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In the fast-paced world of business, there are times when companies face cash flow challenges. To bridge the gap and maintain operations, businesses have several options: a traditional Line of Credit (LOC) with a bank or credit union, credit cards, or some turn to a Merchant Cash Advance (MCA). While MCAs can provide quick relief, they come with several hidden dangers that business owners should consider carefully before proceeding.

What is a Merchant Cash Advance?

An MCA is a type of funding in which a business receives a lump sum payment upfront in exchange for a percentage of the business’s daily sales. The repayment is automatically deducted daily, typically via an agreed-upon percentage of those sales, until the debt is paid off. Unlike traditional loans, MCAs are not based on the business’s credit score, but rather on its sales performance. In fact, a true MCA is not a loan at all, but rather a purchase of the business’s future sales. This is different from traditional factoring where open invoices (receivables) are sold to a factoring company for an upfront advance, then the factoring company collects the invoice and pays itself their fee, and then the balance is paid back to the business.      

While MCAs may seem like an easy solution for businesses that struggle with poor credit or irregular revenue, the nature of the repayment terms and the fees involved can create serious financial strain almost immediately.

High Repayments and Hidden Fees

One of the biggest dangers of an MCA is the astronomical cost. Because an MCA is not a loan, interest rates are not used. MCAs use a factor rate instead. The rate varies but typically ranges from 1.1 to 1.5, which means that a $50,000 advance could cost the business up to $75,000 in repayment. Such repayments, if viewed as a traditional loan, would reflect interest rate percentages in the hundreds if not thousands.   

In addition to high factor rates, businesses also face hidden fees like application fees, administrative costs, and prepayment penalties. These extra charges can quickly add up, making the initial cash advance seem much less advantageous. The overall cost of MCAs is not always transparent.

Repayment Can Be Unpredictable and Burdensome

More and more MCAs use a fixed repayment amount instead of the traditional repayment tied to the business’s sales. On the surface, fluctuating repayment based on sales seems beneficial because payments decrease during slower sales periods. However, in practice, this unpredictability can make it difficult for business owners to plan and budget effectively.

During busy seasons or unexpected surges in sales, the repayment amount increases significantly. For businesses in industries with seasonal fluctuations, this can become particularly problematic. With fixed repayment amounts, budgeting becomes easier; however, the risk is that sales do not match the amounts needed for repayment as well as usual ongoing operating expenses.

Potential for Debt Traps

A major danger of MCAs is the potential for businesses to fall into a debt trap. If a business struggles to keep up with the daily repayments, it may need to take out another MCA to cover the shortfall, thus accumulating more debt. This cycle of borrowing and repaying can quickly spiral out of control, leading to a situation where the business is trapped in a never-ending cycle of debt.

Because MCA lenders typically don’t require collateral, businesses may feel that the process is less risky than taking out a traditional loan. However, the higher-than-average costs of the MCA and personal guaranty make it easy for business owners to overlook the long-term risks, especially when they are under pressure to resolve immediate cash flow issues, such as payroll and rent.

Long-Term Financial Consequences

While an MCA may provide short-term relief, it can have significant long-term financial consequences. The high cost of the advance can reduce profitability over time and affect the overall financial health of the business. Business owners who rely on MCAs may find it difficult to qualify for traditional financing options in the future, as the high debt load may lower their creditworthiness.

Additionally, some businesses that use MCAs may have trouble securing funding from other lenders, as MCAs can be viewed negatively by banks and investors. As a result, the business could face a limited range of financing options, making it harder to secure favorable terms for future expansion.

Litigation Risks

The aggressive repayment terms of some MCA providers can also create more problems than the cash flow. If a business misses a payment or falls behind on its repayment schedule, it may be subject to penalties, increased fees, and even legal action. MCAs are largely unregulated, leaving businesses vulnerable to predatory practices.

Many times, the contract allows the MCA to file collection suits in their local courts, not the courts of the business. This can result in an Arizona company being sued in upstate New York, and vice-versa. Contract provisions may allow for the service of a lawsuit to proceed via e-mail instead of the traditional service of paper in person. Some MCAs even collect a Confession of Judgment in advance so they can skip having to go to court and can simply file a judgment against the business and any personal guarantors when payment is missed.

Proceed with Caution

While Merchant Cash Advances may seem like a lifeline for businesses in need of quick cash, they come with significant risks that should not be overlooked. The high costs, rigid repayment terms, and potential for falling into a cycle of debt can create serious financial challenges for business owners. Many small business failures are attributable to multiple MCAs. 

If a business is having cash flow issues, but is otherwise profitable, it may be worth it to consider filing for bankruptcy relief. Bankruptcy is a powerful tool available to businesses and guarantors that can assist in reorganizing a business and continuing to operate with restructured debt payments.

McConville Considine Cooman & Morin has the expertise to assist both debtors and creditors in all aspects of bankruptcy. We have decades of experience representing people and companies in bankruptcy court and can assist you with your financial issues and help guide you through the bankruptcy process from start to finish. As a federally designated Debt Relief Agency, we assist people and companies with finding solutions to their debt problems, including, assisting them with the filing of petitions for relief under Title 11 of the United States Bankruptcy Code. 

If you have questions regarding merchant cash advance loan, loan repayments or bankruptcy, contact our bankruptcy attorneys, Mikal J. Krueger at mkruger@mccmlaw.com or 585-512-3546, Lucien A. Morin, II at lmorin@mccmlaw.com or 585-512- 3534 or Douglas J. Lustig at dlustig@mccmlaw.com or 585-546-2500.

This publication is intended as an information source for clients, prospective clients, and colleagues and constitutes attorney advertising. The content should not be considered legal advice and readers should not act upon information in this publication without individualized professional counsel.

About MCCM

McConville Considine Cooman & Morin, P.C. is a full-service law firm based in Rochester, New York, providing high-quality legal services to businesses and individuals since 1979.  With over a dozen attorneys and a full paralegal support staff, the firm is well-positioned to right-size services tailored to each client. We are large enough to provide expertise in a broad range of practice areas, yet small enough to devote prompt, personal attention to our clients.

We represent a diverse range of clients located throughout New York State and New England.  They include individuals, numerous manufacturing and service industry businesses, local governments, and health care professionals, provider groups, facilities and associations. We also serve as local counsel to out-of-state clients and their attorneys who have litigation pending in Western New York courts.  For more information, please contact us at 585.546.2500.