Merchant Funding: Pros, Cons, and Alternative Options
An increasing number of businesses are turning to merchant funding to access capital because of the fast application process and quick payouts. However, this type of financing is not without risks because of the high costs and accelerated repayment schedule.
Read on to find out what merchant funding is, how it works, what it costs, and what alternative small business financing options are available to you.
What Is Merchant Funding?
Merchant funding is a type of short-term small business loan.
The two main merchant funding products available are:
Merchant cash advance (MCA): An MCA, sometimes called “business cash advances,” allows you to borrow money against your expected future debit and credit card transactions.
Revenue-based financing (RBF): Occasionally referred to as “royalty financing,” you can borrow against your expected future sales volumes, no matter how the customer makes their payment.
How Does Merchant Funding Work?
Revenue-based financing and merchant cash advances work differently from traditional bank loans in the following two ways.
1. Finance Charges
Interest isn’t payable on either MCAs or RBF facilities.
You won’t find an annual percentage rate on a merchant loan provider’s website. Instead, they’ll advertise a factor rate for MCAs or a royalty rate for RBF loans.
Think of factor rates and royalty rates like fixed interest rates that tell you the cost of your merchant funding upfront.
If an MCA lender wants to charge you a factor rate of 1.5 on a loan of $100,000, the total cost of your facility would be $150,000.
Royalty rates may be presented as a factor rate or as a percentage.
So, if you borrow $100,000 on an RBF facility at a royalty rate of 1.1 (or a percentage rate of 10%), the total loan amount you’ll pay back is $110,000.
2. Repayment Terms
There are two standard ways to repay your MCA or RBF loan — revenue-based or fixed fee.
Revenue-Based Repayments
You can choose to pay a percentage of your revenue. This means you’ll pay less during slower months.
On MCAs, this is how it works. Usually, the company handling your payments deposits your earnings from card payments into your bank account on the same day or within a few business days.
For example, if you brought in $2,500 in daily credit and debit card sales on a Monday, you might receive the remittance on Wednesday. The payment they make to you is known as a “settlement.”
However, with an MCA, you won't get the full $2,500 on Wednesday. Instead, a small portion, known as a “holdback,” goes to the MCA provider. If you've agreed to give 10% of your card sales to the MCA provider, they'll get $250, and you'll receive $2,250.
Some MCA providers will allow you to extend the term of your loan if you repay their facility this way.
With RBF lenders, this works similarly, except they collect your repayments from your checking account. To determine how much they bill you, they may require you to allow them access to your bank account or accounting software to monitor incoming revenue.
Fixed Repayments
If you prefer greater predictability, you can opt for fixed payments.
On an MCA, you agree with your merchant cash advance company the amount you’ll pay back and the frequency of your repayments. However, you usually don’t have the option to extend your facility if you choose fixed payments.
It’s the same with RBF facilities, but you can often take advantage of much longer repayment periods of up to five years.
It’s important to bear in mind: With this type of business funding, your total repayment amount will not reduce if you repay your facility ahead of time unless you agree to it in advance with the lender.
What Are the Pros and Cons of Merchant Funding?
Merchant funding offers businesses significant benefits over traditional business loans. However, it’s also important to consider the downsides before approaching a lender.
Merchant Funding Advantages
Fast turnaround: Applying for this type of funding is quick, and the lender may transfer your loan on the same day or within a few days. That means merchant loans are suitable for small business owners who need near-immediate access to capital.
Bad credit OK: Many lenders’ underwriting teams are happy to provide funding to businesses with a poor credit history and company owners with poor personal credit scores. Some lenders have approval rates of 90% and higher and accept applications with credit scores in the 500s.
Flexible use: Most lenders place no restrictions on how you use your merchant funding facility. So, you can take out merchant funding to cover working capital or to purchase equipment or inventory to pay for marketing campaigns.
No collateral required: MCAs are unsecured, meaning you don’t need to offer collateral like commercial property or your accounts receivables to apply. Instead, the loan is secured against your future sales only. Most MCA providers also don’t require a personal guarantee.
Regular repayments: Unless you agree on a different monthly payment process with your lender, payments are automatically taken from your business bank account or deducted from your merchant account provider’s settlement. Your repayments can also be reduced if you experience a dip in sales, helping your cash flow.
No dilution: Neither MCAs nor RBF facilities require you to offer shares in your company to gain access to the capital you need. This means when the time comes to sell your business, you get to keep all of the purchase price subject to taxes and other fees.
Merchant Funding Disadvantages
High costs: Merchant funding can be very expensive in comparison to standard loan options and other mainstream forms of business finance.
No federal regulations: MCA loans are not covered by federal laws like the Truth in Lending Act because they’re not technically business loans. They are, therefore, not covered by usury and unfair lending laws.
No credit history benefit: Not all merchant loan providers report borrower behavior to credit bureaus, so even if you make every payment in full and on time, this might not show on your credit report or boost your credit score.
History required: Many merchant cash advance and revenue-based finance providers require you to have been in business for at least six months and/or a history of monthly revenue before you can apply. But each provider will have its own requirements. However, this means that this form of funding is not available for brand-new startups.
How Do You Apply for a Merchant Loan?
Traditional banks and credit unions rarely offer merchant funding, so you’ll need to look for an alternative online lender. However, they’re very easy to find with a Google search.
When applying, you’ll need:
Sales history: You’ll need to show at least six months’ worth of credit card transactions or revenue statements to your lender to help them determine how much you can borrow.
Company documentation: You’ll need to provide information on your company, bank statements, statements from your payment processor, and business tax returns.
Identity documents: The lender will need your personal ID plus company proof so they can make sure that you’re legally authorized to apply for the loan on your company’s behalf.
Is Merchant Funding Right for Your Business?
MCAs and RBF facilities are targeted at different types of business.
MCAs are generally but not exclusively used to help businesses tide over cash flow gaps. MCA factor rates are high because the businesses that apply for them might be struggling financially. Since more borrowers are likely to default on their facilities, lenders charge more to cover those losses.
RBF facilities are designed to help fast-growing companies fund growth. They allow firms to access capital based on their future revenue projections, which gives them the chance to scale while minimizing pressure on cash flow.
What Alternatives to Merchant Loans Are Available?
Other forms of flexible financing with quick application turnarounds for small businesses include:
SBA loans: You can apply for an SBA Express Loan of up to $500,000 and receive an answer to your application within 36 hours.
Invoice factoring: Sell your outstanding and unpaid invoices to an invoice factorer and receive up to 90% of the value in about 24 hours.
Business lines of credit: Similar to a business credit card, you can draw down cash up to your company’s set limit and borrow the cash you pay back again with a business line of credit.
Working capital advances: Working capital advances are short-term loans with flexible repayment plans with up to 12 months to settle your advance.
Access the Funds You Need Through Backd
Merchant funding is a way to meet your business expenses by borrowing against the value of your expected future revenues. The streamlined approval process means that you receive the funds quickly, sometimes on the same business day, and you don’t have to risk collateral like your home or business assets.
Merchant cash advance and revenue-based financing eligibility requirements are also low, meaning that you don’t necessarily need a high credit score to be approved.
However, merchant loans aren’t the right fit for every business and do have downsides.
Backd can turn around and fund proposals in as little as 24 hours. We offer the following two funding options that can help you meet your business needs:
Working capital advance: Borrow $25,000 to $2 million over a term of up to 36 months.
Business line of credit: Borrow $25,000 to $750,000 with a flexible repayment plan.
Apply today and be funded quickly.
