Illustration of Merchant Cash Advance

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When searching for alternative funding options, many construction contractors find the “quick cash” promise of a merchant cash advance too good to pass up — but it’s actually too good to be true.

Merchant cash advances promise an easy application, rapid funding, and an “easy” repayment plan. The truth is that these pseudo-loans can cost a construction business owner everything, with personal credit damage, massive interest payments, and a payment schedule that is nearly impossible for a contractor to keep pace with. 

What is a merchant cash advance?

A merchant cash advance — also called an MCA or daily debit loan — is a type of funding that is based on the average amount of cash flowing through a business’ bank account on a monthly basis. They are not technically considered a “loan” because of their repayment structure. The upfront cash is an advance on the purchase of future receivables or credit card transactions.

It’s important to know that, because MCAs are not loans, they are not subject to some states’ (like Florida’s) criminal usury statuteCheck with a licensed construction lawyer to learn more about the legal status of MCAs in your state. 

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How does a merchant cash advance work? 

The amount of an MCA and the cost of that advance is based on the company’s bank information (specifically the number of deposits made) and the business owner’s personal credit score. Merchant cash advances are typically sold by brokers, who shop around your funding request to several MCA lenders, each of whom will run the business owner’s credit.

All of those credit inquiries within a few days means that just by applying for an MCA, you can damage your credit. 

MCA lenders look at the number of deposits made into your company bank account on a monthly basis to determine how frequently new money comes in. They’ll also look at the total amount deposited into the bank account. This determines the likely revenue of the business.

Finally, they’ll check the average daily balance in the bank account. This is used to determine how much can reasonably be auto-debited from the account every day without the risk of a payment being bounced. 

Using this information, the MCA lender will decide how much the business is qualified to receive for an advance, the cost to be applied to the advance amount (this is the cost of the money to the business owner), and how many business days it will take for the advance to be repaid, (typically 6-12 months). You will also pay the broker’s commission as part of the cost of the advance. 

The cost of the advance is determined using a factor rate, which is a percentage of the lump sum for which the client is approved. Factor rates can vary from high single digits to as much as 50% or more. If a client is approved for a $100,000 advance with a factor rate of 30% then the cost of the loan is $30,000. 

The total repayment of the MCA is the lump sum of money plus the cost of the factor rate percentage. In the example above, the total repayment amount would be $130,000.

It is extremely important to review your contract with an MCA lender, as many have a “combined total payment” structure, meaning your company will owe the total payment even if you pay off the advance early. This makes it tricky to get out from under an MCA draining your cash flow

Why MCAs are problematic for construction contractors

It can be tough to secure working capital as a construction contractor. Since the 2008 recession, banks have become increasingly hesitant to loan to specialty trade subcontractors, which are usually family-operated small businesses operating under tight margins. The cash flow reality of construction makes an MCA seem tempting, but the truth is they were not built for the industry. 

Construction companies do not typically receive daily deposits large enough to continually handle a daily debit from an MCA lender. Not to mention that much of the deposits your company receives will go right back out again in the form of payroll, materials purchases, rent, utilities, and more.

If your daily cash flow — the cash coming in and out of your business — cannot handle the daily payment required by the MCA, you will soon find yourself in a world of regret. 

Further learning: Where Is All My Cash? 6 Cash Flow Management Strategies for Contractors

This is where MCAs become an inescapable trap. If you are struggling to make the payments, chances are your broker will try to set you up with another MCA. The second MCA is usually about half of the amount advanced originally and can be offered by the current lender or through another company.

In the MCA world, this is referred to as “stacking” and can take a situation from bad to worse. The cash flow situation at your company didn’t change, and now you are using one bad debt to pay off another, paying interest on interest in a futile attempt to get free. 

If even a single payment is missed — most often because the account is overdrawn — you can be considered in default and charged additional fees and penalties. The MCA lender can, and will, place a UCC lien on the business. As long as the lien is in place it is unlikely that other companies, such as banks or factoring companies, will provide funding that could pay off the bad debt and get the business back on track. 

Finally, many MCA companies include a Confession of judgment in their agreements, meaning that as soon as the borrower defaults, the company can file the confession in court.

Within a matter of hours, your company bank accounts can be frozen — even your personal accounts in some instances. Some MCA lenders will even call your general contractor requiring immediate payment of the advance. Confessions of judgment are not legal in all 50 states, so check with your construction lawyer to know what the laws are in your state. 

Read more: You Know What Is Expensive? Bad Debt

What to do if you already have an MCA

If you are already struggling under the pressure of a merchant cash advance, the first thing you should do is talk to your construction lawyer. You need to know the details of your contract and the laws of your state before you move forward. 

Review your business’ budget and cash flow with your accountant. Look for missed opportunities to increase profits and reduce overhead. Make sure your other debt payments are in good standing; make sure to rebuild your personal credit score as quickly as possible. 

Research your debt options. A business loan or asset-based loan may allow you to refinance a cash advance into less damaging, less risky debt. There are also companies that specialize in restructuring MCA debt. 

The most important thing? Don’t get a second merchant cash advance.