCAs too readily without understanding the potential consequences.

Lack Of Regulation

The MCA industry lacks a robust regulatory framework, which opens the door to abuse by shady firms looking to take advantage of vulnerable businesses. Predatory MCA firms may act like they’re trying to help you but are, in fact, only interested in maximizing their bottom line. Because MCA firms aren’t burdened by regulatory oversight, they possess a great deal of freedom to charge their clients whatever they wish.

Learn how to spot predatory business lenders.

The Factor Rate

MCA payments are based on a calculation called the “factor rate.” The factor rate represents the cost of the MCA and is typically quoted as a decimal figure. Though the factor rate isn’t referred to as an interest rate in the MCA industry, it functions in much the same way.

For example, if you receive a $10,000 MCA with a factor rate of 1.3, the total amount you’ll have to pay back is $13,000 ($10,000 x 1.3). If you pay back this amount after a year, your interest rate is 30%. Let’s assume you pay it back in just three months. In that case, your annualized interest rate will be 229%.

As you can see, an MCA can be outrageously expensive, more so than a credit card or unsecured loan. It’s easy to see the danger of MCAs when your interest rate hits the triple digits.

Can Lead To A Cycle Of Debt

Overreliance on MCAs can lead to a debt cycle if you’re not careful. Once the MCA firm receives its share of your sales, there’s less cash available to cover your business expenses. As a result, you may have no choice but to obtain another MCA, further adding to your payment obligations. Soon, you may find yourself in a situation where your cash advance payments exceed your revenues, leaving you heavily in debt.

The Upside Of Merchant Cash Advances

Though MCAs have clear drawbacks, they offer some advantages as well:

  • Easy to qualify for: MCA firms accept applicants with poor credit and don’t require collateral. Meaning, if you have bad credit and are in need of cash, a MCA can provide you with the funds you need to help your business.
  • Fast funding: You usually gain access to cash right away. The application and underwirtting process is usually quite simple. Most lenders simply require your businesses daily credit card sales to approve you for a cash advance.
  • Flexible payments: MCAs offer a flexible payment process. Payments are based on your sales activity rather than a fixed schedule, so your payments are adjusted according to the number of sales you make. For example, if you have to pay 10% of your credit card sales each month, you’ll need to pay $2,000 if you made $20,000 in credit card sales. Similarly, if you made $35,000 in credit card sales, you’d need to pay $3,500.

Got too much business credit card debt? Consider consolidating your debt.

Is A Merchant Cash Advance Right For Your Business?

Though MCAs have somewhat of a dubious reputation, this form of “lending” is entirely legal in Canada. However, an MCA is not technically a loan in the traditional sense. Instead, you receive cash, and you must repay it through future sales from your business. Essentially, the MCA company is purchasing a portion of your future sales when they “lend” money to you. 

The most common MCA repayment arrangement involves your payment processor automatically deducting a percentage of your debit and credit card sales and transferring it directly to the MCA company. If you’re in need of cash quickly, an MCA can provide you with the financial relief you need to continue your business operations. It can help with cash flow shortages, emergency expenses and other business costs.

Check out the difference between merchant cash advances and business loans.

Alternative Solutions To A Merchant Cash Advance

If a Merchant Cash Advance doesn’t sound like a good fit to you, there are still a number of options to help you get the financial relief you need.

Small Business Loan

If you’re in need of cash quickly or if you have bad credit, consider applying with an alternative business lender. These lenders often have more lenient requirements and a fast underwriting process. Businesses can get funded in less than a week with some lenders. It works like a regular business loan where you get a lump sum of cash which you must repay over a certain period of time with interest.

Equipment Loan

If you’re having a hard time qualifying for a business loan, consider getting an equipment loan. If you need to replace your equipment, you could finance it through an equipment loan. These loans are easy to qualify for as the equipment acts as collateral for the loan, making it less risky for lenders. However, it’s important to note that most lenders will only finance 80%-90% of the equipment price, leaving you to fund the remainder.

Bottom Line

Like any other industry, the MCA industry has its fair share of dishonest and unscrupulous business practices. However, the lack of solid regulations in this sector magnifies these issues. Also, MCAs are a costly way to acquire temporary funding. For these reasons, you should avoid MCAs unless you’ve exhausted all other financing options, such as credit cards, lines of credit, or unsecured loans. 

Should you decide to get an MCA, ensure you do your due diligence and conduct a thorough investigation on each prospective company. Insist on transparency and honesty. Have them explain how they calculate the MCA cost, additional fees you may have to pay, special conditions, etc. Doing so will help you identify an MCA company that’s candid, fair, and principled. Some firms may try to mislead you, but you won’t become a victim if you’re educated and prepared.

Mark Gregorski avatar on Loans Canada
Mark Gregorski

Mark is a writer who specializes in writing content for companies in the financial services industry. He has written articles about personal finance, mortgages, and real estate and is passionate about educating people on how to make smart financial decisions. Mark graduated from the Northern Alberta Institute of Technology with a degree in finance and has more than ten years' experience as an accountant. Outside of writing, he enjoys playing poker, going to the gym, composing music, and learning about digital marketing.

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