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Merchant cash advances: A roadmap to financial distress

On Behalf of | Nov 21, 2023 | Business Bankruptcy |

Small businesses have been facing tough times over the last few years. Rising inflation has caused consumers to cut their spending, supply chain interruptions are wreaking havoc with all kinds of industries and chronic labor shortages are forcing many companies to pay their existing workers overtime. 

That can all combine to create quite a financial pinch that can leave some small businesses struggling to pay their bills or wages on time. Because they often lack resources they can use for collateral, small business owners often have a much more difficult time getting operational loans from traditional lenders – and some have started to turn to the merchant cash advance (MCA) network instead.

While the ready money can seem like a “quick fix” when your business has cash-flow issues, these are some dangerous financial waters. Here’s what you need to know:

What is a merchant cash advance?

MCAs are the equivalent of a “payday” loan for businesses. Your business gets a lump sum of cash that you can use to cover your bills. In return, the company that extended the funds then gets its money back in one of two ways:

  1. They take a percentage of your future debit and credit card sales. This is typically the way that MCAs prefer to operate. They may take the deductions daily or weekly, but you have no guarantee how long that will last since your repayment period depends largely on how well your sales go.
  2. They take fixed payments based on your expected monthly revenue. This is less common, but an MCA that operates this way will take automatic withdrawals from your business account either daily or weekly according to that plan – whether you make the sales you expect or not. The only advantage of this method for your business is the fixed repayment period.

It’s important to understand that the repayment rate on an MCA is calculated on a “factor rate” that varies from 1.1 to 1.5. For example, if your business borrows $20,000 with a factor rate of 1.3, the total repayment would be $26,000 – however, that’s not all you have to pay. In addition to the factor rate, MCAs come with additional fees. That can include an origination fee, daily (or weekly) repayment fees, processing fees and even renewal fees (if you need to extend the advance).

It seems like a good deal, so why is it risky?

First, you’re borrowing against the income you hope to generate – and there are never any guarantees in business. If anything the past few years have taught business owners, is that unexpected events can abruptly derail even the clearest plans. 

In addition, the factor rate that’s applied daily or weekly to your loan is deceptive. The actual annual percentage rate that you are being charged is easily in the triple digits – far beyond the usury limits within the state. (MCAs get around the rules by claiming that they are not actually loans.) 

In essence, while MCAs seem reasonable and flexible in repayment terms, the fluctuating cash flow caused by the daily or weekly repayment obligation can make it difficult to keep up with your regular bills. Plus, if the original problems that caused your cash flow crunch aren’t resolved, you can be forced to renew the loan terms – and that traps your business in a debt cycle that you may not be able to escape.

MCAs are better off avoided at all costs. If you’ve already taken an MCA and you find that your business is now in deeper trouble than before, it may be time to consider a Chapter 11 bankruptcy to break free and obtain real financial relief.