In the past year, many smaller, private and publicly traded companies have struggled to get by. The coronavirus pandemic, and the government restrictions imposed to limit the virus’ spread, have made things even harder.
Against that backdrop, the New York Attorney General has taken action against merchant cash advance companies and their owners in state court. The Federal Trade Commission has filed its own lawsuit against some of the same funders in federal court. The NYAG says the deals are disguised loans covered by NY state usury criminal law and are therefore void. The FTC is targeting deceptive advertising aimed at businesses. For a struggling business, both lawsuits have potential ramifications. The FTC complaint, about deceptive advertising, alleges the defendants targeted vulnerable businesses.
What Exactly a Merchant Cash Advance Is
If you’re the owner of a small business and you want a quick way out of a cash crunch, the answer may seem to be a merchant cash advance. The payment will cost you more than you think. An advance repaid out of your receivables may have unexpected costs you may not see. Before you sign, make sure you understand what you’re getting into. Here’s why it can hurt you more than help you.
What a funding company will do for you is pay you in advance for a cut of your future receivables. The funder is not making you a loan, in theory at least. It’s a form of financial product meant for retailers living on credit card sales, but now it’s for many industries. The funder has direct access to your bank account and pulls daily or weekly amounts. What you owe to the funder is supposed to be a percentage of what you collected.
So a true MCA, though a last resort source of business finance, does have some pros. Here’s a quick summary.
A true merchant cash advance means getting money quickly, as soon as in a week, and often with very little paperwork. The provider has to decide whether you’ll be able to repay the advance, and they usually just look at your daily receipts.
One positive side of a MCA is that it isn’t secured - you don’t have to put up any of your business assets. But the funders will probably ask you to guarantee it and sign a “confession of judgment.” That means you are personally liable, and that the provider can come after you if you don’t pay it off. Note that courts have found those features suggest the sale of receivables is actually a loan.
The payments may go down if your sales do. The “reconciliation clause” adjusts your payments to reflect the percentage of receivables you really collected. But a real MCA, with the reconciliation clause, is meant to reconcile in your favor when you request it. The funder has the risk of collection from your customers. If it says “may” reconcile instead of “shall,” that’s a pretty good argument that it is really a loan. The thing is, many courts have said that reconciliation should be absolute and mandatory. If the funder can collect in other ways, that may mean it’s really a loan, subject to state usury laws. So all this may seem technical but it’s important.
How do you pay back a merchant cash advance? Two ways.
First, the contract determines the percentage of your sales the funder will get, and the provider gets that amount automatically until the advance has been fully repaid. The idea is that your payments come straight out of sales you made. If your sales drop, your daily payment should too.
You can also repay an MCA with a set amount with fees. The funder takes that amount from your bank account, daily or weekly using ACH debit. It withdraws the money until the advance has been fully repaid.
It’s not technically a loan, so it’s not regulated like loans. Providers offer factor rates instead of interest. If payments are set and they don’t reconcile, courts may call it a loan.
The Cons of a Merchant Cash Advance
What does it cost? APRs can range from 40% to 750%, depending on who’s funding you, how large the deal, fees, term and card sales. In New York, though, the law limits the interest rate on loans to 25%. Anything above 25% may be criminal usury and the deal may be void.
With percentage deals, your APR depends on the advance fee and how fast you pay back the advance. Slower sales mean a longer payback and a lower APR. Higher sales mean a shorter payback and a higher APR. A business with strong sales will pay a higher effective rate than one in a slump.
One possible upside is the ability to pay off your debt early. That can save you money on a small business loan, where payments amortize. With a MCA, you won’t have saved anything. If you refinance a MCA to a small business loan, you’ll owe all the fees. You may owe a prepayment penalty, too.
Merchant cash advance deals aren’t regulated by any federal law. These are commercial deals, not loans. They’re supposed to follow the state’s Uniform Commercial Code, not state banking laws. The FTC regulates advertising.
A lot of folks wonder if there’s a credit check for a merchant cash advance. Many places will offer you a merchant cash advance if you have bad credit, but they’ll often still run a check when you apply.
If you don’t qualify for other financing, you might need to take an advance to keep your business going, and it’ll be costly, with frequent payments. But it’s easy to get caught in a cycle of needing the advance again because the frequent payments take a bite out of your cash flow. And then you might default on the next one.
These contracts can be confusing. The “specified percentage” usually refers to the percentage of card sales the company gets. “Purchase price” usually refers to the amount you get, and “receipts purchased amount” is the total amount you pay. You’ll often see no APR for the MCA. If you can’t figure out what the cost would be you can’t compare it to other forms of financing.
Then there’s the confession of judgment. Many contracts require you to sign one. You give up your right to defend yourself if they sue. The funder, by holding a confession of judgment and the right to collect, is not taking a risk. Many courts have viewed “guaranteed repayment” contracts as usurious loans.
The Ultimate Verdict
The funder is looking at the risk that it will lose money from the deal and how much, and you are, too. The ultimate verdict here is that while getting money quickly can be a big temptation, the costs of doing so with a merchant cash advance can be severe. The frequent payments from your receivables may harm you by taking a chunk out of your cash flow and spiraling you deeper in debt.
An honest MCA is not really a loan, but agreements with fees and terms that reduce the funder’s risk of nonrepayment can lead courts to rule the deal is really a loan governed by the state’s usury laws. Courts have found that just because the deal is called a “merchant cash advance” doesn’t mean it is.
Most merchant cash advance firms are based in New York, and the state has criminal usury laws. Massachusetts, California, Texas, Florida and about 30 other states also have usury laws. If you’re going to sign up for a merchant cash advance, read the reconciliation clause and confession of judgment carefully.
About Delancey Street
Delancey Street is a premier, and award winning, business debt settlement company that helps business owners nationwide. Our goal is simple: help you escape debt in a safe and legal manner. Based out of New York, we can help in 49 of 50 states. We tell you how it is; because your business and future is on the line.
