Merchant cash advances: Good deal or necessary evil?

Merchant cash advances: Good deal or necessary evil?

Having trouble getting the cash flow you need to keep your business going or growing? If the credit crunch has made it hard for you to qualify for a traditional loan, you may be considering a merchant cash advance.

Just be sure you know what you're signing up for. If you're not careful, a merchant cash advance could end up draining your business instead of reviving it.

What is a merchant cash advance?
A merchant cash advance is a lump sum payment made to a business in exchange for an agreed-upon percentage of future credit and debit card sales. It's important to understand that merchant cash advances are not loans and that their repayment terms are very different.

Here's how they work: Suppose Amy Smith, the owner of a small gift shop, signs a six-month merchant cash advance agreement. She gets $10,000 in a lump sum at the start of the agreement and will have to repay the cash advance company $13,500.

The cash advance company, meanwhile, looks at several months of Smith's credit card receipts to calculate the percentage (called the factor) of those sales that she would owe them each day. Smith's factor is 10 percent, which means, on days when her credit card receipts are $1,000, she owes the cash advance company $100; on days when she brings in just $500 in credit card business, she owes them $50.

If Smith's credit card sales over six months are more than the cash advance provider estimated they would be, her debt is discharged sooner; if they are less than anticipated, Smith will have to continue to give the cash advance company its 10 percent of her credit card receipts until her debt is fully repaid.

Are cash advances a good idea?
Many merchants like cash advances because they provide access to much-needed cash that's difficult to obtain anywhere else.

"It's also a fast process to get funds from these companies," says Janinne Dall'Orto, senior manager at First Annapolis Consulting, a Linthicum, Md.-based consulting firm for the payments industry. "From the time [business owners] apply to the time they get the funds is just 10 days to two weeks, and there are very few documentation requirements."

While cash advance providers do look at a business owner's credit scores and credit history, "it has to be a very, very bad score for them not to qualify for a merchant cash advance," Dall'Orto adds. Cash advance companies will also require the merchant to prove they accept credit cards (and present three months of credit card statements) and prove they have a lease on their store for at least one more year, Dall'Orto says.

Despite the ease of getting merchant cash advances, many in the financial industry have concerns.

"In my mind, merchant cash advances are a necessary evil right now because of the tough credit environment with traditional lenders," says Ami Kassar, CEO and founder of MultiFunding, a company that assists small businesses in finding financing.

The high interest rates charged by cash advance providers draw the most criticism. Because they are not classified as loans, merchant cash advance providers are not bound by laws that set usury caps on interest rates. Merchants can end up paying an interest rate equivalent to 30 percent or more.

Kassar says business owners should insist that the cash advance company provide at least a projected annual percentage rate (APR), based on the provider's calculations of how long it will take to repay the advance.

"If you understand what the money is really going to cost, you can compare a cash advance to other choices that might be available," Kassar says. "Often, the rate is deliberately designed to confuse the business owner."

One mistake a business owner might make is equating an APR with the amount withdrawn from sales

"I had a client who was in a 15 percent daily withdrawal agreement, and he thought that his interest rate was 15 percent," Kassar says. "But when we actually calculated the APR, it turned out to be 97 percent. You've really got to be careful and not get fooled."

Kassar says that the method of paying back the cash advance makes planning difficult for merchants. With a traditional loan, there's a fixed payment amount and a fixed schedule, but, with a merchant cash advance, the business owner knows only that their daily payment will be a percentage of their sales; they have no idea of what the actual amount of that payment will be.

Kassar is also concerned that merchants become "addicted" to cash advances despite their high interest rates.

"Although the typical terms are six months, they are designed to get you to renew after three months," he says. "Some people have taken as many as 18 of these on renewals and they live by them."

Consider your options
Kassar advises business owners to plan head so that they can consider alternatives to merchant cash advances.

"Try to get a business credit card; you'll know the rates," he says. "The other thing is don't wait until the last minute ... try to get your books and accounting under control and understand your cash flow so that you're not forced into one of these loans if you can possibly help it."

The Small Business Administration's SBAExpress loan program might be one alternative source of funding, Kassar says.

"Merchants with better credit should also see if they can qualify for the loans that some merchant cash advance companies are offering," says Dall'Orto. Some of the more established firms, such as RapidAdvance and AdvanceMe are now offering loan products in addition to cash advances.

Business owners who do decide on a cash advance should seek a well-established and experienced cash advance company, Dall'Orto adds. "Owners also shouldn't be paying a finder's fee for a cash advance; there's enough supply in the market right now."

Whether you get a cash advance or a loan, be a smart borrower, Kassar says.

"When you borrow money you have to understand exactly what it's going to cost you and evaluate in terms of other choices," he says. "You have to make sure that you are really confident that you have a good way to pay the money back."

See related: Can your business afford to go cash only?, Credit crunch forces firms to go elsewhere for funding

Published: October 15,2023