Small businesses often have to navigate a treacherous economic environment when starting. Other than establishing a customer base, merchants have to prove they are a legitimate business to merchant account providers and carefully review technical language so merchants aren’t duped into unnecessary equipment or long-term agreements.
With the ebbs and flows of the business cycle, all this has restricted access to capital from traditional banking channels because they’re either too small, too new, or just too risky. Banks have long loathed taking on excessive risk from new businesses, requiring them to furnish details on the company’s revenues, net worth, and credit profile of the business owners and seek collateral to guarantee loan repayment.
This has resulted in the disruption of the lending environment with alternative financing options such as merchant cash advance (MCA) and automated clearing house (ACH) advances.
What is a Merchant Cash Advance?
A merchant cash advance (MCA) is a prepayment of future credit or debit card receipts that the merchant typically processes. MCA lenders don’t use standard metrics used by traditional lenders to determine credit worthiness, such as personal and business credit scores, total revenue, or the company’s longevity. Although credit history is not something that heavily weighs in the MCA providers’ decision-making, it can be used to decide to offer a more considerable advance.
Instead, the MCA provider would see what credit and debit card payment processing trends look like for the business and how stable the cash flow is over a period of time. The MCA provider assesses reasonable repayment structures deducted directly from daily batch processing. This daily deduction can be a fixed amount or a certain percentage of payments processed, anywhere from 10-30%, known as the holdback rate.
The repayment mechanism occurs via split payment processing, where the MCA provider partners with the merchant’s payment processor to integrate payment processing data to deduct the predetermined holdback rate.
The fee charged for merchant cash advances, the factor rate, can range from 15% to 60% and is predicated on the size and duration of the MCA. A merchant seeking a $100,000 advance which the MCA provider expects to be repaid in six months, may have a factor rate of 15%. The total repayment amount after six months will be $115,000.
What is an ACH Advance?
An automated clearinghouse advance (ACH) works like an MCA, but there are key differences. While the MCA looks to appraise business cash flows based on daily credit and debit card payments processed, an ACH lender looks at the total sales proceeds of a business. So rather than relying on the merchant statement, ACH lenders rely on bank statements.
The repayment mechanism of an ACH advance is also different. ACH lenders do not utilize split payment processing and don’t need to partner with your payment processor. Instead, repayment is made via a daily direct debit from the merchant’s bank account based on predetermined amounts, often a fixed amount is agreed upon before the advance is made and is not centered on a portion of daily receipts.
Finally, the pricing structure of an ACH advance is like that of an MCA. ACH lenders charge a factor rate similar to an MCA, with the only key difference being that the holdback rate is not a percentage but a fixed amount.
Drawbacks of Merchant Cash Advance
There are many drawbacks of using an MCA. Therefore, we recommend using that only as a last resort once a business has exhausted all funding options. The primary disadvantage of an MCA is that there isn’t sufficient oversight of MCA and MCA providers. A 30% factor rate for a six-month MCA is the equivalent of a 60% annualized percentage rate. There are some MCA providers with a factor rate of 80%, sometimes even more. In comparison to traditional lending products, these rates are akin to predatory.
Another drawback is that a merchant may need to switch payment processors. The MCA lender must integrate with the payment processor to effectively split processing fees before the funds are transferred into the merchant’s account. This is an arrangement that the MCA provider will already have established with several payment processors and will most likely loathe having to expend additional resources to replicate the process with yet another merchant account provider.
Drawbacks of ACH Advance
One major drawback of an ACH advance is that repayment is a fixed amount rather than a portion of sales. One of the biggest advantages of an MCA is the flexibility that such an option offers. The repayment of MCA can vary depending on the payments processed by a merchant. So if businesses are experiencing a downdraft, the repayment can be slower as well. As sales rebound, repayments increase proportionally. That benefit is not available for ACH advances.
Which is a better option for your business?
MCA offers merchants flexible financing that can be repaid over a period according to a business’s performance. ACH provides the option of a more considerable advance since all business receipts are evaluated for cash flow appraisal rather than just credit/debit card payments. There are many advantages and disadvantages to both funding options. Where an MCA may offer flexibility and still some room for future advances by utilizing advances against non-card payments, ACH provides a more significant advance that may be precisely the liquidity need of the hour.
ACH and MCA are compelling options when there are no viable alternatives to financing. An entire industry of alternative funding has permeated because traditional financing options have been unable to address business needs. However, the alternative financing industry is swarming with predatory lenders quoting exorbitant interest rates and processing fees due to limited oversight and regulation. Businesses must consider all these options carefully and borrow responsibly.