Most small businesses at some point will seek external funding to support growth. Usually that’s achieved through a bank loan. However, merchant cash advances are becoming a popular source of funds. Here we look at the pros and cons of the different funding types so you can make the right choice.
What is a merchant cash advance?
If you’re unfamiliar with this type of funding then let’s first be clear about what it is. With a merchant cash advance the business receives money upfront secured against its future credit card sales. The provider draws money from the business’s future credit card transactions as repayments on a daily or weekly basis.
The repayment amount is based on a percentage of daily credit card sales and could range from 5-20 percent. So for example, if a business does $10k in credit card sales with a 10 percent repayment rate then the repayment amount would be $1k. The percentage doesn’t change but the amount may vary depending on the volume of credit card sales that day or week.
In addition, the cost of the advance is often expressed as a figure such as 1.2 or 1.3. An advance with a rate of 1.3 would mean that the business is repaying $13k for every $10k advanced for a year.
Advantages
- Speed: often it takes only 24 hours to apply for and receive monies with a merchant cash advance.
- Credit history: is not important with a cash advance.
- Short-term: advances are primarily aimed at short-term financing, say for acquiring product. Most are designed to be repaid in 6-24 months.
- No set monthly repayments: a business will pay more when sales are good and less when sales are down. This can be very helpful in quiet periods when cash flow is tight.
Disadvantages
- Cost: the APR of a merchant cash advance can work out to be very high so if it’s not paid off quickly then it can be a costly source of funding.
- Borrowing limits: typically the sums of money advanced are relatively small. It’s unusual to see a merchant cash advance of more than $250k.
Small business loan
The standard source of funding for small businesses has traditionally been a small business loan from the bank. But how does it compare to the merchant cash advance?
Advantages
- Cost: overall a small business loan is less costly especially if it covers a longer term.
- Borrowing limits: small business loans are generally available for much greater amounts than merchant cash advances.
- Fixed monthly repayments: it can be to your advantage to have certainty over costs with fixed monthly repayments.
- Longer repayment periods: typically repayments can be spread out over a longer period of time, making a loan a more cost-effective long-term solution.
Disadvantages
- Speed: it can take weeks before a small business loan is approved and the cash is made available.
- Credit history: this will be relevant in the context of an application for a business loan. Indeed the owner will often have to personally guarantee the loan.
Ultimately, the choice as to which source of funding is right for you will be determined by how you intend to use the money. If you have a good credit history and can afford to take your time over the application process then a business loan is probably the best option. If, however, you need the money quickly and are prepared to pay for it, then the merchant cash advance is an alternative you can utilise.