What is a merchant cash advance (MCA), and how does it work?

Key takeaways

• Merchant cash advances are paid back over time as a percentage of future sales.
• They’re a great option for quick, no-interest, easy-to-access funding. However, it may involve high costs over time.
• The advances are calculated based on a factor rate, which determines the total amount owed, and a holdback amount, which is the percentage of the sales that goes towards the loan.

Table of contents

• What is a merchant cash advance?
• How merchant cash advances work
• Calculating the costs of merchant cash advances
• Merchant cash advances vs. business loans
• Other merchant cash advance alternatives
• Choose the right loan type for your business
• FAQ

What is a merchant cash advance?

A merchant cash advance isn’t a loan, but rather a type of financing that business owners pay back with a percentage of their future sales.

How merchant cash advances work

Here's how it can work: A merchant cash advance company provides the business owner with a lump sum of money upfront. The business then repays the lender from a percentage of the business's daily or weekly credit and debit card sales.

This involves using a factor rate, which calculates the total amount owed, plus the holdback amount, which is the percentage of each sale that goes towards repaying the merchant cash advance loan.

As with any form of financing, merchant cash advances have pros and cons.

Pros of merchant cash advance

Depending on your business goals, merchant cash advances can be a quick and flexible way to access funds for startups. The potential pros of merchant cash advances include:

• Flexible requirements: Business owners may not need a strong credit history or physical collateral for approval. However, merchant cash advance lenders may have their own requirements.
• Payments based on sales: Merchant cash advances typically don't have set payment amounts. Instead, they are generally repaid based on a fixed percentage of current sales. So, if sales are low, the payment amount may decrease accordingly.
• Quick access to funds: Since merchant cash advance requirements are flexible, business owners can often apply and receive funding quickly. This is one of the big benefits of a merchant cash advance for startups.
• No interest rate (technically): MCAs don't technically have an interest rate. Lenders determine the cost using the factor rate.

Cons of merchant cash advance

Merchant cash advances may not be ideal for every business, with various high fees to consider. The cons of merchant cash advances include:

• Expensive fees: A business cash advance can come with high factor rates, origination fees, administrative fees, underwriting and/or funding fees compared to other types of business financing.
• Frequent payments: Merchant cash advances are usually repaid in daily or weekly payments instead of monthly installments.

Calculating the costs of merchant cash advances

A merchant cash advance is calculated differently from a traditional loan. Instead of an interest rate, MCAs use a factor rate and a holdback percentage. Here's a step-by-step breakdown:

1. Determine the advance amount. This is the lump sum of cash a business receives upfront from the MCA provider. For this example, let's say a business needs $10,000 for inventory.

2. Identify the factor rate. The factor rate is a decimal number  that represents the cost of the MCA. This number is given by the MCA provider and is a multiplier used to calculate the total repayment amount. In this example, 1.3 will be the example factor rate.

• Tip: The lender determines the factor rate based on factors like your business's cash flow, credit card sales volume, time in business, and perceived risk. A higher factor rate means a higher total repayment amount.

3. Calculate the total repayment amount. Multiply the advance amount by the factor rate. This gives you the total amount your business will have to pay back to the MCA provider.

• Formula: Total Repayment Amount = Advance Amount × Factor Rate. For example, $10,000 × 1.3 = $13,000, which makes the total cost of the advance $3,000.

4. Determine the holdback percentage. The holdback percentage is the portion of daily credit card sales that the MCA provider will automatically deduct until the total repayment amount is satisfied. This percentage is agreed upon when the MCA agreement is signed. This example will use 15% as the holdback percentage.

5. Calculate the daily repayment amount (variable). The actual dollar amount deducted daily will vary based on daily credit card sales.

• Formula: Daily Repayment Amount = Daily Credit Card Sales × Holdback Percentage. For example, if a business has $500 in credit card sales on a particular day, the repayment for that day would be $500 × 0.15 = $75.

6. Estimate the repayment period. Typically, the repayment period isn't fixed like a traditional loan. It depends on a business's credit card sales volume. If sales are higher than anticipated, businesses can repay the advance faster. If sales are slower, it will take longer.

• Tip: To estimate the repayment period, divide the total repayment amount by the average daily (or weekly) repayment amount.
• Formula (estimation): Estimated Repayment Days = Total Repayment Amount / Average Daily Repayment Amount. For example, assuming average daily credit card sales are $400, making the average daily repayment $400 × 0.15 = $60 and estimated repayment days $13,000 / $60 ≈ 217 days (approximately 7-8 months).

Merchant cash advances vs. business loans

Whereas a merchant cash advance has no set repayment period, a business loan is a type of financing in which a business receives money from a lender and pays back the money in regular installments over time, plus interest.

It's important to understand the differences between a merchant cash advance and a business loan. Merchant cash advances, for example, may come with lower borrowing amounts and shorter repayment terms than business loans. For this reason, merchant cash advances can be a popular solution for new and growing businesses looking for quick access to funding.

Costs for merchant cash advances and business loans are usually charged differently. Traditional loans typically:

• Come with fixed or floating interest rates, which are applied to the remaining loan balance each month. So, if a borrower pays off their loan early, they may reduce the amount of interest paid on the loan.
• Are commonly repaid in predictable, fixed installment amounts each week or month. In contrast, merchant cash advances are repaid based on a percentage of the business’s sales.

Eligibility requirements may also differ for small business loans compared to merchant cash advances. For instance, business owners may not need a strong credit history to apply for a merchant cash advance. Instead, the lender may consider projected sales and revenue to determine eligibility.

Ultimately, the choice of merchant cash advance vs. business loan will depend on the needs of each business.

Other merchant cash advance alternatives

While merchant cash advances can provide quick access to capital, several alternatives may offer more favorable terms and lower overall costs for a business. Exploring these options can lead to a more sustainable financial solution.

Here are some common alternatives to merchant cash advances:

• Credit cards:  Business credit cards can offer a revolving line of credit for short-term funding needs. They often come with interest-free periods and reward programs, but carrying a balance can result in high interest rates.
• Grants: Government or nonprofit organizations typically offer grants to support specific business activities or demographics. Though they are highly competitive, they provide capital without the burden of repayment.
• Invoice factoring or financing: Businesses can access funds based on their outstanding invoices. With factoring, invoices are sold to a third party at a discount, while invoice financing is borrowing against the value of the invoices.
• Line of credit: A business line of credit provides flexible access to a pre-approved amount of funds that you can draw upon as needed and repay over time, with interest charged only on the drawn amount.
• Microloans: Nonprofit organizations or community development financial institutions (CDFIs) typically offer these loans, which often target startups, small businesses, and underserved entrepreneurs.