Business cash advances are becoming increasingly common among businesses in many sectors across the United States. The reason for this popularity is obvious: they are typically offered with lightning-fast approval, little paperwork, and your cash is usually deposited into your bank account almost immediately after you apply. For this reason alone, a business cash advance may appear to be a perfect solution when an entrepreneur has pressing or urgent financial obligations such as making payroll, replenishing inventory, or marketing costs. However, while business cash advances are presented as simple, there are several significant risks associated with them that most business owners do not consider. Before entering into any business cash advance arrangement or any similar loan arrangement, be sure to educate yourself thoroughly about the risks involved.
The Real Cost: Effective APR Can Be Shockingly High
Business cash advance providers do not charge interest like business loans and other types of financing. Instead, they charge based on a factor rate (usually between 1.20 and 1.50), which is utilized to determine the total amount to be paid back. For instance, if you borrow $50,000 at a factor rate of 1.40, you will be obliged to pay back $70,000.
Quite a few business owners are unaware of how a factor rate converts into an effective annual percentage rate (APR). As cash advances are normally required to be repaid within six months to twelve months, average effective APRs for cash advances are usually between 40% and over 150%, thus making them significantly more expensive than a typical business loan or a line of credit.
Daily or Weekly Withdrawals May Suffocate Your Cash Flow
Most MCA providers do not require fixed monthly installments but instead arrange for daily or weekly automatic withdrawals from your business bank account. Continuous withdrawals from businesses with seasonal or fluctuating revenues can lead to a significant reduction of working capital. Some entrepreneurs may encounter a liquidity crunch in which they have to take on additional debt to cover ongoing expenses. Many who have recourse to business cash advances soon realize that they have fallen into a borrowing cycle to repay previous advances.
Limited Legal Protections
Business cash advances exist outside the protections offered to businesses under federal and state consumer protection regulations for business loans. Many lenders are not required to clearly display the APR equivalent and/or the interest rate on the loan. The contract terms are usually heavily one-sided in favour of the lender. You may find that you have agreed to a confession of judgment, a personal guarantee, and have given the lender broad access to your business bank account before you were aware of these pitfalls. Once you have executed the company cash advance agreement, you will find it difficult, if not impossible, to reverse any negative terms that may have been included within the agreement.
Using a fixed merchant cash advance factor rate provides a straightforward calculation of the total repayment amount, allowing a business to know exactly what it owes from day one regardless of how long it takes to pay back the advance.
Risks to Your Personal Finances
Quite a few business cash advance contracts come with personal guarantees or UCC liens on business assets. In this case, not only your business but also your personal finances will be in jeopardy if you do not comply with the repayment schedule. In case of non-payment, you may experience account freezing, lawsuits, credit and reputation damage, or even business closures. That temporary money situation may grow into a real jeopardy of your business.
No Early Payment Discounts
Unlike standard loan products, which reward borrowers with lower interest rates if paid in full before the scheduled due date, almost all business cash advance agreements require the total sum of the advance to be paid back in full, since the date of repayment is irrelevant when calculating interest costs. Thus, there is virtually no financial benefit to paying a cash advance off early as a result of an increase in cash flow. This structure severely limits the flexibility of cash advance financing, resultantly placing additional strain on the borrower’s finances.
Smarter Alternatives to Think About
It is advisable for business owners to look for more secure funding sources before deciding on a business cash advance, such as:
- Standard term loans
- Business credit line loans
- SBA loans
- Invoice financing
- Equipment financing
Although these alternatives may require more formalities or take longer to get approved, in most cases, their prices are transparent, and the presence of regulatory safeguards makes them more durable.
Conclusion
A business cash advance may result in quick availability of cash, but there are significant risks associated with using one. Entrepreneurs should be aware of high effective APRs, daily withdrawals that reduce available cash flow, limited legal protection, complicated pricing, and personal liability risks; these factors could result in greater actual cost than may initially appear to be the case. It is essential for entrepreneurs who are using business cash advances to understand all of the conditions outlined in the contract, to seek guidance from qualified professionals before signing contracts, and to evaluate and compare other financing options that may be safer. The speed of the approval process should not be a trade-off for long-term financial viability.
