When cash flow tightens, plenty of owners reach for the fastest money on offer. The dollars are fast, but the terms are tough. That pushes business owners into deeper debt with no clear exit. A merchant cash advance is a method of obtaining financing for your small business by receiving an upfront cash advance from a funder in exchange for a percentage of your future credit card sales until the advance is paid back in full. A merchant cash advance is not a loan. Merchant cash advances can be extremely helpful in the short-term, but they can lead to serious financial problems in the long-term if you don’t know what you’re doing. When the payments become too much, owners start hearing about debt settlement and MCA debt resolution as if they were the same thing. They aren’t, and the difference starts with how an MCA works.
The cost is figured differently from a loan, too. Instead of an interest rate, the funder uses a factor rate, usually between 1.1 and 1.5, and multiplies the amount of the advance by the factor rate to get a payback amount. For example, if a business needs to borrow $10,000 and finds a funder who offers a factor rate of 1.4, they will have to pay $14,000 in exchange for a $10,000 advance. Typically, a bank loan is paid back monthly over three to five years. A merchant cash advance is repaid daily or weekly by automatic withdrawals from the merchant processor. The majority of MCA contracts are 90 days to 180 days. Once you agree, the paybacks begin immediately.
It’s easy to see why so many owners consider taking an MCA. Unlike bank loans, which require excellent personal and business credit, merchant cash advances are approved based on revenue and time in business, and they are not secured by business assets. In a sense, this means that small business owners who can’t qualify for a traditional term loan or line of credit can still access financing in the form of a cash advance. Once an application is submitted online, funders generally require the owner to upload their bank statements and tax returns. Once approved, the owner typically receives a lump sum within 24 to 48 hours. That’s the part many business owners like best. It’s fast. But there’s also a trap.
A business that doesn’t qualify for a loan might qualify for an MCA. But if your business isn’t eligible for a conventional loan, you probably shouldn’t use an MCA, either. High costs could sink a business that can’t get a cheap bank loan. Many small business owners who obtain MCAs are unable to qualify for loans elsewhere because they are already over-leveraged. In this case, a funder’s choice to lend to a business that is barely keeping its head above water could easily be considered predatory. Many contracts are complex, with the advance being personally guaranteed. Also, the daily or weekly payment on the MCA is generally fixed, not a percentage of sales, so that money has to come out even if the sales don’t come in. It happens all the time. Business owners hope the advance will help them over a rough spot. They don’t see the huge jump in their debt. And as profits drop, payments take a bigger bite out of what’s left.
Many business owners are unaware that a merchant cash advance is more expensive than they expect. People tend to think in terms of annual percentage rate, or APR, so when a business owner sees a factor rate of 1.4, they assume they’re paying a 40% APR, when in reality, the rate is significantly higher. This is because the fee is calculated only once on the original principal and divided evenly over the payments, while with an amortized loan, the interest is gradually reduced along with the principal. MCA companies are unregulated because they aren’t considered loans, and this is unlikely to change.
Falling Behind on Payments
When owners start to fall behind on paybacks, funders rarely say no to another advance. So the next day, the owner takes a second cash advance to pay the first, and a third cash advance to pay the second, an event referred to as “stacking.” What this means for the owner is that a large portion of their revenue is committed to the merchant cash advance funder, along with very little room for profit and very high risk of falling behind on payments. Some owners try consolidating their MCAs instead, but that is only marginally better than stacking.
The worst part of merchant cash advances is what happens when owners default on payments. Funders are often aggressive and litigious when an owner defaults. They’ll make calls to the owner that border on threatening, send 406 lien notices, freeze business and personal bank accounts, freeze online card processors like Stripe, Square, and Shopify, and even contact customers directly and demand that they pay the money they owe the business. This can very quickly bring a business to its knees and damage the owners’ relationships with their customers. That strips an owner of cash and options.
MCA Debt Resolution Different from Settlement
The majority of debt settlement firms employ a business model that worked ten years ago, before the current MCA industry became what it is. As part of the debt settlement process, the owner is expected to save up a certain amount of money in an escrow account. The debt settlement firm will then use the money in the account to negotiate lump-sum settlements with creditors in exchange for a discount on principal. This practice works well for unsecured debts such as credit cards, vendor debt, and equipment leases. It does not work well for merchant cash advances. Settlement can fail with MCAs because of two factors. First, aggressive collection practices by the funder make the debt from the MCA get paid before other unsecured debt. Second, time spent trying to build a cash reserve leaves the owner exposed to the funder. The damage done in this time can put the business in a position from which it may never recover. It can feel inevitable, but choosing to stop paying and start saving isn’t an appropriate option for business owners who fall behind on their MCAs.
How is MCA debt resolution different from settlement? Settlement allows you to save cash and wait to make an offer. It’s built for credit cards and vendor debt. But MCA funders don’t wait. The resolution must deal with the MCA before the funder’s collection tactics start wrecking the business. Getting out of an MCA is a deep, dark undertow. It may suck you in, and once you’re in, it’s hard to get out. If you are behind on payments or stacking advances to stay current, talk to someone before the liens arrive. Ask a firm how it will protect your accounts while it negotiates.
