What Businesses Should Know About Merchant Cash Advances

Despite signs that the credit vise is loosening for small business owners -- such as a new report from PayNet that shows lending to small firms up 26 percent in May from a year ago -- longer-term measures indicate that small business financing is still tight.

In the spring 2011 edition of the Small Business Barometer, published by Capital Access Network, just 34 percent of small and mid-size businesses surveyed reported that they'd taken a collateral-based loan from a bank. A quarter of small business owners reported that they'd been turned down for a loan, credit card, or other financial product by a bank, with three-quarters of those saying that they weren't offered any alternative.

So what do they do? A lot of business owners who can't get a bank loan, credit card, or personal loan turn to alternatives. Some of the better-known alternatives are factoring companies, peer-to-peer lending networks, and "nontraditional" loan providers (which we'll leave to your imagination).

A lesser-known alternative -- but one that's accelerating in popularity -- is the merchant cash advance. The industry started just a decade ago but has since grown to include more than 50 companies. Why? Because a merchant cash advance can be a quick source of cash if you own a small business and can't access mainstream financing. But it could also be a quick trip to deep trouble.

What You Should Know

Merchant cash advance providers give a business a chunk of money in exchange for a percentage of its future card sales. They usually work with restaurants, retailers, and service companies, and they appeal most to businesses that have a lot of card sales but don't have good credit or much collateral.

The downside is that cash advance providers charge a lot for their service, often taking a premium of 30 percent or more on what they give. The upside, as merchant cash advance providers are quick to note, is that their advances aren't loans. There are no regularly scheduled payments and there's no hard deadline for payment in full. Instead, the advance provider takes an agreed-upon percentage of a merchant's daily card sales until the provider has its advance back, plus whatever premium it's charging.

This is attractive to merchants because their payments slide up and down according to their sales. When sales are slow they pay less, and when sales are strong they pay more. Of course, the size of the advance provider's premium, if averaged out as an interest payment, could be as high as 200 percent APR -- and could easily wipe out the profit of many merchants, which tend to operate on very thin margins.

Of course, there are laws against interest rates like that. But they apply to lenders -- and merchant cash advances don't legally qualify as loans. Advance providers, who, naturally, would like to avoid federal regulation, point out that they have a strong incentive not to charge a percentage of sales so high that it puts a client out of business. They note that they don't take collateral and don't ask for a personal guarantee. So if a client goes under, they lose too.

If you're a merchant who can't get a bank loan, that might reassure you. Your opinion will vary according to how much you need money and what percentage of your sales a cash advance provider is asking for.