When the owner of a Texas business services company needed quick operating cash, merchant cash advances seemed like the perfect solution. But the decision nearly cost him his business. Kevin Gilbert, EVP Credit Administration for AR Funding, explains why. 

 

In his role as a credit administrator at AR Funding, Kevin Gilbert is often asked whether merchant cash advances (MCAs) can help businesses free up cash during tough financial times.

His answer is always an unequivocal “no,” and this true story about one of AR Funding’s clients explains why.

The client owns a business services company that delivers and assembles furniture and equipment. During the pandemic, business exploded as companies scrambled to set up home offices, reconfigure workspaces, and install health and safety precautions. To finance this growth, the owner decided to try invoice factoring as a way of accelerating cash flow, and became a customer of AR Funding in 2021.

Payment delays destabilize the business 

For a while, invoice factoring gave the owner the flexibility he needed to support growth. But over time, he ran into financial trouble when his customers continued to delay the invoice approvals process. Because invoice factors require proof that a company’s products or services were delivered to the customer before they can advance the funds, the owner had to wait longer and longer to receive the cash. 

As a result, he decided to look into MCAs as a way to receive the cash without invoice approvals. An MCA gives business owners cash in exchange for a percentage of their projected future sales rather than their current sales. 

At first, MCAs solved the problem

Within 48 hours, the MCA company was able to advance the operating cash the owner needed. Each month, the owner received an advance equal to a percentage of the total projected sales, less a factor rate of 35%. The cost of the advance was steep, but the ease and simplicity of the application process made this financing option very attractive.

Gilbert says quick access to cash is the main reason businesses choose MCAs.  

“The allure of MCAs is their accessibility,” he explained. “Unlike traditional loans, they often don’t require extensive credit checks or collateral. It can take just one phone call to set up the arrangment and start receiving funds.” 

New and bigger problems emerge

The initial attractiveness of MCAs soon began to fade as the true cost of the cash advances became clear. Within months, the owner was struggling to meet his financial obligations as the MCA company deducted a large sum directly from his bank account every month, even during months when sales were slack. Although he had signed a contract with the MCA company, the owner was shocked by the amount of money that was withdrawn from his account month after month. 

Within six months, the owner was unable to meet his financial obligations to the MCA company, and it responded by taking control of his business account and debiting money on a daily basis. Despite closing sales of approximately $100,000 per month, these debits began to overwhelm the business. Desperate to stop the cash outflow, the owner closed his bank account.

The realities of MCA financing

Gilbert was not suprised by the owner’s experience with MCAs. 

“MCA contracts are notoriously complex and filled with hidden fees and fines,” Gilbert warned. “Once we had a chance to review the contract the client had signed, we saw that the MCA company was deducting 35% from our client’s sales, along with other fees and penalties.” Gilbert said that even with decades of financial experience, he has difficulty understanding the complicated terms. 

“Unfortunately, once the business owner realizes what they have signed, it’s too late,” explained Gilbert. “They can’t afford to stay, and they have to pay a huge penalty to get out of the contract.” 

Gilbert stressed that MCAs are not subject to the Truth in Lending Act, which exists to protect consumers against inaccurate and unfair lending practices. For business owners who are used to the protections that consumer credit cards have in place, this can be a shock. 

MCA companies can also be relentless in their pursuit of the money they are owed. In this case, the MCA company filed suit against the owner, demanding full payment of a year’s worth of fees. The company also issued legal letters to companies collecting money on behalf of the owner to demand the funds be forwarded directly to them. 

Ultimately, the MCA company cut off all sources of working capital, leaving the owner unable to do business. It took them a month to find the money to pay off the MCA contract and extricate themselves from the situation, and they nearly lost their business in the process.

Before you take out an MCA…

This customer’s experience highlights the dangers of MCAs, especially for small businesses. Here are some ways for business owners to avoid making a mistake that could jeopardize their company’s existence.

Key considerations

• Understand the contract. MCA contracts are intentionally complicated and contain hidden fees and penalties. Seek legal advice before you sign.
• Take your time. MCAs are often a response to a time-sensitive cash-flow issue, but it’s important to slow down and take a beat before moving forward. 
• Explore alternatives. Don’t sign a contract until you’ve examined every other source of alternative financing, including invoice factoring, inventory financing, and purchase-order financing. 
• Plan for higher business costs. If you do get an MCA, be prepared for high factor rates and fees, and reflect that reality in your business plans.
• Talk to a financing expert. Talk to an expert who can help you evaluate your options and run some numbers. The experts at AR Funding are always here to help!

“MCAs should be a last resort,” Gilbert advises. “Before signing anything, read the fine print carefully and explore all other funding options.”