What Is a Merchant Cash Advance?
The basic idea behind a merchant cash advance agreement is that the lender is literally purchasing the right to some of the borrower’s merchant credit card or debit card receipts in exchange for an upfront payment to the borrower. The agreement typically contemplates an agreed upon "buyback" if and whenever the borrower closes the sale, and also authorizes the lender to immediately to divert a certain agreed upon percentage of sales from the borrower’s credit and debit card transactions to the lender, until the "buyback" amount has been paid. Merchant cash advances are often an attractive financing option for retail and restaurant businesses whose income can be inconsistent at times .
Unlike traditional loans, advances may be unsecured, and the lender is not agreeing to a fixed interest rate. All lender’s fees must be disclosed in the agreement upfront. However, the handling fees and the percentage share of the borrower’s credit and debit card transactions often result in an effective "interest rate" that is much higher than a traditional loan. On the other hand, merchant cash advances need not be repaid if the borrower goes out of business, however, the borrower will likely lose its point-of-sale system and equipment to the lender.
Key Components of a Merchant Cash Advance Agreement
When entering into a Merchant Cash Advance Agreement, three principal components govern the substantial part of the understanding between the parties: (1) the advance amount, (2) the repayment terms and (3) the holdback percentage. The advance amount is the total sum of money the borrower can borrow from the lender. It calculates the maximum the lender will lend to the borrower. The repayment terms detail the payback schedule for the borrower, including the specific amount of "hold back," or settlement, that will be deducted from the borrower’s daily credit card collections. The holdback percentage is a fixed percentage of the borrower’s daily sales receipts via their credit card processor and in essence serves as the borrower’s weekly payment on their loan(s). Therefore, the lender continues to collect these payments directly from the borrower’s credit card processor until either the loan is completely paid off or the lender and borrower enter into a new forbearance agreement.
Terms and Conditions Explained
A Merchant Cash Advance Agreement should be read carefully and understood, since they are all different, be sure to get legal advice and/or at least consult with a merchant cash advance professional that can help you understand what the terms and conditions mean so that you know exactly what you are agreeing to.
Most Merchant Cash Advance Agreements will have the following terms and conditions:
- 1 Amount of Deposit. Lender shall make available to the Merchant Cash Advance Account(s) the amount set forth on the Cover Page attached hereto as the "Amount of Deposit," which shall be released by Lender to Merchant in its sole and absolute discretion.
- 2 Payback Amount. Merchant agrees to pay an amount to Lender pursuant to the Fixed Payback Rate and Share Percentage as set forth in the Cover Page attached hereto in order to receive the Amount of Deposit, by means of electronic funds transfer from the Merchant Checking Account(s) on electronic funds transfer dates from a Merchant Account to Lender’s Merchant Money Managing Accounts. The aggregate amount payable to Lender under the Agreement is known as the "Payback Amount."
- 3 Application of the Deposit and Interest. Unless this Agreement is terminated as provided herein or in the Event of Default relating to the Merchant’s insolvency or liquidation, each Deposit will roll over automatically and will be converted into a new Deposit with respect to the same Merchant Checking Account(s) and on the same terms of this Agreement, including the Fixed Payback Rate applicable thereto, until the aggregate Payback Amount of such Deposit has been paid in full. The Lender will apply the fixed payment date amounts to the accrued interest and principal owed to Lender. Lender shall refund to Merchant, or into the Merchant Checking Account(s), any amounts prepaid in excess of the Payback Amount. If the Deposit is prepaid and if as of the prepayment date the time that Merchant is scheduled to repay the total amount due to Lender was less than nine months, the amount scheduled to be paid to Lender during that month shall be multiplied by the fraction of 9 minus the number of months remaining over 9 in order to arrive at the Fixed Payback Rate for such Deposit.
- 4 Electronic Funds Transfers. It is a condition precedent to this Agreement that Account Bank has agreed to Electronic Funds Transfers for the collection of amounts owed to Lender under this Agreement. Lender covenants that it shall honor any agreement with the Merchant made with the Account Bank in respect of electronic funds transfers and pay such accounts the entire amount of the Deposit as and when due, whether or not such amount has been collected by Lender from the Merchant Checking Accounts through electronic funds transfers.
Merchant Legal Responsibilities
All merchants and business owners operating under a cash advance agreement need to realize that they have signed a contract with legal obligations. The amounts due under the agreement can be substantial. If a merchant defaults on his or her obligations under the cash advance agreement there can be lasting legal repercussions.
A merchant cannot simply walk away from that debt. The most important thing that a merchant can do to mitigate risk in connection with a cash advance agreement is to either never sign the agreement in the first instance or deal with the cash advance company in an open and honest way so that the advance company understands that the agreement has been defaulted on.
Default, obviously, is the merchant being unable to pay back the cash advance. The consequences of default can be very harsh. When a merchant signs an MCA agreement, the merchant is essentially giving up his rights to receive money from his credit card processor in order to pay back the loan. The cash advance company withholds amounts due under a cash advance agreement by issuing a notice to the credit card processor. The processor then withholds the amount due under the cash advance agreement and deposits those funds in an escrow account set up for the cash advance company. The transfer of funds to escrow creates a second layer of uncertainty for the merchant.
The cash advance company essentially holds the merchant’s money hostage for the duration of the cash advance agreement. The cash advance company essentially holds the merchant’s future sales hostage until the merchant can pay back the cash advance. Withholdings average approximately 15% of funds processed. In addition to withholding the amount due, a cash advance company can issue other fees and penalties, including the following:
As noted above, a merchant must think through the ramifications and consequences of entering into an MCA or cash advance agreement. Filing bankruptcy can be detrimental to a business’s attempts to reorganize, especially if the cash advance company has a right to immediately call a default or accelerate the amount due.
Merchant Cash Advance Pros and Cons
What makes MCAs an attractive option for some business owners is that they can be secured relatively easily with minimal paperwork, and the terms of repayment are flexible. MCAs are repayable through a daily deduction from the business owner’s credit card receipts or bank account. The process of obtaining merchant cash advances is fast, with funds being deposited into the applicant’s bank account as soon as 24 hours after the initial inquiry has been made . In addition, the process of negotiating an MCA is remarkably simple.
On the other hand, merchant cash advances are not without their own disadvantages. Interest rates frequently run between 35% and 70% APR. In addition, the repayment terms can be challenging. Franchisees and small business owners have been known to assume loan repayment terms of up to three years. At high interest rates over an extended period of time, such loans could result in the borrower becoming trapped in a downward spiral of debt.
Getting the Best Terms
Cash advance companies are often willing to negotiate the terms of the transaction, but only if you have done your homework. Your ability to negotiate will largely depend on how strong your business is and where you are in your life cycle. If you are in a good position, negotiable items could be any one of the items discussed above. If you are in a bad position, you may just be able to shop around to get a better rate, but not much else.
The first step in the negotiation process is to do your homework and know what terms are reasonable for your industry. Companies may vary in terms of their strength, but it is a good starting point to know what other companies in your industry are paying.
The terms of payment you have with your credit card issuer also plays a critical role. If you are getting a favorable rate with credit cards, you can negotiate a better rate with the cash advance company. Many customers deal with cash advance companies because they cannot keep their credit card processing fees low. However, if you are paying a decent rate with the credit card issuer, you can use that to get your cash advance company rates lowered.
You should always start out by getting multiple offers from multiple cash advance companies. You should treat a cash advance transaction no differently than any other financial transaction, in that you should shop it around to see what deal you are able to obtain.
Selecting the Right Provider
While merchant cash advance agreements can benefit businesses, they are not for everyone. Prospective borrowers must investigate whether the terms are truly favorable, and select a lender accordingly. A great place to start your research is online. Consumer protection agencies, watchdog websites (such as the Better Business Bureau), and independent customer review outlets often contain valuable data. If, for example, reviews consistently report issues with surprise fees or aggressive debt collection practices, you might want to consider a more reliable lender.
The provider should be up front about all terms of the agreement. The initial business loan application and agreement must clearly state the interest rate, repayment schedule, and requirements for collateral, if any. Merchant cash advances typically incur much higher interest rates than standard financing, so make sure you are crystal clear about how much you are paying in the end. A dishonest provider may promote the interest rate as a multiple of the principal amount instead of an annual percentage rate, inflating the amount due. A cash advance of $5,000 repaid within a year’s time at a rate of 1.39 may sound reasonable until you do the math: 1.39 times $5,000 equals a total amount of $6,950, which is an interest rate of 39%.
Unethical lenders may attempt to garnish your earnings through a payroll deduction, allowing them to automatically deduct the payments from your bank account or from your customer credit cards. This is a red flag that indicates the lender has no interest in helping your business grow. If your cash flow is down, the lender should extend the loan term instead of only focusing on short-term repayment.
Common Traps
Mistakes are common in the heat of the moment, and the cash-strapped merchant seeking immediate liquidity can be a particularly vulnerable target. Although there are many pitfalls for the uninitiated, one of the most common problems that I see as a commercial finance attorney relating to merchant cash advances arise from merchants’ mischaracterization of credit "repayment" as "collateral." The term used by the parties (e.g., "Lender is entitled to payment from Revenues") is often irrelevant to whether a particular agreement constitutes a loan or a collateralized transaction.
Somewhat unintuitively, a credit transaction will be deemed a disguised sale rather than a loan if, upon examining the economic realities of the transaction, it is demonstrable that title to the property to be purchased has already passed to the buyer even though payment is deferred . Thus, repayment is not made out of the loan proceeds, but rather the buyer has already paid a set price to the seller and merely needs to make installment payments for convenience.
The simple truth, however, is that Merchant Cash Advances are designed to be treated as sales of future receivables and not as loans at all. However, provided that you’re not perfectly straddling the line, it’s probably not worth the trouble and expense to litigate whether the agreement is in fact a secured sale. Having said that, there are several strategies that you can employ to minimize the risk of being held to a particular finance arrangement:
If you’re having liquidity issues then the last thing you want to worry about is legal terminology. But if you want to be sure that your agreement is in fact a sale rather than a loan, then it’s absolutely essential to avoid using terms like "collateral" instead of "purchase."