The Real Cost of Merchant Cash Advances: A Fintech Insider's Perspective

Key Takeaways for Ecommerce Brands:

1. ‍Merchant Cash Advances (MCAs) provide quick capital for ecommerce sellers but can carry effective interest rates exceeding 100% due to their unique repayment structure and lack of regulatory oversight.
2. While high MCA interest rates reflect legitimate risk management by lenders, proper underwriting could allow for more competitive rates for creditworthy borrowers.
3. MCA interest expenses are typically tax deductible immediately when repayment is tied to sales percentage rather than specific dates, offering a valuable tax advantage for borrowers.

‍Enter Tuesday morning at a bustling fintech conference in Chicago. I'm trying to focus on my laptop screen while navigating through crowds of entrepreneurs and investors. The usual conference buzz fills the air—startup pitches, venture capital discussions, and the endless networking. As I settle into a corner table with my coffee, I overhear an animated conversation between two eCommerce sellers discussing their funding challenges. One mentions merchant cash advances (MCAs), and my work antenna immediately perks up. Within minutes, I'm drawn into their conversation, sharing insights about financing options for online businesses. And there, amid the conference chaos, we dive deep into MCAs, financing structures, and the true cost of capital.

As more online sellers face ecommerce cash flow management challenges, financing solutions like MCAs have gained prominence. For many businesses, traditional working capital loans are the first choice for funding, but MCAs provide a faster alternative. And while traditional inventory financing options exist for ecommerce businesses, MCAs have become an increasingly popular alternative.

What Are Merchant Cash Advances?

Now, let me back up a little bit, for the sake of the uninitiated. MCAs, or merchant cash advances, are the hot topic now in the e-commerce world. In simple terms, this is a financing agreement, not classified as debt (so no limitation on interest rates), in which cash is advanced to merchants in return for a percentage of the merchant's future sales. Understanding your cash conversion cycle—the time between paying suppliers and receiving customer payments—is critical when considering MCAs. For example, an online seller can get $100K, in return for a future repayment of $110K that must be repaid within a certain period (let's say six months), and the repayment will come out of 20% of the seller's sales.

Understanding effective ecommerce cash flow management is crucial when considering MCAs. For online sellers juggling ecommerce accounting responsibilities, MCAs can seem deceptively simple.

The True Cost of MCAs

While the concept may seem straightforward, the true cost of MCAs often surprises even experienced sellers.

The average online seller that gets this offer thinks to themself: "Hey, I need the cash today since I may not have planned my inventory and cash forecasting well, and I am probably not eligible for a bank loan, or I already maxed out on my line of credit, so what the heck. In essence, if I have to pay $10K interest on $100K, isn't this just 10% interest? Or maybe 20%, since it is annualized, and 10% for half a year equals (roughly) 20% annually?"

Wrong again—since, as opposed to ordinary loans or credit lines—when I repay the loan amount early, I will have minimal interest (plus a possible fee due to early repayment)—with MCAs, whenever you pay back the loan, you will almost always have to pay back the full $110K. Meaning, let's say I have a really good month, and 20% of my sales allow me to repay the full $110K amount within that one month. The e-comm seller is thrilled—they managed to repay the loan really quickly and get it off their plate. But in essence, their effective interest rate is sky-high, and can actually be over 100% since they had an effective interest of $10K over just one month.

Why High Interest Rates Make Sense

For lenders, these high rates are essential to mitigate risk. However, for sellers, understanding these rates is crucial to making informed decisions.

This isn't necessarily a bad thing. While proper ecommerce cash flow management should be the priority, sometimes quick access to capital becomes necessary. Many critics argue that the high effective interest rates (which are not regulated) are exploitative, particularly for inexperienced borrowers, as they often lead to financial strain—with the simple click of a mouse.

But, after giving it a bit of thought, and as a staunch capitalist at heart—at the end of the day, I think these MCAs actually make a lot of sense. These are really high-risk loans, and a lot of the borrowers will end up defaulting. These lenders need to ensure that they get an IRR that satisfies their investors and need to bake into the calculation that the default rates are really high. That, along with the fact that the underwriting here is really basic, means that the high interest rates are necessary to cover that risk.

Though MCAs can be more expensive than traditional inventory financing, their speed and accessibility make them attractive to sellers needing immediate capital. While a working capital loan might offer better rates, the lengthy approval process makes MCAs attractive for immediate needs. Smart cash conversion cycle management can help reduce dependency on high-cost financing options.

The Role of Underwriting

Loans, just like insurance, require underwriting. The more granular underwriting the lender or carrier carries out actually allows lower premiums or interest payments to better-rated borrowers or insureds, as the risk can be stratified between borrowers at different levels. In our example, if the MCA lender carried out sound underwriting (or if the borrower just went to take out an ordinary 7(a) SBA loan), assuming sound financials and a good credit rating, the interest rate would be much lower. In our MCA case, as the borrowers are being lumped together with other borrowers with varying credit ratings, the lender conservatively assumes the worst-case scenario and needs to take high interest rates to cover their associate risk.

The Future of MCAs

Assuming this area would be regulated (and my friend from the conference thinks it is only a matter of a year or two until it is)—the entire industry would be changed. The lenders would need to do much better underwriting, which would give better interest rates to stronger borrowers but prevent weaker ones, or those without credit ratings, from receiving access to capital.

Granted, as many people claim, perhaps the contract language included in MCAs is not clear enough. And trying to sneak personal guarantees into the loan language really isn't cool. But as a concept, I think that MCAs actually make a lot of sense.

Beyond the core aspects of ecommerce cash flow management, sellers should also consider the tax implications of MCAs.

Tax Implications

Now for the tax implications—interest and fees paid on MCA loans are deductible. Not only are they deductible, but in many cases, they are deductible immediately. Without totally geeking out, the general rule is: if the loan repayment is tied to specific dates (you need to return x% by date y), then the interest expense will be tied to those dates. But, if there is no catch-up with specific dates, and you pay a % of your sales no matter when they occur, you can usually take all of the interest as a deduction on day one.

Proper ecommerce accounting practices are crucial for tracking both MCA obligations and their tax implications. 

While MCAs offer quick access to capital, they come at a cost. Before committing, ensure you're well-informed about your cash flow and financing options. Consult an expert to explore tailored solutions that fit your business needs.