What is a merchant cash advance?
A merchant cash advance is a lump-sum payment from a lender based on future credit or debit card sales. It’s different from traditional bank financing and distinct from alternative financing like factoring or asset-based lending, which have been around for a long time. In the realm of financing options for companies struggling to keep up with their loans and leases, merchant cash advance loans are far riskier because of the onerous terms and conditions often obscured in the legalese fine print.
Why has there been a rise in the popularity of merchant cash advance lenders?
They are easily accessible online with a relatively simple application. The process is nowhere near the depth or scope required for bank financing or asset-based lending.
What are their lending criteria?
Most merchant cash advance lenders don’t examine the company's cash flow. They do not assess the company’s balance sheet, nor do they ask probing questions about business viability. They focus on the creditworthiness of the underlying customer of the borrowing company.
What are the costs?
Merchant cash lenders charge high interest rates and various fees, making the overall cost of money extremely high. When you break down the dollars-in versus dollars-out over the duration of the loan, you realize just how expensive it is.
This is short-term borrowing to get out of a bad situation. I suggest that these loans be viewed as rented equity investment. It’s a new money infusion to fill a gap in the capital structure of the business. Long-term revenue decline, peaks of profitability and valleys of losses, capital expenditures that have not yet generated sufficient return on investment, and other structural financial setbacks can result in the moment in time when the situation looks bleak. At these times, the cost of new money is measured against avoidance of greater harm such as running out of money and having the doors shut on the business. Merchant cash advances are often the last resort for borrowers, venturing into a quasi-street-money world of lending.
If the company is solvent and making money, this kind of lending does not make sense. But for companies struggling to survive, it can be a necessary, albeit expensive, solution to an immediate need. An example of one such situation might be the company’s health insurance is about to lapse and employees will lose their healthcare coverage. A merchant cash advance might be a better alternative than having employees’ claims go unpaid.
These loans fill the need for survival money at a critical juncture and should only be used as a last resort.
What alternative directions could companies consider instead of thinking this quick fix will save the day?
Many business owners who turn to merchant cash advances have already exhausted other alternatives. They have leaned heavily on trade creditors, deferred lease payments, and cut overhead. I suggest reviewing restructuring options before jumping into the world of merchant cash advances.
How do these lenders see themselves?
Some merchant cash advance lenders see themselves as a technology solution, akin to Uber or Lyft in their respective industries. They position themselves not as lenders but as future accounts receivable purchasers, entering into a contract with your company to acquire new invoices being generated. They claim it's a contract for the future purchase of receivables, not a loan, and thus they don't need to act like lenders. However, merchant lenders will most often file UCCs to make their presence known to other lenders and any prospective buyer of the business.
(A UCC filing is a document that lenders use to establish their legal right to assets that a borrower uses to secure a loan, allowing the lender to seize the borrower’s collateral in the case of default).
Their position that they are not lenders of money has major implications for financial restructuring, whether the process involves bankruptcy, secured party sale, or non-bankruptcy orderly wind-down.
In the end, how do they collect their repayments?
In addition to high interest rates and fees, their tools for repayment and debt collection are what make them truly toxic to vulnerable businesses. It’s critical to understand these lenders repay themselves through daily auto-debits from the company's checking account. Until this actually starts happening, it’s difficult for borrowers to really appreciate how hard it is to manage cash flow when there is a daily auto-debt right out of the checking account.
By definition, the company that's short on funds now has to navigate the juggling act of receivables and payables along with looking at the bank account to see what auto debit is hitting today. This daily debit adds a layer of complexity to an already difficult situation.
If someone is looking to buy a company, should they ask about merchant cash advances? How can they identify them when digging into the financials, and what is their responsibility if they purchase the company?
The implications of merchant cash advance loans in buying or selling a company are serious. The M&A buyer won't want to take on the seller's responsibility for merchant cash loans. Identifying these advances is crucial, but they may not even appear on the balance sheet. And, if they do, there is often a variance between what the borrower thinks is the payoff amount and the actual amount the lender insists upon receiving.
What can happen if you fall behind with a merchant lender?
The small type in merchant cash advance agreements often gives the merchant lender the right to contact the company’s customers directly in a default situation. This can create irreparable damage to the company’s reputation and jeopardize the sale of intangibles to a potential M&A buyer. We had a recent case in which the M&A buyer had to go to bat against the seller’s merchant cash advance lender who was sending legal hardball notices to the customers. It was resolved, but only after an intense effort to push back on this over-the-top aggression.
