Are merchant cash advances a ripoff? It depends.

What do I need to know about merchant cash advances?

Merchant cash advances have been gaining in popularity ever since the 2008 financial crisis, when banks tightened up their small business loan restrictions and business owners had to look elsewhere for funding. They’ve only recently become a mainstream issue, though, thanks to increased media coverage and mobile payments giant Square’s decision to start offering a merchant cash advance service. Much like the cash advance programs offered by its competitors, Square Capital has quickly attracted its share of both praise and criticism from industry observers who disagree on whether these loans-that-aren’t-really-loans are ethical. Are merchant cash advances simply scams that prey on desperate merchants, or are they a low-risk source of funding for business owners who can’t secure loans from risk-averse banks?

The answer is yes. Or no. It actually depends.

To understand whether a merchant cash advance is a good deal, you should first understand what a merchant cash advance is.

Is a merchant cash advance a loan?

Technically, no. A merchant cash advance is actually a sale of a merchant’s future credit card sales. In other words, the merchant agrees to sell a portion of their future credit card earnings for a discounted upfront price.

Let’s say a merchant—let’s call her Tracy—wants to secure $10,000 in funding right now. Her merchant cash advance provider is willing to supply that amount in exchange for $12,000 in future credit card sales (or “receivables”) at Tracy’s store. By agreeing to these terms, Tracy is actually selling $12,000 worth of her future credit card earnings at a discount of $10,000 in order to have access to that cash immediately.

That sounds a lot like a loan.

That’s because it’s very similar to a loan, but it’s technically different. This is where we encounter the main criticism of merchant cash advances: merchant cash advances are classified as “Purchases and Sales of Future Receivables” rather than as conventional loans, so they aren’t subject to usury laws. Usury laws are in place to prevent predatory lenders from charging excessive fees or enforcing unfair repayment terms, and they’re generally seen as a vital form of protection for borrowers.

Those regulations don’t apply to merchant cash advances, meaning that there are no limitations on the interest rates that can be attached to merchant cash advances. For instance, the maximum interest rate on a loan through the Small Business Administration (SBA) is 6%. Merchant cash advances, however, often have effective annual percentage rates (APRs) well over that amount.

Let’s consider Tracy’s example again. The overall amount she pays to her provider ($12,000) will ultimately equate to 1.2 times the initial amount she was paid ($10,000). This 1.2 figure is known as a factor rate, and it can vary from 1 to 1.4 or more depending on the circumstances of the cash advance. If Tracy repays her merchant cash advance in full within one year, she will pay an effective APR of 20%. If she repays it in full within six months (a common repayment window in the merchant cash advance industry), her effective APR will be 40%.

That’s a terrible deal!

By the standards of a conventional small business loan, yes, Tracy’s APR is astronomically expensive. But there are other features of a merchant cash advance that can make it an appealing option for some merchants.

For one thing, cash advances are usually repaid through a seamless daily deposit of a portion of the merchant’s credit card sales rather than in large monthly installments. So instead of setting aside a specific amount of savings each month for the impending loan payment, the merchant will simply give a percentage of each day’s credit card sales to the merchant cash advance provider. This percentage is called a holdback rate and can be up to 25% of each sale on top of the merchant’s existing credit card processing fees. Although this form of repayment can take a serious chunk out of a business’s daily revenue, the merchant has the comfort of knowing that the advance is automatically paid back in small increments on slow days or in large increments on busy days.

Another key feature of merchant cash advances is that they usually come without the need for collateral or a personal guaranty. The merchant cash advance provider assumes the risk of the business failing when it purchases that business’s future sales, so if the merchant’s store goes under, the cash advance simply isn’t repaid.

Similarly, merchant cash advances don’t usually require monthly minimum payments, fixed interest rates, business use restrictions, or strict repayment deadlines. This degree of flexibility can be enticing for merchants who don’t wish to deal with the application and budgeting processes associated with traditional loans.

What are the risks of a merchant cash advance?

Merchant cash advances aren’t as dangerous as their critics claim, nor are they as safe as their defenders claim. Here’s a list of potential risks associated with merchant cash advances:

High effective APRs – As noted above, the interest rates associated with merchant cash advances can far exceed the maximum allowable rates for other sources of financing.

Lower business revenues – Since cash advances are repaid using a business’s daily sales, the merchant’s business revenues will be greatly reduced for the duration of the repayment period.

Potentially predatory – Cash advances are often marketed to merchants with poor credit or limited collateral and could be used to dupe these merchants into bad deals that they have little hope of repaying.

Hidden fees – Merchant cash advances typically do not include monthly fees or late penalties, so you should be suspicious of providers who charge these fees.

Attached merchant accounts – Most merchant cash advances are established either directly through a merchant account provider or through that provider’s third-party affiliate. Although it is necessary for credit card processors to work with merchant cash advance providers to correctly route credit card sales, it is their responsibility, not yours, to work out the method by which they will integrate their services. It is not recommended that you switch merchant account providers just to obtain a merchant cash advance.

“Balloon” payment clauses – Some merchant cash advance agreements include fine-print clauses that will demand immediate, full repayment of the remaining amount due if the merchant triggers specific penalties. Although these scams are rare, you should be sure to read your contract carefully to avoid violating these clauses and suddenly sending your full cash advance debt into collections.

Checking account access – Rather than automatically diverting the merchant’s credit card sales as they are processed, some merchant cash advance providers prefer to directly withdraw the appropriate amount from the merchant’s business or personal account at the end of each business day. Although this method may seem more convenient, it grants the provider access to the account for the purposes of collecting repayment. In this arrangement, if the provider does decide to accelerate repayment, it will have contractual permission to simply remove the amount from the merchant’s account and deal with a dispute later on.

Flexible retrieval rates – Merchant cash advances are typically repaid via a fixed holdback rate. Although the daily total paid out to the provider fluctuates, the percentage itself never should. However, some contracts contain terms that allow the provider to increase the holdback rate under certain circumstances. This may unexpectedly cut into revenues and leave the merchant with a sudden shortage of funds.

Aggressive collection practices – Merchant cash advances may not show up as debt on a credit report, but they can still be collected via traditional high-pressure methods. It’s not unheard of for a provider to unilaterally decide that a merchant has breached his or her contract and immediately place the outstanding amount into collections. Clear lines of communication and diligent documentation are necessary to avoid things getting ugly.

Application fees – Most merchant cash advance providers don’t charge application fees, but some do. You should be sure to find a provider that doesn’t charge for application, or, at the very least, one that charges only a nominal amount to cover the costs of the approval process.

What are some best practices when shopping for a merchant cash advance?

In addition to watching out for the above costs, you should be sure to understand which method of remittance is the best for your business. There are generally three ways to repay a merchant cash advance:

Split withholding is a seamless payment method in which the merchant’s credit card processor automatically routes the appropriate holdback amount to the provider and then deposits the remaining amount in the merchant’s banking account. It is usually the most preferable option because it is entirely automated and instant.

Lockbox withholding occurs when all of the merchant’s card sales are sent to a bank account controlled by the provider first, then the appropriate amount is sent to the merchant via ACH. This transfer window is usually at least one business day.

ACH withholding is a payment method in which the provider tracks the merchant’s credit card processing information and then withdraws the appropriate amount directly from the merchant’s checking account. This method has the benefit of depositing all sales directly into the merchant’s account first, but it has the drawback of granting providers the right to collect payments from the account on their terms.

Once you understand what terms to look for in a merchant cash advance agreement, you should be fine as long as you keep the following tips in mind:

• Inquire about all possible fees up front
• Ensure compatibility with your current payment processor
• Ask for an estimated effective APR for comparison purposes (or just calculate it yourself)
• Read your entire contract
  • Watch for repayment term limits, balloon clauses, penalties, hidden recurring fees, indemnity clauses, collections rights, flexible retrieval rates, and account access
• Shop around and get quotes—this is a competitive industry
• Understand the repayment terms
  • What is my holdback rate?
  • What total does my holdback rate come out of?
  • How will my holdback rate affect my business revenues?
• Prepare for reduced income during the repayment period

Most importantly, though, don’t get a merchant cash advance to save your business, because it won’t. If your business is struggling, a high-interest financing option will not save it. Merchant cash advances can be a smart move if you anticipate an upcoming surge in sales, or if you are certain that an infusion of cash (for new equipment, product improvements, critical personnel, etc.) will result in a significant boost in revenues. They aren’t intended to be life preservers.

Other Useful Resources:

How Merchant Cash Advances Work (Bloomberg Businessweek)

Merchant Cash Advances as an Alternative Source of Small Business Financing (About.com)

Merchant Cash Advance Financing: The Good, the Bad, and the Ugly (Women on Business)

Do you have any questions or advice about merchant cash advances? Let us know in the comment section below: