Beware of Hidden Fees: Merchant Cash Advances vs. Asset-Backed Inventory Financing

In the world of e-commerce, businesses that seek growth commonly require financial assistance. Many financial service providers have stepped up to fill this need, but there is one type of financing in particular that is often misunderstood and considered by some to be misleading or unfair. Known as Merchant Cash Advances (MCA), this type of fixed-fee revenue-based financing can seem like a straightforward and simple way to access needed funds, but it often hides high-interest rates and complicated calculations that can leave borrowers baffled.

Merchant Cash Advances are typically used by businesses looking for fast, flexible, and collateral-free financing with repayment based on sales. MCAs certainly have their place and can offer a lifeline when a business runs into a cash crunch as they prioritize sales performance over credit history, allowing firms with lower credit scores to qualify. However, some critics draw comparisons to “payday loans” and argue they have similar predatory and deceptive characteristics with high effective interest rates and a lack of transparency.  Just as payday loans can create a cycle of debt for individuals, Merchant Cash Advances might lead businesses into a cycle of cash flow stress, hindering growth opportunities.

What’s Lurking Within These Murkey Money Deals?

High Cost Merchant Cash Advances:
The Devil in the Details

One of the primary concerns with Merchant Cash Advances is the lack of transparency regarding terms and fees, as these hidden fees can translate into exorbitant interest rates.  While the fees may appear reasonable at first glance, when converted into an Annual Percentage Rate (APR), they can be shockingly high. 

Also hiding within these cash infusions often lies a labyrinth of “mini-loans.” As repayments are made based on a percentage of sales, borrowers essentially procure new mini-loans daily. Consequently, the repayment structure of daily sales deductions makes the effective APR fluctuate constantly, driving up the overall interest rate and resulting in erratic cash flow for businesses.  These opaque details can make it challenging for borrowers to fully comprehend the actual cost of the advance leading to financial strain and potential difficulties in repayment. 

As a growing business, it is essential to have a comprehensive understanding of the underlying mathematics associated with Merchant Cash Advances before committing to any financing arrangements that could potentially strain your financial resources. 

Calculating the Cryptic Costs

Illusory Simplicity, Hidden Complexity

Unlike transparent loans that clearly disclose the annual percentage rate (APR), Merchant Cash Advances allow lenders to bypass interest rate disclosures by technically “purchasing” your future receivables. This loophole lets them bury exorbitant fees in the transaction amount rather than state an annualized interest rate.  Rather than providing an APR, a Merchant Cash Advance agreement will provide a Transaction Amount based on a percentage of the amount of the cash advance.  Understanding the difference between the transaction amount/fee and how that equates to an APR is extremely important when evaluating whether an MCA is right for your business.

Imagine you’re offered a $100,000 loan with a 9% upfront fee, and you have to pay it back based on 15% of your daily revenue. At first glance, it might seem like you’re only paying 9% in fees, but it’s actually much more costly.

Here’s why:

1. Daily Repayment: You start repaying the loan just one day after borrowing, but you’ve already paid a 9% fee upfront. To figure out how expensive that one-day loan is, calculate the annual interest rate (APR) on that single day by doing 9% times 365 days. This gives you a whopping 3,285% APR for that first day!
2. Mini-Loans Every Day: Over the course of 180 days (6 months), you make daily repayments. Each day is like a mini-loan because you pay back a portion of your loan based on your daily revenue.
3. APR Adds Up: The APR for each of these mini-loans is different. The first day’s APR was 3,285%, but as you continue to make payments, it gradually decreases.
4. Average APR: To find the true cost of the loan, you need to average all these daily APRs over the 180 days. The overall APR, or the effective APR, ends up being about 104%.

In simple terms, the “just 9%” fee can be misleading because it’s like a hidden interest rate. Your daily repayments compound the cost, making the loan much more expensive than it initially appears.

Illustrating the Calculation

1. Initial Loan Amount: $100,000
2. Upfront Fee: 9% of $100,000 = $9,000
3. Total Repayment Amount: $100,000 + $9,000 = $109,000

Now, we’ll calculate the daily repayments and the total fees paid over 180 days (6 months):

Daily Repayments:

• You repay 15% of your daily revenue each day.

To calculate the effective APR, we’ll need to consider the total fees paid and the initial loan amount:

Total Fees Paid:

• You paid a $9,000 upfront fee.
• Over 180 days, you repay 15% of your daily revenue, which accumulates into additional fees.

The effective APR is a bit more challenging to calculate precisely because it depends on your daily revenue and how much you repay each day. However, for this example,  we can make a simplified assumption that you pay back a fixed amount each day. Let’s say you repay $1,500 daily:

Total Fees Paid (Daily Repayments):

• $1,500/day x 180 days = $270,000

Now, let’s calculate the effective APR using this simplified assumption:

1. Calculate the total fees paid (including the upfront fee): Total Fees Paid = Upfront Fee + Total Fees from Daily Repayments Total Fees Paid = $9,000 + $270,000 = $279,000
2. Calculate the effective APR: Effective APR = (Total Fees Paid / Initial Loan Amount) x (365 / Loan Term in days) Effective APR = ($279,000 / $100,000) x (365 / 180)Effective APR ≈ 642.50%

So, with the assumption of repaying $1,500 daily, the effective APR is approximately 642.50%. Keep in mind that this is just an estimate, and the actual effective APR would depend on your daily revenue and repayments. However, it illustrates how the true cost can be significantly higher than the initial 9% fee over a 6-month period. The total fees paid would be a staggering $279,000 in this scenario!

Beyond Obscured Rates MCAs also come with:

• Burdensome daily/weekly repayment schedules
• High risk of default if payments can’t be met
• No disclosure of lower-cost financing options
• Threats to your personal credit with guarantees
• Little flexibility to accommodate your growth 

Inventory Financing vs. Merchant Cash Advances

When it comes to sustained business growth, selecting the right financing avenue is crucial. Inventory financing outperforms merchant cash advances on several key fronts. Firstly, this type of collateral-backed asset financing offers businesses the opportunity to secure larger loan amounts compared to Merchant Cash Advances, as they are based on the value of the assets being used as collateral. This provides businesses with greater flexibility and access to more substantial funds for their expansion plans. Additionally, inventory financing typically comes with lower interest rates and longer repayment terms, making it a more cost-effective option in the long run. 

It’s crucial for business leaders to carefully review the terms and conditions of any MCA agreement in order to make strategically sound decisions.  By delving into the intricacies, understanding the costs, and knowing all your options, you can avoid the pitfalls of merchant cash advances and make informed decisions that align with your business’s financial capabilities and long-term goals

Why We Believe Inventory Financing is the Optimal Choice:

1. Favorable Rates:
   

   Asset-backed inventory financing boasts lower interest rates, driven by the security collateral provides. MCAs often carry higher costs due to their unsecured nature.

2. Ample Funding:
   

   Collateral-backed options offer higher loan amounts secured by valuable assets. MCAs pale in comparison when substantial capital is required for expansion or acquisitions.

3. Flexible Repayment:
   

   Asset-backed loans offer adaptable repayment terms, a contrast to the rigid daily deductions of MCAs. This flexibility aids efficient cash flow management.

4. Credit Building:
   

   Through consistent repayments, inventory financing builds credit history. MCAs lack this credit-enhancing feature.
   

5. Negotiation Leverage:
   

   Inventory financing empowers negotiation for better terms, a benefit not inherent in MCAs’ fixed structures.

6. Default Safeguard:
   

   Inventory financing guards against default with tangible assets. This mutual assurance fosters trust between the borrower and the lender.

While there may be a vast array of financing alternatives available, we believe that inventory financing stands as the optimal choice as it offers the trifecta of lower rates, adaptability, and credit-building potential, as opposed to Merchant Cash Advances which may impose financial strain and hamper long-term viability.  While MCAs entail a swift application process and limited paperwork, many believe they should be considered the last resort for financing, after exhausting other funding options.