Think Twice Before Taking a Merchant Cash Advance
Merchant cash advances (MCAs) are an alternative financing tool frequently offered by merchant card processors (such as Stripe, PayPal, Square, etc.) to small businesses needing access to extra cash in a hurry. Their seemingly low advertised 10-15% ‘factor rates’ might look very appealing on the surface, but this financing vehicle can end up being extremely expensive, with actual annual percentage rates often exceeding 40% and sometimes even reaching triple digits. Here’s what to know about MCAs, why they can be so expensive, and a few things to keep in mind.
What is a Merchant Cash Advance?
An MCA, or merchant cash advance, is an alternative financing method for small businesses. It’s technically not a loan; rather, you get a lump sum of money advanced to you that you then pay back over time with a portion of your future debit and credit card sales.
The MCA provider is effectively purchasing your business’ future sales in exchange for a predetermined fixed fee, called the factor rate. If that sounds to you a lot like factoring invoices, you’re on the right track.
The mechanics of a Merchant Cash Advance…
MCAs can be structured various ways:
Percentage of debit/credit card sales
The most common way for MCAs to be repaid is for the provider to automatically deduct a daily, weekly or monthly percentage (the ‘repayment rate’) of your debit/credit card sales until the advance (plus the factor amount and any other fees) is paid back in full. Depending on the repayment rate and your actual debit/credit card sales volume, the repayment period can range anywhere from three to 18 months.
Fixed withdrawals
Instead of skimming a fixed percentage off the top of your future merchant card processing sales, some MCA providers withdraw fixed dollar amounts directly from your bank account on a daily, weekly, or monthly schedule regardless of your actual business’ sales volume. The fixed withdraw amounts are calculated in advance based on your estimated monthly revenue.
Typical MCA rates and fees
As with most traditional business loans, the MCA provider will consider your industry, years in business, recent financial performance, your volume of credit and debit card sales, and often your personal credit score to set your MCA terms such as the factor rate, repayment rate, fixed withdraw amount, and other fees. Businesses that appear to be at higher risk of default can expect to receive higher factor rates and repayment rates than their lower risk peers.
Factor rates these days tend to range between 10-15% of the amount of cash advanced. The factor rate may not include additional fees such as underwriting or administrative fees, which will increase your overall cost of capital.
So, what is the true cost of a Merchant Cash Advance?
The total cost of an MCA is very simply the total of all fees assessed on top of the amount of cash advanced to you. The sneaky part lies in how fast you end up repaying the advance, relative to the total amount of fees paid.
Take for example the following terms which were recently offered to one of our clients, an ecommerce business selling around $250,000 per month through Stripe:
Advance amount: $100,000
Factor rate: 12%
Repayment rate: 15% of monthly sales
Other fees: $0.00
On the surface, 12% appears to be a reasonably attractive factor rate. With $0 other fees assessed, our client would receive a $100,000 cash advance and then pay back a total of $112,000 over time, ending up with a total cost of $12,000.
But if our client continues to average $250,000 per month of merchant card sales during the repayment period, the 15% repayment rate means that Stripe would be skimming $37,500 off the top each month (15% of $250,000 = $37,500) so the entire $112,000 would be paid back in exactly 3 months – which equates to around a 48% effective annual interest rate!
Note: If the repayment rate was only 3.73% of $250,000 monthly sales (instead of 15%), Stripe would skim $9,333 off the top each month ($250,000 x 3.73% = $9,333) so it would take 12 months to complete the repayment. Or if the repayment rate remained at 15% and our client only had $62,219 in monthly merchant card sales, Stripe would only skim $9,333 off the top each month and it would again take exactly one year to repay the entire $112,000. In either case, that would equate to a much more reasonable 12% annual percentage rate on the $100,000 cash borrowed. Unfortunately, those more reasonable terms don’t seem too common with MCAs these days...
Fixed withdrawal amounts can remove some timing uncertainty if you have that option available, but the bottom line is that the faster the repayment, the higher the effective cost becomes. MCAs can get even more expensive if you pay off one MCA early and roll it into a new MCA to get another cash advance sooner – you’ll effectively be paying double the fees without getting the full cash advance for double the time.
What happens if you default on a Merchant Cash Advance?
If you’re late on a MCA payment you probably won’t get a scary visit from a baseball bat-wielding mobster, but a default on your MCA can often be more severe than defaulting on a traditional loan because MCA companies are not subject to federal lending regulations. Some MCA contracts require you to waive your right to dispute or defend yourself in court if they file a judgment against you, for example. Both personal and business bank accounts could be frozen, your credit will be impaired, and your future income could be surrendered to the MCA company.
Tax and accounting treatment of Merchant Cash Advances
Merchant cash advances are not loans but rather advance payments on future sales, which means they are not taxable at the time of the advance. Business owners will still pay taxes on their actual earned income, though, including the income that goes to repay the MCA. Your repayment of the cash advance itself is not a tax-deductible expense, but all the fees you pay are deductible.
When cash is received from an MCA it should be recorded as a current liability on your balance sheet. The funds should not be recorded as income.
As payments are deducted from your future sales, the portion of each payment that repays the original advance amount should reduce the current liability on your balance sheet and the rest gets booked as fee expense on your income statement. Don’t forget to record your actual full sales revenue as income, even though the MCA provider skims a portion off the top before depositing the remainder into your bank account. (Note: accrual basis bookkeeping helps keep these things straight, while cash basis methods often result in embarrassing mistakes.)
Are MCAs ever a good idea?
Sure! Because of how expensive they usually are, MCAs are not a good substitute for equity financing of long term operating costs. But if you don’t qualify for a better priced alternative debt financing vehicle from the options below, there are still some use cases where MCAs can make financial sense. The trick here is that you’ll want to have reasonable expectations for generating a net positive return on investment (ROI) after considering the interest and other fees associated with the MCA — otherwise it’s not worth it.
Let’s say, for example, that your ecommerce brand is fortunate enough to have a very successful paid marketing channel that consistently delivers a return on ad spend (ROAS) — in terms of gross profit, not just revenue — that is greater than the cost of the MCA, and you have excess inventory available to fulfill new orders that result from that extra ad spend. In that case, you’ll generate a net-positive result by investing the MCA funds into extra targeted marketing to capture extra profits faster than if you didn’t increase your marketing spend. But if you don’t have the extra inventory available or you’re not confident that the incremental ad spend will result in net positive profits, taking the MCA might turn out to be a very expensive experiment.
If you’re about to land a strategic wholesale account that requires you to invest more capital into inventory than you have available to spend, it might be tempting to use an MCA to fund another production run to help you win that new account…but if your products don’t all sell through fast enough or you end up having to discount or take back some stock and refund the reseller, that could erode your profit margins and leave you with less profit than the cost of the MCA. This scenario might present more potential risk than reward.
Or maybe you’re running a SaaS business with predictable CAC, a short CAC payback period and you have reasonable expectations (based on solid recent historical data) that your marginal profit from new subscribers would be higher than the cost of the MCA. You might stand to generate net positive profits by using the MCA to accelerate paid customer acquisition, then wash, rinse, and repeat to continue growing faster than you would otherwise be able to do with your own capital reserves. But if your conversion rates aren’t yet stable or your CAC payback period is too long, or if you haven’t been in business long enough to have predictable churn rates and CLV, you might want to think twice before using a high-cost MCA to fund increased marketing spend.
Merchant Cash Advance Alternatives
As discussed, MCAs can be an expensive form of financing with potential short-term and long-term negative consequences. Before accepting an advance, consider your many options, including but not limited to:
Business line of credit
Personal line of credit
SBA loan
Equipment financing
Inventory financing
Bridge loan
Invoice financing (“factoring”)
Purchase order financing (“PO financing”)
Business term loans
Small to medium sized banks, credit unions, and specialty financing companies usually provide the most attractive terms.
You’re not limited to only working with your current or other local banks either! We encourage our clients to cast a wide net and as a result, they often end up having multiple lenders competing for their business.
Have questions on how to get started? We are happy to provide some free advice, help make introductions to local and national financing partners, and of course even roll up our sleeves to do the technical accounting work involved.
