What are better alternatives to a merchant cash advance for a small business?

Most small business owners are cautious when they plan for cash needs, but even the best-run businesses sometimes find themselves strapped.

Cash: you might think you have enough to tide you over if a customer is late paying a bill. And maybe you’re right! But what if three of your best clients don’t pay for a month - and then you still have to make payroll? If that doesn’t get you, there are plenty of other ways to run into a cash crunch, even if you do everything right. Maybe a key piece of equipment breaks down. Or a pipe bursts and floods the storeroom. You might even be tempted by an amazing price on expensive items, just because a competitor is going out of business.

Whatever the situation, there are usually plenty of ways to get a fast infusion of cash. A merchant cash advance might be one of the answers. These transactions can be made very quickly, but they are not always the best choice for the business.

When a lease is coming due, you might be tempted to agree to any cash advance merchant offers. But it is in your best interest to do the same homework you would with any large investment of time and money. Find out how the repayment schedule affects your cash flow. Research the other options before you decide to sign.

Against Your Future Credit Card Sales

A merchant cash advance (MCA) is an advance of cash against your future credit card sales. The lender looks at how much you took in sales in recent months, and projects future sales. Then they pay you a percentage of that projection in one lump sum.

In a simplified example, if your business averages $22,000 in credit card sales a month for the last three months, the provider might project sales of between $22,000 and $25,000 a month for six months. It discounts the amount heavily, so instead of advancing $150,000 it might offer you something like $90,000. Real offers will vary.

The repayment will come through a daily deduction from the sales that run through your credit card machine. When you take in $10,000 in sales one day, a provider might deduct 10% ($1,000), and send the rest to your account.

If you run out of cash and have trouble paying your regular bills, a merchant cash advance could be a short-term fix.

If you need the money to go out next week, an MCA gets you cash on day one. A loan from the bank will have to go through underwriting, a process that could take months.

A merchant cash advance is an excellent choice if you need fast access to working capital, to take advantage of a bargain purchase, or to fix equipment that won’t wait. Repayment is usually automatic, and you can get approved and paid with far less paperwork. And you can get approved with lower credit scores than with many other programs. It is likely to be the fastest way to get cash in your hands in an emergency.

That Speed Comes with Downsides

But that speed comes with downsides. The advance is expensive, and its repayment terms can be very demanding on cash flow.

A bank will spend a long time underwriting a loan. A lender that takes less time will probably miss some things that would have been red flags. Less vetting means more risk, and the lender will expect to lose some money on default. So the fees on a merchant cash advance are much higher than those of most bank loans.

The MCA lender will present you with a factor rate, rather than an interest rate. You get charged a flat amount, and you will pay most or all of it even if you pay early. So it is always a good idea to look around before you sign anything.

The factor rate is usually 1.0 to 1.5. If you agree to a 1.5 factor rate on an advance of $100,000, you pay back $150,000, and $50,000 of it is fee or cost.

One of the big disadvantages to a cash advance is the way it is repaid. Daily deductions make it hard to budget, and they can strain the cash flow that makes your business run. A bank loan that takes a payment every month can be more difficult to get, but easier to manage.

Note that the biggest tradeoff here is having a high enough credit score to qualify. If your credit has been dinged, you might have to fall back on the more expensive options.

Several Alternatives

If you’re worried about the cost or the impact on cash flow, an MCA might not be your best option. When you start looking at other loans, you can find better options. None of them will be right for every business, so compare costs and terms before you agree.

If you know you will need occasional access to capital but you’re not sure when, a line of credit may be what you need. Once you get approved, you can access the money whenever you need it, up to your limit. Pay it down and you can draw it again without re-applying. You only pay interest on the amount you actually draw.

A line of credit has more options than an SBA loan. The interest rates are often lower than a credit card’s.

People often take out a line of credit from their bank and then set it aside as a hedge against trouble. Having access to extra funds is comforting if things go wrong.

Even with good credit you still have to provide tax returns, proof of sales and much more paperwork than with an MCA. Plus it will likely take weeks or longer to get approval.

When you buy a car, you borrow money from the dealer or the bank. When you buy a machine for work, the process is similar. Your business takes out a loan and buys the equipment. The money goes straight to the seller, and you start repaying.

When a key machine breaks down, it can shut down the business while you get it replaced. When you need equipment to run the company, an equipment loan may work better than a cash advance.

An equipment loan is secured by the equipment itself. If you default, the lender takes the asset and tries to resell it. That makes the loans lower risk, and lowers the interest rate. Lenders usually give you a fixed monthly repayment amount, instead of a daily percentage.

Getting paid can take forever. You finish a job and send out an invoice. And then there’s that pile of invoices you have been chasing for three months. When you need cash in a hurry, they don’t do you any good.

Factoring converts those outstanding invoices to cash you can use to run your business. For a fee, the lender will buy up some or all of your outstanding invoices and give you the cash up front. Rather than wait months to get paid, you can take care of immediate needs.

Factoring transfers ownership of the invoice to the lender, who takes the risk of nonpayment. With factoring, the lender advances you the cash and does the collections. An invoice financing loan has you borrowing against your invoices as collateral. You continue to own the invoice and do the collecting yourself.

Some owners resist factoring because they worry the lender might be aggressive in trying to collect the invoice. For that reason, some lenders will offer you a financing contract instead. It is likely to pay you less, but it lets you protect your image with your customers.

The funding process for factoring is lengthier. For an advance, the lender checks your credit and the status of your business. For factoring, the lender may also look at the credit of the companies that owe you money.

If you need cash in a hurry, a personal loan is an option. It can be hard to qualify if you have credit problems, and it puts your own credit at risk. If the business goes under, you are still on hook for the payment. Think twice about risking your retirement to help your business.

Unless you are starting a business, it should support itself. When it can’t do that, something is wrong. Find out what it is. If you keep injecting your personal money into the business, it may lead to trouble with your own finances.

When you are shopping for a personal loan, the bank may want you to show top credit scores and low debt relative to income. If you are a small business owner struggling with cash flow, a personal loan may be out of reach. The lower qualifying standards of an MCA lender may make it your best option, though the cost is likely to be higher.

Some credit cards will extend a credit line for you to use as needed. They can be useful for smoothing out a bumpy cash flow, especially if your business carries heavy receivables. This is not a good fix if you have a big one-time need, but it can be a lifesaver for a business that needs a cash flow cushion. Cash advances from credit cards are very expensive, so try to keep them short-term.

You don’t have to pay anything if you don’t charge anything, so you only use them when you need them. However, they carry a high cost, and their limits may not be enough to fund a big purchase. Use them wisely.

Deciding to get an MCA can be a simple choice. You know you have an opportunity, and that you won’t be approved for better options. But for other purposes, an MCA may not be the best use of your money. You may end up paying more in interest than you would otherwise. If you have a more stable need, you should shop around before you sign any papers.