By Chad Otar
The most significant problem most small and midsize businesses (SMBs) face is funding, especially at the start when the business is still trying to lift off the runway. Many startups fail to obtain sufficient funding by traditional means at this stage and close shop, while others find alternative ways to raise capital.
For the lucky ones, it is as easy as asking the venture capitalists backing them to provide more funding, and since the VCs are already invested, they will often provide more capital. However, many entrepreneurs don't have this luxury, and the options quickly become scarce. Aware of this daunting challenge facing SMBs, innovative lenders came up with a different kind of funding solution. Typically, whenever a business needs capital to continue its operations, the first option to consider is a term loan. However, this option often takes time before funding is approved, and requirements for qualification may be out of reach for startups without an established credit record.
Rather than relying on a business's creditworthiness to determine how much to offer in funding, some lenders turned to something more readily accessible: revenue. Just as the name suggests, the difference between this and a loan is that it is an advance on future sales. In the case of a merchant cash advance (MCA), the potential lender will look at the cash flow records of the business to estimate how much they can advance.
Of interest are the merchant's sales, based on daily gross sales, since those figures can be more easily verified and repayments made. Once the amount of cash advance is agreed upon, the business receives the advance within a short period. The fee for the advance is based on a specified percentage of daily sales, and payments are typically made daily or weekly.
To better understand how an MCA works, consider a company that, say, sells custom made clothes. When this company needs capital to continue its operations, the owner applies for a merchant cash advance. The lender assesses the company's records and decides to offer an advance of $10,000. Of course, this must come at a cost, referred to as a simple fee for the cost of capital.
Once the business receives the money, it will owe the lender $10,000 plus the simple fee. Repayment periods usually range from three to 18 months. Payments are customarily deducted daily or weekly from credit card transactions, and/or total daily or weekly sales made via other means, such as cash or check.
Most repayments for the advance are processed automatically by automated clearing house (ACH), and/or the credit card processing company at the end of each business day according to the specified percentage of gross sales. Alternatively, the amount can be deducted from the business bank account daily or weekly, based on a specified percentage of total credit card and/or check and cash transactions.
In many ways, an MCA looks like a business loan, but they are not the same. Indeed, the differences between the two are determined by how they are set up. A merchant cash advance is paid from a split of card transactions processed or taken daily or weekly directly from the merchant's account. A loan is repaid within a specified period, in set payment amounts, and at regular intervals.
Today, many SMBs rely on funding options such as MCAs for good reasons. First and foremost is that an MCA is approved and processed much faster. Whereas a term loan may take weeks for approval, an MCA can be processed within the same day or 24 hours. This is an important consideration for a business that needs quick cash to pay for utilities, staff, equipment or resources.
Another reason is that MCA providers will not turn down an advance to a business simply based on its credit score. A startup needs to be in operation for a few months or even years before it can receive a bank loan. On the other hand, MCA providers will only need to look at the company's cash flow records and a couple of other factors to determine whether it is eligible for an advance.
Every business owner must ask themselves this question at some point, and the answer depends on two factors. First, MCAs are most suited to all companies seeking to receive a sizable advance. Second, the advance must be put into good use to ensure the impact on cash flow does not cause any difficulty in running the business.
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