Getting a Merchant Cash Advance Is Easy But Repayment Can Be Onerous The short-term financing is sensible for investments that will generate more revenue but a serious burden if cash flow remains flat.
By David Rubin Edited by Dan Bova
Opinions expressed by Entrepreneur contributors are their own.
A Merchant Cash Advance is a short-term advance of funds against a business's receivables. To pay it back, a fixed debit, or in the case of some companies, a percentage, is taken directly off each sale daily or weekly. The Merchant Cash Advance business is a whole new industry that is booming, mainly because bank lending criteria have become so tight since the Great Recession that very few small businesses are able to qualify for bank loans.
Sometimes a cash advance is genuinely necessary, but it's important to know when to pull the trigger, and when not to. Whether the cash advance comes from a credit card or a Merchant Cash Advance, this facility is best used as a stopgap when there's an expected increase in revenue. For example, if you're a contractor and, in order to win a bid on a $500K job, you need to have upfront money for materials and labor. Or you're opening a retail location and need to buy inventory.
Related: Case Study: How a Merchant Cash Advance Worked in a Pinch
There are countless other examples that a small business owner needs capital to create growth: a new restaurant needs funds for inventory or salaries, a florist brought in last minute to create arrangements for a massive event, a dentist or doctor buying a piece of equipment and is able to get a new income stream from the diagnostic tests.
These are all examples where an increase in income is anticipated. Business is basically good and growing, even amid a bumpy and unpredictable cash flow, but you can't fund the capital outlay with your working capital. When the business needs the funds short-term to generate more revenue or cash flow it makes sense to take a short-term advance to secure that business growth.
You see these enticing offers: no paperwork, five-minute application, borrow up to $100K. Yes, $100K right now could solve a lot of problems. But the rule of thumb is that unless you're using it to generate the new income stream that pays back the advance, it could create bigger problems than it solves. More succinctly stated: don't use this instrument to fill a hole that creates an even bigger one.
Related: Square Ramps Up Its Offering with a Merchant Cash Advance Program
To decide whether or not to take one, ask yourself these questions:
Will this help me win more business?
Will this help me grow my business?
Will this enable me to buy a new piece of equipment that generates cash?
Do I absolutely need the money right away?
And in terms of your ability to pay it back:
Can I generate the sales I need, so that I won't feel it when a percentage (or fixed sum) is taken out of every credit card swipe?
Can I pay my other bills if I'm losing a percentage (or fixed sum) off the top of my sales?
• How long can I go without missing this percentage or fixed sum being taken off each sale I make. Am I reasonably sure I can go the entire length of the expected payback period?
Do I put through a high volume of credit card transactions?
Related: PayPal to Give Small Businesses Access to Working Capital in Minutes
The price of a cash advance is significant. The cost of funds could be anything from 20 Percent to 40 percent on the advance, depending on your credit score and other risk factors. However, this is offset by the fact that the instrument provides some real, tangible advantages to small businesses – the application process is simple, funding decisions are made quickly, you'll receive the funds in hours or days, not weeks.
Moreover, and you can still get funded at a range of credit scores, starting in the low 500s if other mitigating factors check out. In addition, payback is incremental, so the cost of funds is not so keenly felt. Payments are automatic, there are no checks to write, you don't have to remember to remit a payment. And with some Merchant Cash Advance firms, there is transparency in the form of daily reporting, daily ledger and history. Also, there's a huge difference between taking an advance and, say, using a factoring service, where the factor lays claim to all the receivables, and you receive "what's yours" after the factoring company has been paid "what's theirs."
There are many providers of merchant cash advances, so you should perform your due diligence. Try to avoid hidden costs. If you use a broker, make sure they don't charge you -- your best bet is to go through a direct funder or a broker that is paid by a direct funder. You should also look for flexibility in the payback terms in terms of weekly vs. daily remittances, fixed daily debit; and some funders offer fixed gross percentage, so that payback can be more flexible and based on your cash flow levels.
Bottom line, if you're generating enough cash, and with the right volume of increased sales, this financial tool can make good sense. But you have to be sharp and informed to use it successfully.
Related: Applying for a Short Term Business Loan Online? These 4 Steps Can Protect Your Startup.
