Merchant cash advance

LINK_POOL

• Internal Links:

  1. business financing
  2. working capital
  3. cash flow
  4. receivables
  5. credit card processing
  6. underwriting
  7. factor rate
  8. annual percentage rate
  9. usury laws
  10. default
  11. small business
  12. liquidity
  13. risk assessment
  14. collateral
  15. debt financing

• External Links:

  1. https://dfs.ny.gov/reports_and_publications/press_releases/pr202302011
  2. https://www.clevelandfed.org/about-us
  3. https://ag.ny.gov/press-release/2024/attorney-general-james-announces-historic-judgment-against-predatory-lender
  4. https://www.supervest.com/a-history-of-merchant-cash-advances-alternative-investments/

What Is Merchant Cash Advance?

A merchant cash advance (MCA) is a form of business financing where a lump sum payment is provided to a business in exchange for a predetermined percentage of its future sales. This falls under the broader financial category of alternative finance, offering a rapid source of working capital for businesses that may not qualify for traditional bank loans. Instead of fixed monthly payments, repayment of a merchant cash advance typically involves daily or weekly deductions from the business's sales, often directly from its credit card processing receipts or through automated clearing house (ACH) withdrawals from its bank account. This structure means that payments fluctuate with the business's revenue, potentially offering flexibility during periods of lower sales volume²⁵, ²⁶, ²⁷.

History and Origin

The concept of the merchant cash advance emerged in the late 1990s. The idea is often attributed to Barbara Johnson, who, while operating Gymboree Playgroup & Music franchises, sought a way to secure funds for a marketing campaign by leveraging future credit card sales. This led her and her husband, Gary, along with Les Falke, to co-found AdvanceMe (later CAN Capital), which is recognized as one of the first companies to formalize the merchant cash advance model²², ²³, ²⁴. They developed a patented system that enabled a credit card processor to split each transaction, sending a portion directly to the funder and the remainder to the merchant, a process known as split-funding²⁰, ²¹. This innovative approach addressed a need for quick liquidity for small business owners who often found it challenging to secure conventional financing. The industry experienced significant growth, particularly after the 2008 financial crisis, when traditional lenders tightened credit availability, making MCAs a more visible funding option¹⁸, ¹⁹.

Key Takeaways

• A merchant cash advance provides a lump sum of funds in exchange for a portion of future sales, typically credit card or debit card receipts.
• Payments are usually made daily or weekly, adjusting with the business's sales volume, unlike fixed loan installments.
• MCAs are often quicker to obtain and have more flexible qualification requirements compared to traditional bank loans.
• The cost of an MCA is typically expressed as a factor rate rather than an annual percentage rate (APR).
• Merchant cash advances are generally designed for short-term financing needs, such as managing cash flow gaps or seizing immediate business opportunities.

Formula and Calculation

The cost of a merchant cash advance is determined by a "factor rate," which is a multiplier applied to the advanced amount to calculate the total repayment obligation.

The formula for the total repayment amount is:

For example, if a business receives an advance of $50,000 with a factor rate of 1.3, the total amount to be repaid would be:

This means the cost of the advance is the difference between the total repayment amount and the advance amount, which in this case is $15,000. Unlike traditional debt financing, the factor rate does not compound over time, providing a fixed cost known upfront¹⁷.

Interpreting the Merchant Cash Advance

Interpreting a merchant cash advance involves understanding its total cost and the impact of its repayment structure on a business's daily cash flow. Since the cost is defined by a factor rate rather than an interest rate, direct comparison with traditional loans can be challenging. A factor rate of 1.3 means that for every dollar advanced, $1.30 must be repaid. Businesses need to evaluate whether the immediate access to working capital justifies this cost, especially considering that the effective APR can be very high due to the short repayment periods. The daily or weekly repayment mechanism, tied to sales, offers flexibility as payments reduce during slow periods, but it also means quicker repayment when sales are strong.

Hypothetical Example

Consider "Smoothie Spot," a small juice bar looking to purchase new, more efficient blenders for $10,000 to meet increased customer demand during the summer tourist season. Traditional bank loans might take too long to process, and Smoothie Spot needs the blenders quickly.

Smoothie Spot applies for a merchant cash advance and is approved for $10,000 with a factor rate of 1.35. The total repayment amount will be:

The MCA provider analyzes Smoothie Spot's average daily credit card sales of $500 and sets a daily holdback percentage of 15%.

Each day, 15% of Smoothie Spot's credit card sales will go towards repaying the advance:

So, Smoothie Spot will pay approximately $75 per day towards the $13,500 obligation. If sales increase to $700 on a busy day, the payment would increase to $105, accelerating repayment. Conversely, if sales drop to $300 on a slow day, the payment would be $45. This flexible repayment, directly linked to daily receivables, allows Smoothie Spot to manage its cash flow without fixed, rigid payments.

Practical Applications

Merchant cash advances are commonly used by businesses that require quick access to capital for short-term needs, especially those with fluctuating or seasonal revenue. They are often sought by small businesses in sectors like retail, restaurants, and services that generate consistent credit card processing volume. Practical applications include purchasing inventory to meet peak demand, covering unexpected expenses, funding immediate marketing campaigns, or bridging temporary cash flow gaps. The rapid underwriting process and minimal collateral requirements make MCAs an accessible option for businesses that may not qualify for conventional loans or need funds faster than traditional lenders can provide¹⁴, ¹⁵, ¹⁶. Due to their distinct structure, various states, including New York, have implemented disclosure laws for commercial financing, which often include merchant cash advances, to provide businesses with more transparency regarding terms and costs¹¹, ¹², ¹³. For example, the New York State Department of Financial Services adopted a new regulation in 2023 requiring standardized disclosures for commercial financings up to $2,500,000, aiming to help businesses compare offers more effectively.¹⁰

Limitations and Criticisms

Despite their advantages in speed and accessibility, merchant cash advances face significant limitations and criticisms, primarily concerning their high effective cost and regulatory status. Because MCAs are often structured as a purchase of future receivables rather than a loan, they may not be subject to state usury laws that limit interest rates on traditional loans⁷, ⁸, ⁹. This can result in extremely high effective annual percentage rates, far exceeding those of conventional debt financing.

Critics argue that this lack of traditional regulatory oversight can lead to predatory practices, where businesses may find themselves in a cycle of debt. The daily or weekly repayment structure, while flexible, can also be aggressive and disrupt a business's daily cash flow if not managed carefully⁶. Furthermore, if a business's sales decline, the percentage deductions can still represent a significant burden, potentially leading to financial strain or even default. Regulators and law enforcement have taken action against MCA providers accused of deceptive practices or misrepresenting MCAs as loans with usurious interest rates. For instance, in February 2024, the New York Attorney General announced a judgment against several merchant cash advance companies and their principals for usury and fraud due to illegally high-interest, short-term arrangements disguised as MCAs⁵. This highlights the importance of thorough risk assessment and understanding all terms before entering into an MCA agreement.

Merchant Cash Advance vs. Traditional Business Loan

The primary difference between a merchant cash advance and a traditional business loan lies in their legal structure and repayment mechanics. An MCA is typically not classified as a loan, but rather as a sale of future revenue, which means it may operate outside the stringent regulations that govern loans, such as usury laws. This distinction significantly impacts the cost structure and the level of consumer protection. Traditional loans offer predictability with fixed payments and defined terms, while MCAs provide flexibility with payments tied to sales, but often at a higher effective cost.

FAQs

What type of businesses typically use a merchant cash advance?

Businesses with consistent credit and debit card sales, such as restaurants, retail stores, salons, and other service-based businesses, often utilize merchant cash advances. They are particularly suitable for businesses that need quick working capital but may not qualify for traditional bank loans due to credit history or other factors.

Is a merchant cash advance a loan?

No, a merchant cash advance is generally not legally considered a loan. It is structured as the purchase of a business's future receivables at a discount. This distinction is crucial because it often exempts MCAs from certain lending regulations, including usury laws that apply to loans.
³, ⁴

How quickly can a business receive funds from a merchant cash advance?

One of the key advantages of a merchant cash advance is its speed. Businesses can often get approved and receive funds within 24 to 48 hours of applying, making it a viable option for urgent cash flow needs. ¹, ²The process involves rapid underwriting based primarily on sales history rather than extensive financial documents.

What is a factor rate, and how does it compare to an APR?

A factor rate is a multiplier used to determine the total repayment amount of a merchant cash advance. For example, a factor rate of 1.3 means you repay 1.3 times the advanced amount. It is different from an annual percentage rate (APR), which expresses the annual cost of a loan as a percentage and accounts for compounding interest. Because MCAs have short repayment periods and fixed costs, their effective APR, if calculated, can be very high.

What happens if my business sales decline after getting an MCA?

If your business sales decline, your daily or weekly repayment amount for a merchant cash advance will also decrease, as it is a percentage of your sales. This flexibility can be beneficial during slow periods. However, it also means that the time it takes to repay the advance will extend, potentially increasing the overall effective cost of the funding, and could still lead to financial pressure if the decline is severe.