About 20% of small businesses fail in the first year, and almost 50% close down in less than five years, according to data collected by the U.S. Bureau of Labor Statistics. While some of these entrepreneurs don’t make it because they didn’t satisfy a need, had a bad business plan, or chose the wrong location, just as many small businesses suffer from lack of financing.

The issue is complicated. Many entrepreneurs turn to self-funding to open their small businesses, but that approach is risky. Many of them tap into retirement accounts or emergency savings to get the cash they need, only to pay expensive fees and penalties. Small business loans are another option, but it can be difficult to find loans for businesses with no credit. Luckily, there is another option: merchant cash advances.

What is a Cash Advance for a Small Business?

A merchant cash advance or MCA is an alternative to a small business loan. Like a business loan, an MCA gives a small business an immediate influx of capital, but that’s where the similarity stops. Instead of making a monthly payment to a lender to repay the loan, merchant cash advances are repaid in one of two ways:

  • by the MCA provider taking a percentage of any card-based sales (credit or debit)
  • through fixed monthly payments directly debited from the business bank account

How Does a Cash Advance Work?

MCAs do not have interest rates the way loans do. Instead, they apply a factor rate based on the particulars of the business. The factor rate is usually somewhere between 1.1 and 1.5, but some are even higher. Some variables include:

  • Industry
  • Years in business
  • Current financials
  • Volume of documented transactions
  • Credit score of business owner

Example MCA

Let’s say a small retailer needs extra cash to buy enough stock for the holiday season. The retailer applies for an MCA of $30,000 and receives a factor rate of 1.4 with a required repayment rate of 10% of monthly sales.

  • This means that the retailer will pay $42,000 over the course of the cash advance ($30,000 x 1.4).
  • If their monthly credit card sales are $20,000, they will pay $2,000 per month ($20,000 x 10%) or $67 per day ($2,000/30 days in a month) for 11 months.
  • If their monthly credit card sales are $40,000, they will pay $4,000 per month ($40,000 x 10%) or $133 per day ($4,000/30 days in a month) for 4.5 months.

However, keep in mind that the actual calculation may include additional fees. The exact costs will vary by lender and depend on the business itself.

What are the Downsides of Cash Advances?

The costs of taking a merchant cash advance can be high. Using the example above, the retailer will pay an extra $12,000 to receive $30,000 and have less than a year to pay it all back. Also, businesses that do not have a long history, operate in a difficult industry or are struggling to cover overhead may find that getting an MCA is difficult.

What are the Benefits of a Cash Advance?

Merchant cash advances are expensive, so they tend to work best when a company needs to cover a short-term expense — but they do work. The business receives the money very quickly, and the requirements are flexible. Also, because MCA repayment is based on sales, the business doesn’t risk being required to make a hefty payment when sales are slow.

Other benefits of a Cash advance include:

  • No collateral required: No collateral is required to qualify for an MCA, which means that businesses that do not have the assets to offer as collateral can still access capital.
  • Flexible repayment: As mentioned, repayment is based on sales, so businesses only have to make payments when they are doing well. This makes merchant cash advances a good option for seasonal businesses or irregular sales.
  • Fast funding: One of the biggest advantages of an MCA is that the funding process is very quick. In many cases, businesses can get the money they need in as little as a few days.
  • Bad credit is okay: Because merchant cash advances are not loans, businesses that have bad credit (or no credit history at all) can still qualify.
  • Receive Lump Sum:  Businesses receive the full amount of the advance upfront, which can be helpful when a lump sum is needed to cover an unexpected expense.

Using a Cash Advance for Your Small Business

Taking a cash advance for your small business does come with certain risks and disadvantages, but the benefits of getting a quick influx of cash when you need it may be worth it. Do your homework before you decide whether a cash advance is the best fit for your needs or if small business loans may be a better choice. Good luck!