What is merchant financing and should my business use it?

A one-time lump sum of cash, based on the business’s credit card sales.

A percentage of what your business makes every day or week goes to repaying the advance.

Approval may come in a day or two.

Costs can be considerable, with APRs that can top 100%.

Merchant financing may appeal to businesses with lots of credit or debit card sales because it’s fast and easy to get. You could apply one day and get funding the next. But it is typically among the priciest options available, so you should consider it as a last resort.

Here’s how it works: a financing company provides an up-front lump sum of money that is repaid, along with a fee, based on the business’s credit or debit card sales.

People often use the term “merchant financing” and “merchant cash advance” interchangeably, but an MCA is only one type of merchant financing.

Two main kinds of merchant financing are:

• Merchant cash advances, a type of financing in which a lender provides funds up front and receives a percentage of your daily or weekly credit and debit card sales as repayment. The company you work with buys some of your future credit or debit card sales. Merchant cash advances are usually offered by third-party finance companies.
• Financing from the companies that process your debit or credit card sales, such as PayPal, Square and Stripe. These companies essentially provide funding to merchants and get repaid out of a portion of sales.

The application process for a merchant advance can be really quick. The amount you qualify for is based on your sales history, but can range from a few thousand dollars to a few hundred thousand dollars. Approval is based mainly on your business’s credit card sales, more than your personal credit score.

Once approved, you could see money in your bank account in one or two business days.

Repaid Out of Your Daily or Weekly Sales

The money you qualify for is repaid out of your daily or weekly sales. The funder withholds a percentage of your debit and credit card sales until the money is fully paid back. Repayment may happen by debiting your bank account each day or week, or by the company taking a fixed percentage of each debit or credit card sale.

But when it’s a percentage of your daily or weekly sales, it can take a long time to pay off. The more you make, the more you pay. You pay a bigger chunk on busy days and less on slow days.

Here’s an example of how it works:

• A business gets a $20,000 advance from an MCA funder.
• The MCA funder assesses a factor rate of 1.2.
• This means the business owes $24,000 in total.
• The business makes an average of $2,000 in credit and debit card sales per day.
• The MCA funder sets a holdback percentage of 10%. That means the business will have $200 deducted from its daily sales.
• The business will need to make about 120 daily payments to pay off the advance.

In this case, the business pays a total of $4,000 in fees over roughly four months. On any given day, the business would pay more or less toward the advance, depending on its daily card sales.

The cost of merchant financing is called a factor rate, and it’s a decimal rather than a percentage. To determine the total repayment amount, multiply the amount you get by the factor rate. Say you get a $1,000 merchant cash advance with a factor rate of 1.15. That means you owe $1,150.

It’s difficult to compare the cost of merchant financing to a bank loan or a credit card. Most business loan costs are quoted as an APR, or annual percentage rate. When a merchant advance is compared to a loan, a quick way to see what it costs is to estimate its APR with an MCA calculator.

In the $1,150 example above, if you paid 2% of $1,000 in daily sales, it would take about two months to repay the advance (including fees). If you apply the same metrics to an MCA calculator, you get an estimated APR over 188%.

On the plus side, the approval process is often based more on your business’ credit and debit card sales and not your business’s credit score.

With repayment taken straight out of your credit and debit card sales, you can’t miss a payment.

If your business has an off day or week, your payment will be lower.

You can typically get this type of financing in about one or two days. That makes it valuable to people who need cash fast.

One drawback of merchant cash advances is they are often more expensive than other types of business loans.

Every time you get a credit card payment, a portion of the proceeds automatically goes to the cash advance company. That means less cash flow, and that can make it harder to manage expenses. Some businesses get into trouble getting additional advances as soon as they pay off the last one.

Merchant cash advances are not technically loans, so there’s no oversight from federal agencies. Some merchant cash advance firms use misleading marketing to obscure terms and push sales through high-pressure tactics. And while many firms are good to work with, predatory players do exist.

Merchant financing may make sense for you if:

• You’ve tried, but cannot get a traditional loan.
• You need cash within 48 hours, rather than days or weeks.
• You have strong daily card sales.

Consider other options if:

• You can get a cheaper loan from a bank, an SBA lender or online lender.
• You can afford to wait.
• Your credit card sales can’t cover day-to-day costs.

Alternatives

There are alternatives that may be worth looking into before you get merchant cash financing. If you’ve been in business for a year and have fair credit, you may qualify for a term loan or business line of credit. A business line of credit or loan is generally a more cost-effective option if you can qualify.

Online lenders often allow you to complete the preliminary application online without a hard credit check. And funding can come within a few days of submitting a full application.

Compare options.

Headway Capital, for instance, provides a business line of credit, repaid weekly or monthly. You must have $50,000 revenue, 625 credit, six months in business.

OnDeck, for example, reports loan terms of up to 24 months. But repayment is made weekly or daily, not monthly.

Fora Financial provides working capital loans for businesses with a credit score of 570 or better. The lender quotes its loan fees as a factor rate, not an APR. The company also sells merchant cash advances.

An SBA microloan may also suit small needs. SBA microloans are small sums, of $50,000 or less, delivered by community nonprofit lenders. They have low rates and terms up to seven years.

A microloan may be a good choice for you if:

• You can’t get bank or other SBA loans.
• You want the lowest rate.
• You can manage a long-term loan.
• You have time to apply and wait for funds.

Business credit cards are a useful tool in the right circumstances. With a credit card, you can buy routine things up to your limit and repay flexibly over time. You only pay interest on what you use.

If you can qualify, credit cards are useful if:

• You don’t know exactly how much you need.
• You’ve been in business less than a year.
• Your revenue is too low for merchant or bank financing.