Running a business means you can’t afford to be short on capital.
But sometimes, your cash flow just isn’t where it should be. Perhaps your biggest clients are late on their invoices, or you’ve just had to make a big, unexpected purchase that’s affecting all of your business finances.
And when you have bills to pay and paychecks to distribute, the pressure starts building.
While term loans might offer the best interest rates on the market, it often takes days—or even weeks—for you to get approved. Additionally, long-term loans are much easier to get if you have a long history in business and a healthy credit score.
If the need for working capital is dire, many small business owners decide to take out a merchant cash advance. Let’s go over how a merchant cash advance works, the pros and cons, and whether it is right for you.
How does a merchant cash advance work?
When you are approved for a merchant cash advance, you receive a lump sum (usually between $2,500 and $250,000) of capital—sometimes within just a few hours, as merchant cash advances are typically provided through online financing companies. Yes, it really can be that simple, but read all of the fine print.
That’s because the catch comes with the repayment terms. Merchant cash advances tend to be the most expensive financing options on the market, thanks to their easy application process and relatively low qualifying criteria.
Once you’ve received your lump sum, you’ll start repaying it automatically through an agreed-upon percentage of your daily credit card transactions. This means that you won’t have a set repayment schedule—you’ll pay more as your business earns more, and less when you bring in less.
What are the advantages of a merchant cash advance?
One of the biggest advantages of a merchant cash advance is the easy approval process. Unlike applying for other loans that require tons of paperwork and preparation, such as SBA loans, merchant cash advances don’t require you to provide an extensive application.
Since your loan repayment terms are secured by an established percentage of your future credit card sales, merchant cash advance providers are not too concerned with your credit score.
Additionally, merchant cash advances don’t require you to have several years of proven profitability in order to qualify. Because of these relatively easy qualifying standards, most small business owners won’t have a problem securing a merchant cash advance.
Another big advantage of a merchant cash advance is that it doesn’t require you to put up any sort of collateral. You can apply for an advance and quickly see the capital hit your account—no collateral required.
What are the disadvantages?
Because you will be paying off your merchant cash advance on a daily basis through a portion of your credit card sales, it’s vital to remember that your cash flow will be unavoidably interrupted.
This can be a good thing—after all, you’ll be making payments on a daily basis, but you won’t be required to pay the same amount each day. The amounts taken from your account will be proportionate to the amounts you’ve earned.
However, this also means your cash flow will take a hit for the foreseeable future, until you’ve paid back your entire lump sum—plus fees. And you can be sure that one of the biggest drawbacks of merchant cash advances is their relatively high fees.
Your agreement will include a factor rate and a withholding rate. The factor rate determines the amount you’ll pay back—simply multiply the amount of your advance by the factor rate to determine the amount you’ll need to pay back. For example, if you borrow $10,000 at a factor rate of 1.25, that amount will be $12,500.
The withholding rate refers to the percentage of your sales the merchant cash advance provider will withhold until the full amount you owe has been paid off. If your withholding rate is 10%, you’ll only get to keep 90% of your daily credit card sales until your debt is paid off. Make sure your business can make it through this leaner period of limited cash flow before you apply for a merchant cash advance.
Should I apply for a merchant cash advance?
A merchant cash advance makes the most sense for businesses who need quick access to capital—and have no better options.
If you work in an industry where you have many daily credit card transactions, such as restaurants and retail stores, a merchant cash advance might be a good short-term financing option. It can help you quickly cover unanticipated expenses, debt payments, inventory purchases, and other things you may need working capital for.
When used smartly and responsibly, merchant cash advances can be used for quick growth. If you are a business owner with limited time in business or a low credit score, a merchant cash advance may make the most sense for you. You may simply not qualify for other financing options, and a merchant cash advance could be a good stepping stone on your path to becoming a desirable borrower.
However, before you apply for a merchant cash advance, you should consider all of your options. How quickly do you need access to capital? How much do you need to borrow? What can you afford to pay in interest or fees?
Short-term loans can sometimes have high interest rates, but they are often lower than the fees associated with merchant cash advances. If you need working capital quickly, they can also be a good option.
The main difference will be in the repayment terms: will you be able to make the frequent, rigid payments that come with a short-term loan? You will likely have to make them on a weekly (sometimes daily) basis, and the repayment amounts will not vary depending on the amount you bring in. If your business revenue is sporadic, a merchant cash advance may be the way to go.
Be honest with yourself and your business. If you need capital quickly and can afford to take indefinitely part with a percentage of your cash flow, but can’t afford to make the frequent payments associated with a short-term loan, consider a merchant cash advance.
Meredith Wood is the Editor-in-Chief at Fundera, an online marketplace for small business loans that matches business owners with the best funding providers for their business. Prior to Fundera, Meredith was the CCO at Funding Gates. Meredith is a resident Finance Advisor on American Express OPEN Forum and an avid business writer. Her advice consistently appears on such sites as Yahoo!, Fox Business, Amex OPEN, AllBusiness, and many more.