Why Merchant Cash Advances for eCommerce Businesses Aren't Ideal

Why Merchant Cash Advances for eCommerce Businesses Aren't Ideal

You know the emotional rollercoaster of managing cash flow if you have a small business. If you're an eCommerce merchant, the rollercoaster may feel more like a runaway train, particularly when you start exploring funding options.

eCommerce sales are becoming a significant percentage of retail sales around the globe, making up an anticipated 20.2% of the 2023 market and expected to reach 23.3% of retail sales by 2026. Despite the steady growth of the eCommerce industry in the modern era, the financial services industry has a lot of catching up to do.

While there are many financing options available for eCommerce merchants, those from banks have been designed with traditional businesses in mind. Many merchants can end up feeling confused, frustrated, and put at risk by the funding opportunities in the market.

Merchant cash advances (MCAs) are a popular approach due to their easy application process and typically swift turnaround for approval. They also have a high approval rate, with a study published by the Federal Reserve finding that 84% of loan applications were approved in 2020.

However, there was a sharp drop in the utility of merchant cash advances in the following year's report, with only 8% of businesses applying for merchant cash advances and only 52% of applicants to online lenders receiving funds. They're more accessible than other funding types, but are they the best option for you?

Let's talk about merchant cash advances for eCommerce so you can determine if they're the right approach when you need to boost cash flow. In this article, we'll explore: 

  • What merchant cash advances are
  • The potential benefits they offer to eCommerce business owners, as well as their general pros and cons
  • Conventional alternatives to merchant cash advances, such as long-term and short-term loans
  • The attributes of a cash advance program that can help your business grow

What Are Merchant Cash Advances for eCommerce?

You may be unsurprised to hear that a merchant cash advance (MCA) is a financing method that enables merchants to receive cash in advance of sales income. That's an overly-simplistic descriptor, of course, but it's a good start.

A merchant cash advance provides a lump sum to merchants for business expenses, particularly when finances are tight, sales are slow, and merchants can benefit from having extra funds to reinvest in their businesses. Especially helpful for small businesses, MCAs typically have a shorter repayment cycle (24 months or less). They also have very predictable repayment terms: daily or as a percentage of every sale rather than a monthly amount.

Because merchant cash advances are repaid daily from a percentage of your credit card sales, many small businesses find them much more manageable. The deduction is made automatically and settled by your payment processor directly to the lender. Rather than a loan, they function as an advance receipt of funds and are repaid by future sales.

Related: How to Get Funding for Your Online Business

Put more simply, the daily loan repayment is tied to the business's daily sales. Days with more sales allow borrowers to repay more of the cash advance, and days with slower sales have a lower repayment amount. This structure offers more flexibility for seasonal or fluctuating sales without the rigid structure of conventional, fixed repayment plans.

The Difference Between Loans and Merchant Cash Advances

We've mentioned that a merchant cash advance is not a loan. Fundamentally they're much different, both in terms of structuring the exchange of money and your day-to-day repayment obligations. Let's look at some key differences between MCAs and traditional loans.

Long-Term Loans

Long-term loans are exactly as they sound, with a repayment term of five years up to a decade or more. These loans have a lengthy application process, requiring a lot of details about your financial and business or sales history. Your credit score will also have a significant impact on your assessment for approval, and you'll likely have to put up collateral to qualify for this kind of loan.

Long-term loans are best suited for well-established businesses with a lengthy credit history to back up their request. These loans are typically for larger cash amounts and are commonly used for significant events like mergers, acquisitions, or expansion. While interest rates are often lower than short-term loans, the fee can add up over the loan's lifespan, particularly if the balance isn't paid back each month.

Short-Term Loans

As an eCommerce merchant, you're likely in the small business category, and as such, a short-term loan is a more reasonable starting point. Short-term loans are typically designed for smaller amounts and are available more immediately than their long-term counterparts.

Short-term loans have a faster repayment schedule, with lenders expecting complete repayment within months or just a couple of years. These traditional loans often lean heavily on your personal credit history and require collateral to secure the funds. Many small businesses consider short-term loans for emergencies, unprofitable or off-peak business cycles, or to meet recurring costs when money is unavailable. 

The funds are commonly used for covering payroll, continuing marketing campaigns, or buying additional inventory—expenses businesses must continue to take on to keep their doors open. Interest rates are relatively high, and you will be required to make minimum monthly payments in most cases, whether your sales are strong or nonexistent.

Merchant Cash Advances

First established in the 1990s, merchant cash advances (MCAs) began as a mechanism for borrowing against future credit card sales. Barbara Johnson, alleged creator of MCA and co-founder of the company that patented technology for splitting credit card sales, visualized the original MCA as a way to utilize 'future receivables' and leverage it for more immediate funding.

From there, the idea evolved into its most recent incarnation: a way to receive a lump sum of cash upfront, with repayment tied to future sales. Today's technology makes MCAs even more versatile, as eCommerce sites can easily integrate with MCA tools for fast, accurate, and convenient calculation of credit or debit sales and repayment without the business owner's direct involvement.

MCAs are not loans. Instead, they're an advance on future revenue and are therefore not subject to the same regulations as traditional banking financing options. On the plus side, that means these advances are more accessible, with a quicker turnaround for approval and receipt of cash. They also tend to have a lower barrier to entry and don't require lengthy financial and background checks to back up your application.

A merchant cash advance provider will purchase a portion of your future sales by partnering with your credit card processor. This is beneficial to everyone involved. The eCommerce business owner can tap into future receivables and access cash immediately. 

At the same time, it gives the provider access to receiving funds from the processor on a daily or weekly basis to repay the balance. The automated nature of repayment means you don't have to worry about defaulting on your loan.

Pros of Merchant Cash Advances

As with anything, there are upsides and downsides to merchant cash advances for eCommerce businesses. Before you start filling out applications and writing business plans for spending your cash, it's essential to see the big picture.

Quick Access

One aspect that makes merchant cash advances for eCommerce an attractive option is their easy application process. Rather than collecting piles of financial history, credit reports, and detailed business plans to state your case, the provider reviews your daily credit card receipts as a means of assessing eligibility.

Easy Approval

Since MCAs are unsecured, you won't need physical collateral to receive funds. You can put your mind at ease without the need to put your business assets on the line and risk losing them if you are unable to meet a repayment commitment.

With an easy application process and the lack of collateral requirements, approval for merchant cash advances for eCommerce is swift. Remember that while you won't need to put your physical assets on the table, your provider may require a personal guarantee. This guarantee effectively states that if the business is at any point unable to repay the loan, you will be personally responsible for settling the debt.

Flexible Use

Merchant cash advances for eCommerce are flexible options. Whereas some financing options require specific details of how you will spend the cash or a business plan to back up the request, MCAs are open to your discretion.

Need to boost your cash flow to cover payroll? Low inventory at a slow sales period and need to stock up before the orders start coming in again? Do you want to reach new customers through marketing activity but don't have the funds? A merchant cash advance can offer the cash you need when you need it.

Cons of Merchant Cash Advances

While MCAs can offer fast access to cash, there are also some drawbacks that can negatively affect your business's long-term growth.

Higher Fees

Nothing in life is free, of course, and if you want all of the ease of access to merchant cash advances for eCommerce, you'll pay for it.

The annual percentage rate is, on average, between 40% and 350% percent depending on the lender, size of the advance, extra fees, and how long it takes you to repay your debt. Your sales will factor in as well, of course, as your advance will be repaid as a percentage of credit and debit card transactions.

Related: How eCommerce Lending Can Help Online Sellers Grow

At the same time, MCAs don't really use annual percentage rates. Instead, they use a 'factor rate,' which will be discussed in more depth below. This can make it difficult to calculate the true terms of the loan and may make you think you're getting a lower rate than you really are.

Are you thinking of saving money by repaying your loan early? Not so fast. Many institutions offering merchant cash advances for eCommerce will penalize you for early repayment. If your advance is provided at a factor rate of 1.4, your effective APR may rise to a minimum of 60% for paying off a 12-month advance in only six months.

As a reference, traditional bank loans have an average interest rate of 10.82% as of April 2023. Online lenders currently offer interest rates between 6% and 30%, depending on the specific provider, with SBA loans typically offering rates ranging from 10% to 13.5%. Also, average business credit card interest rates hover around 22% for new cards and 20% for existing account holders. Each of these options, however, can incentivize early loan repayment, or at least not penalize it.

Merchant cash advances are among the most expensive ways to boost your cash flow, and they can even lock you into a repayment cycle that is detrimental to your business if you want to repay early and remove liabilities from your books.

A reported 60% of small businesses say cash flow is a primary challenge, and approximately 40% of SMBs couldn't survive for more than two months if cash flow halted. Make sure you choose a lending option that will make it easier, not exaggerate this challenge.

Impacts on Cash Flow

Due to the nature of repayment, merchant cash advances for eCommerce can present challenges for your cash flow. You'll be repaying your advance frequently - often daily or weekly - through a preset amount taken from your incoming sales before you receive payment.

While that means you don't have to fumble with accounting workflows and managing due dates, it also means a reduction in funds received. That amount can be dramatic depending on the size of your loan and the size of your fees. As we mentioned, you'll be penalized for repaying the loan early, so that's not an option for many merchants.

Indirectly, this could also spell trouble for your financial calculations. Because MCAs are paid first before you can truly recognize the revenue, your financial models may show depressed revenue amounts. You may also miscalculate taxes, cash flow, and other metrics because of the actions taken before cash even hits your books. 

Debt Cycle Dangers

The ease of access to MCAs can move merchants into a debt cycle. For those who don't qualify for other lending options, borrowers may find themselves with no further avenue than another merchant cash advance for eCommerce merchants. The high costs and frequency of repayments can squeeze cash flow and increase the risk of default for many small businesses.

Confusing or Complicated Contracts

When you start to look at the fine print of your MCA, you may find that they are pretty confusing. Repayment structures, high costs, and early repayment penalties add layers of complexity to understanding all of the terms of your cash advance.

While the lending industry uses standardized terms when discussing their offerings, MCAs have a language all their own. The amount you receive? That's called a purchase price. Specified percentage? That's the repayment amount taken as a percentage of credit card sales. Are you looking for your APR? You won't find one in merchant cash advances for eCommerce. Instead, MCAs use a factor rate—a decimal value that makes up the cost of getting the loan.

For example, a merchant cash advance provider may offer a factor rate of 1.21 on a $20,000 advance. If you multiply the principal—or 'purchase price'—by the factor rate, you get a total cost of $24,200. This means there is no amortization.

Since providers don't use APRs, it's also challenging to compare offerings to decide what's best for you. One method is to calculate the total cost of each option and know how much money your business would spend at the end of the arrangement for the same principal or purchase price. While this can help you roughly compare the different offers, it doesn't account for variable rates, the benefits of paying a loan down early, or other, more complex considerations. 

Some merchant cash advance providers also include other fees, penalize early repayment, and restrict what the cash can be used for. These and other terms can turn an appealing method of funding your business into an overly constrictive barrier to independent growth and control over your own business.

Pro Tip: Keep an eye out for a confession of judgment. That's a document you sign that releases your right to defend yourself if your provider takes you to court.

A Better Way to Boost Cash Flow

Don't despair. You're not limited to the choice between putting the deed to your house on the line or paying exorbitant rates. There are alternatives to a merchant cash advance for eCommerce that won't break the bank - or take your peace of mind.

eCommerce merchants and online businesses need a financing option that better fits the needs and unique considerations of today's markets. Conventional options such as an equity line of credit may stipulate what expenses funds can be used for, and small business loans often require too much collateral or a long paper trail of financial credentials. 

While merchant cash advances can be a better fit, they also come with limitations. Shopify;'s program, for example, restricts what the funds can be used for, has unclear qualification criteria, and has a factor rate of 1.1. Instead, you can opt for a less restrictive cash advance that:

  • Has a simple fee structure
  • Charges a flat rate of 1% without complex factor rates or calculations
  • Offers monthly repayment schedules instead of daily repayments
  • Has no narrow restrictions on how you use the cash to fuel your business

Onramp doesn't just want to give you money - that's only one way we can help. We want to support you in optimizing your business needs and see you thrive. We offer lending designed around you. Set up a call so we can learn more about your goals and show you how we can partner with you to reach them.