Merchant Cash Advance (MCA) and Connecticut
(What is an MCA, How does an MCA Work, and What are the Benefits of an MCA)
November 13, 2024
Introduction
In today’s fast-paced business environment, securing quick financing can be crucial for sustaining business operations and fostering growth. One financial product that has gained in popularity, due to its fast access to capital, flexibility and ease of application, is the merchant cash advance (MCA).
An MCA is an alternative type of commercial financing that is not a loan. Instead, an MCA is a purchase and sale of the future revenue of a business, where a lump sum of capital is advanced to a business in exchange for the MCA funding company purchasing a percentage of the business’ future revenue. The repayments are typically structured as a daily or weekly deduction from the business’ revenue until the advance is repaid, along with a factor rate. Due to MCA repayments being a percentage of a business’ future revenue, the repayment amounts can vary with the business’ sales, through a “reconciliation” process, making the payment structure flexible and adaptable to the business’ cash flow.
Connecticut has become a prominent jurisdiction for the MCA industry, including due to the favorable prejudgment remedy laws. Most recently, the Connecticut legislature passed Public Act 23-201 (codified at Conn. Gen. Stat. Section 36a-861 et seq, and effective July 1, 2024), evidencing the growing importance of the MCA industry in Connecticut.
This article details the MCA financial product, including the history, structure and unique benefits that MCAs offer to businesses and the financial world.
History of the Merchant Cash Advance
The MCA financial product dates to the early 2000s, with its origin spawned by the demand for a more accessible financing option than traditional loans, that often involve a difficult and lengthy approval process. Initially, MCAs were used primarily by businesses with high credit card sales, such as retail stores and restaurants. These businesses would seek advances from their credit card processors to cover immediate cash flow needs. The product gained traction as alternative financing companies identified the opportunity to provide capital based on a business’ future revenue.
Over time, the market for MCAs has evolved and expanded into the formalized MCA product known today, with MCA funding companies offering various structures and terms to accommodate different business needs. The industry has also seen increased regulation, reflecting its expanding significance in the world of finance.
Structure of a Merchant Cash Advance (How MCAs Work)
When a business obtains MCA financing, it receives a lump sum cash advance in exchange for selling a percentage of its future revenue until the advance, plus a factor fee, is repaid. The repayments are usually deducted from the business’ daily or weekly revenue. As a fundamental feature of MCAs, the repayment amount is tied to a percentage of the business’ future revenue, which can vary (up or down through a “reconciliation” process) with changes to the business’ revenue. Structurally, this makes the repayment term for MCAs indefinite, subject to extension or acceleration.
Key Features of MCAs
Speed and Accessibility. MCAs have higher approval rates and provide quicker access to funds than traditional loans.
Factor Rate. MCAs use a factor rate to determine the total repayment amount (i.e., the total amount of future revenue sold and purchased). A factor rate is a multiplier applied to the principal advanced amount. For example, a factor rate of 1.4 on a $50,000 advance, means that the total repayment amount will be $70,000. This is unlike traditional loans that charge interest to the principal over the loan term.
Flexible Repayments. MCAs are repaid through a percentage of the business’ future revenue. This means that the repayment amount (as set initially, and after subsequent recalculation) can be adjusted with the business’ sales performance. This process is called “reconciliation”, and it allows for the repayment amount to be recalculated based on the actual revenue generated by the business. This procedure ensures that the repayments remain in line with the purchased percentage of revenue. This is a key feature of MCA agreements.
Here’s an example of how the reconciliation process works:
- The merchant experiences a decline in sales or revenue. This could be due to a variety of factors, such as a seasonal downturn, a temporary economic slowdown, or a specific event that has impacted the business.
- The merchant notifies the MCA provider of the decline in sales. This is typically done in writing, and the merchant is often required to provide documentation to support their claim.
- The MCA provider reviews the merchant’s information and determines whether a reconciliation is warranted. If the merchant’s revenue has declined significantly, the MCA provider will adjust and lower the repayment amount to correctly reflect the purchased percentage of revenue.
Rates and fees. MCAs typically include upfront fees, as follows:
- Origination fee: often a percentage of the advanced amount.
- Underwriting or funding fee: charged for reviewing the financing application (can be a percentage of the advanced amount or flat fee).
- Administrative fee: charged for processing or maintaining the MCA agreement (often a flat fee).
For example, if the MCA terms include $5,000 in fees on a $20,000 advance, the merchant will receive $15,000 in net funding.
Example MCA Terms in Practice
Consider the following example to help further illustrate the structure of an MCA agreement:
MCA funding company and merchant agree to a $100,000 cash advance to the merchant, to be repaid through 20 percent of the merchant’s weekly revenue, with a factor rate of 1.4, and upfront fees of $7,500. Under this example, the net advance to the merchant would be $92,500, with a total repayment amount (i.e., the total amount of future revenue sold and purchased) of $140,000 ($100,000 x 1.4 = $140,000). The total cost of financing, excluding the principal amount advanced, would be $47,500 ($40,000 factor fee + $7,500 fees). If the business consistently generates $200,000 in sales each month, it will take the business 14 weeks to repay the advance of $140,000. To calculate the repayment term:
- Repayment: $200,000 in monthly sales x .20 (20%) = $10,000 weekly repayment
- Term: $140,000 / $10,000 = 14 weeks
Important to note, and as stated above, a fundamental feature of MCAs is that the repayment amount is a percentage of future revenue, which can vary. For this reason, the repayment term is indefinite by definition, and at best, can only be estimated at the outset of the agreement.
Benefits of MCA
Broad Accessibility. Among the most significant attributes of MCAs is that they provide access to capital for a wide range of businesses that may be unable to obtain traditional loan financing. MCA funding companies focus more on sales and growth potential and less on extensive financial histories and credit evaluations. This makes MCA financing a viable option for startups, small businesses and those with poor credit histories. Indeed, MCAs have a higher approval rate than business loans according to the Federal Reserve Banks 2023 Report of Employer Firms: MCAs 90%; Equipment loans 87%; Business line of credit 76%; Business loan 66%; SBA loan or Line of Credit 64%.
Quick Access to Capital. Another unique benefit of MCAs is that they offer rapid access to capital. MCAs provide a faster turnaround than traditional loans that can involve a lengthy approval process. Businesses typically receive funds within a few days of approval. This quick access to capital can be crucial for businesses to address urgent financial needs (e.g., operational expenses, inventory purchases, or unexpected costs) and seize immediate business opportunities.
Streamlined Application Process. The application process for MCAs is less cumbersome than traditional loans that often involve a demanding application process including detailed review of credit evaluations and financial statements. This streamlined approach helps businesses secure funding with minimal delay and administrative burden.
Flexible Sales-Based Repayment Structure. MCAs have a distinctive repayment structure, tied to the merchant’s sales revenue, which allows businesses to manage payments in line with their cash flow. This means that during periods of lower sales, the repayment amounts can decrease, reducing the financial strain on the business. Conversely, when sales are strong, repayments can increase, allowing the repayment amount to be paid off faster. This flexibility can be advantageous for businesses with variable sales or seasonal fluctuations. Traditional loans, with fixed monthly payments, can place a more rigid financial burden on businesses, especially during slower revenue periods.
Versatile Use of Funds. Funds from an MCA can be used for various purposes, including inventory purchases, equipment upgrades, marketing initiatives, managing payroll and covering emergency expenses. This versatility allows businesses to address immediate financial needs and invest in opportunities without restrictions.
Conclusion
MCAs provide an important and unique financing option that complements traditional loans and other financial products. Their rapid access to capital, factor rate pricing, flexible repayment structure, broad accessibility and minimal use restrictions, make them an attractive financing option for many businesses, and sets it apart from conventional loans.
Lucas B. Rocklin is a creditor rights attorney. He has extensive experience in representing financial institutions and creditors in workout and litigation matters (commercial and consumer) including collections, foreclosures, bankruptcy and landlord-tenant litigation. Attorney Rocklin also practices labor law including collective bargaining agreement negotiations and arbitrations.
Joseph R. Dunaj is a member of the firm’s commercial litigation, and bankruptcy and creditor rights groups. His extensive experience includes representation of financial institutions and creditors in various collection cases and foreclosure cases, inclusive of settlement negotiations, title matters, and both appellate and bankruptcy work.
John T. Szalan is a member of the firm’s commercial litigation and creditor rights groups. His experience includes representation of financial institutions, creditors, and institutional real estate clients, inclusive of settlement negotiations, title issues, and real estate transactions.