Merchant Cash Advance

If you are a small business owner that sells via card sales and/or has accounts receivables outstanding from customers, then a merchant cash advance is a quick potential option to obtain short-term financing based on future revenues.

What is a Merchant Cash Advance?

A merchant cash advance enables a business owner to unlock the value of their credit sales and/or other receivables on an accelerated timeline. Using these receivables streams, the business approaches a provider who then advances the money in cash to the business. It is an effective short-term financing and/or working capital solution for businesses for whom a bank loan is not a feasible option.

How Does It Work?

The merchant cash advance (MCA) financing option is typically used by businesses that have a majority of their revenues originating from card sales (debit or card). By definition, the MCA is not technically a loan as it doesn’t charge interest on the principal that you are advanced. The providers of merchant cash advances are instead paid through the future sales made by the business, wherein they take a cut of future revenues until the MCA is paid out in full.

These financing tools are often found in a couple different types of structures:

1. The most common type is where the customer gets a cash advance upfront from the provider with an agreement for a fixed percentage of future sales (known as the holdback) to be remitted directly to the provider.
2. The second type has gained popularity as MCA providers look to expand their target market from solely businesses operating on card sales. For businesses that have cash sales making up a majority of revenues, the MCA can still be an option. After the provider advances the cash as usual, the business then pays a weekly (or daily) fixed debit amount to the business. This amount is known as the Automated Clearing House (ACH) withdrawal.

The question now arises as to how the provider makes a profit if there is no interest charged on the actual merchant cash advance?

To answer this, it is pertinent to get familiar with a term called the factoring rate.

The factoring rate is essentially a multiplier on the principal, which details the total amount of fees to be paid. For example, on a cash advance of $10,000 with a factoring rate of 1.25, the customer would pay $10,000 x 1.25 = $12,500 in total principal and fees. Therefore, the provider would ultimately receive $2,500 after the principal is paid back for the risk they take in advancing the money to the borrower.

A Numerical Example:

Consider a pizza shop business that needs $50,000 in cash. The shop generates approximately $1,000 every day in card sales. If the owner now chooses to obtain the cash via a merchant cash advance, the MCA provider might quote him/her a holdback rate of 20% and a factoring rate of 30%. This means that 20% of the $1,000 in daily sales is remitted to the provider and $65,000 in total has to be paid back to the provider inclusive of principal and fees ($50,000 x 1.3 = $65,000).

With a total amount of $65,000 to be repaid and $200 paid back every day, it would take the customer 325 days in total to pay back the merchant cash advance.

What are the Associated Merchant Cash Advance Rates Based On?

In the above explanation, two main rates were identified as the key drivers in a merchant cash advance transaction: the holdback rate and the factoring rate. Depending on the type of business, these two rates can vary significantly between different customers.

The holdback rate is typically a function of:

1. The level of sales a business makes: Since the provider will be paid back directly from the sales closed in the future, this is perhaps the most important consideration when evaluating the holdback rate to be charged.
2. Length of time it will take to repay the advance
3. Size of the MCA: The greater the funds advanced, the higher the holdback rate as this represents a greater risk to the MCA provider.

On the other hand, the factoring rate is based on:

1. Card Processing Statements: Before advancing the cash, the provider would likely want to see a stable, consistent business history of card sales to ensure that they would be repaid in full and in due course of time.
2. Bank Statements: Monthly bank statements are a good proxy of financial health as they indicate the level of cash that a business generates. The higher the net worth of your business and/or the greater the ability to generate cash, the lower the factoring rate that will be charged on the merchant cash advance
3. Business History: The number of years that a business has been in operation for is another important factor as it demonstrates stability and experience to weather potentially adverse conditions. Most MCA providers require at least a year’s worth of operations for a customer to be eligible for a merchant cash advance.
4. Tax Returns: These statements are another proxy for financial health as the level of tax that a business generates is usually correlated to the profit it has generated for the year (assuming no tax deferrals or other tax-related practices). The more profitable the business, the lower the risk and hence, the lower the factoring rate that the provider is willing to charge.

While these are the two key drivers to look for when obtaining a merchant cash advance transaction, it is important to remember that the factoring rate is not the same as an interest rate or an annual percentage rate (APR). While interest rates directly impact the business’s cost of capital, the factoring rate is excluded from the cost of capital as it doesn’t represent debt to the company (and is obviously not counted as equity either).

Factors to Consider when Choosing a MCA:

Just as with any conventional interest-bearing loan, there are a multitude of factors that have to be considered when choosing between different types of merchant cash advances. Some of these include:

1. The cash advanced: Merchant cash advances are a potentially expensive form of financing. Therefore, it is important to only receive the amount that is currently needed by the business instead of the maximum amount that the provider may be willing to offer.
2. Holdback: The holdback rate is applied on future sales, however, the business owner also has to be cognizant of potential cash flow hurdles. When operating a business, there are multiple operating expenses including salaries, wages, payments to suppliers, overhead costs etc. A higher holdback rate means that a lower percentage of revenues are available to service these other expenses. If that will represent a potential cash flow problem, then it might be better to explore other financing options or select a provider that is willing to charge a lower holdback.
3. Factoring Rate: It is important to shop around between different providers who either have different risk parameters or view the risk of your business differently. This would ensure that you gain the lowest possible factoring rate.
4. Additional Fees: As a prospective customer, it is critical to watch out for hidden fees including administrative fees, late payment fees and/or other penalties. This is outlined in the contract documents, so it is vital to review them possibly with a legal expert to ensure that you understand all terms and conditions prior to signing on the dotted line.

Qualifying for a Merchant Cash Advance in Canada

The application process for a merchant cash advance can be relatively simple if the business already has the existing card infrastructure.

• • Step 1: Complete the application.

The initial step of the process consists of an application where the provider requests information such as the owner’s social security number, business HST number and/or other such information about the business.

• • Step 2: Furnish documents.

Once the application is complete, key documents such as the business’s card processing statements and bank statements (3-6 months) have to be provided for the provider to make a decision.

• • Step 3: Approval.

Once the provider receives the requisite information and documents, approval can be received in as little as 24-48 hours.

• • Step 4: Card Processing.

Since the provider is paid out directly from future sales, the card processor will have to be configured to remit a fixed percentage of each card transaction’s sales directly to the provider.

• • Step 5: Read and sign documents.

Understand the terms of the documentation and ensure that you are aware of when payments to the provider will be initiated to avoid cash flow problems at a later stage.

Receive the funds!

Uses of MCA:

A merchant cash advance is typically used for emergency expenditures that a business encounters. If a business generates a stable level of cash via card transactions but does not have access to a small business loan or revolver facility, then the MCA is a viable option to gain short-term financing quickly. The MCA can then be used for any business purposes including payments to suppliers for raw materials, salaries and wages, overhead costs, unforeseen expenses, etc.

Advantages of MCA:

Disadvantages of MCA:

Merchant Cash Advance FAQs

1) What is the maximum that can be advanced under MCAs?
While different providers have different caps, typically MCAs are obtained for between $5,000 and $50,000. They are intended to be a short-term financing source.

2) What is the average holdback and factoring rate?
This would vary from provider to provider, but holdback rates can be as low as 8% to as high as 30%. Factoring rates range from 1.2x to 1.5x.

3) Is there any usage restriction?
As long as the funds are channelled into the business, they can be used for any business expenses without restriction at the owner`s discretion.

4) How long do I have to repay?
The MCA has no fixed term. It is designed to be repaid as per the volume of business revenues.

5) How can I minimize cash flow problems when obtaining an MCA?
Some simple methods to increase cash flow within the business are to: negotiate longer repayment terms with suppliers, shorten the accounts receivable collection cycles, enforce better inventory control to ensure cash is not tied up in inventory etc.