When raising money more small companies than ever are choosing a merchant cash advance as their funding solution. This may not be the best choice, but the bank crisis has often made this the only realistic choice. Banks have dramatically cutback their lending until things stabilize.
This raises an interesting question. “What are the best ways to use the cash advance money you get?” The reason this is an important question is a merchant cash advance is an expensive source of funds. That means you should carefully plan how to best use this business capital to actually grow your business.
Let’s first look at how a cash advance works. A merchant cash advance is NOT a loan. It is a purchase of future credit card sales at a discount. Here’s a restaurant example (but any business doing credit card sales may qualify). You want $12,000 to upgrade your bar. A funding source agrees to buy a portion of your restaurant’s future sales. They evaluate the last several months of your credit card sales and see that you average $10,000 in MasterCard & Visa receipts monthly.
The funder looks at a number of factors but agrees to fund you. They offer to buy $16,000 worth of future credit card sales for the $12,000 that you need. (By the way, the funder will most likely not say it this way, but that is structurally the way it works).
Typically, funders will determine the rate factor to charge you by analyzing the risk, cash advance amount, years in business and a few other factors. Almost all funding sources in the cash advance industry use a factor between 1.3 to 1.5 times the cash that they advance to you. In our example above, the factor I used was 1.33.
One great merchant cash advance feature that most entrepreneurs love is your payback is totally dependent on your actual credit card sales. There is no fixed payback amount. The merchant cash funding source sets a holdback or credit card reserve percentage.
This holdback should never be higher than 25% of your monthly credit card sales. If your credit card sales drop, then your monthly payback will also decrease.
In our example, let’s say there is a 25% holdback on the $12,000 advance. That means you will pay $2,500 per month for about 6 1/2 months. You need to determine whether your business can support the payback.
This brings us back to the question of how to use these cash advance funds wisely. It makes a lot of sense to invest in expansion or efficiency related improvements.
When you expand you obviously expect increased sales. Cost of funds is far less important when you are relatively certain sales will increase. The same is true for new equipment or high value added inventory. These add leverage to your business and should yield higher profits.
On the other hand, think long and hard about using a merchant cash advance for digging out of a deep financial hole. That thirty to fifty percent premium you have to pay back in under a year can make it impossible for your business to recover.
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