What is a MCA Agreement?
An MCA agreement, or Merchant Cash Advance Agreement, is a financing agreement used between a business and a third-party source that allows the business to receive funds quickly, up front. Importantly, the agreement is not with a bank and it is not a loan, meaning the parties are in a different starting position than the typical lender-borrower relationship. The purpose of the MCA agreement is to acting as a bridge loan of sorts – providing a quick influx of money when a business needs cash flow that it otherwise cannot generate on the timeframe needed. For example , a business may need funds to cover unexpected expenses in the middle of high-growth period or at the end of a busy season, and thus may use the MCA agreement as a pre-season loan until anticipated revenues are realized. The funds are then used to pay off the debt from the MCA lender. As a newer alternative to traditional financing, merchants may benefit by amending a bank loan, but should be aware of what they are getting into before signing on the dotted line.
Essential Elements of an MCA
To begin understanding a merchant cash advance, it is important to understand the agreement itself. An MCA agreement lays out in detail the merchant’s responsibilities and obligations throughout the life of the agreement. Although there is no "Standard MCA Agreement," as a starting point each agreement will contain the five following components:
- The Advance Amount – The MCA agreement will detail the amount of money being advanced to the merchant.
- The Retrieval Rate – The MCA agreement will detail the amount of money the lender will retrieve (in addition to the principal amount) each business day to pay back the loan.
- Terms of the Agreement – The MCA agreement will set forth the terms of the advance and the terms of repayment. A standard term is 6 months.
- Personal Guarantee – Personal guarantees are common under MCA agreements. A personal guarantee makes the owner or directors of a business personally responsible for the debt of their corporation.
- Default – The MCA agreement will detail what constitutes default on the part of the borrower. This section of the agreement is very important to understand. If a default occurs, the MCA lender has special rights under the law, such as the ability to close the merchant’s bank account and seize funds.
Benefits of an MCA Agreement
One of the most cited benefits of an MCA agreement is flexibility. The same can be said for MCA lenders. Lenders are less strict about things like time in business and credit history. This opens the door to a greater number of businesses seeking alternative sources of financing. Other benefits of an MCA agreement are a speedy access to capital and little to no closing costs. The lender, for example, may not require an appraisal and other costly measures for the disbursement of funds.
The speed of access to capital and flexibility can be some of the most important factors for companies like mobile phone vendors or repair shops. A mobile phone store may need additional capital for stock when it knows a new device is launching soon. Getting inventory on shelves as soon as possible is a key to competing with rival stores. A repair shop may need new equipment or employees for a busy season. Both types of companies would not have the time to navigate the headache of traditional loan applications in order to account for the busy period. An MCA agreement could be the perfect fit.
MCA Agreement Risks
It is important to remember that the way the parties label their agreement matters. Despite the fact that a merchant cash advance (an "MCA") is a transaction of small business lending, the MCA industry has attempted to argue that an MCA is something other than a loan, perhaps because doing so enables MCA providers to avoid regulation under state usury laws and evade federal consumer lending laws (such as the Truth in Lending Act ("TILA"). So, while much of the risk analysis in this section is written as if the MCA Agreement is a loan and not a "sale of receivables" you should be aware of the risk that the agreement might be recharacterized.
In the maritime context, for example, one court has stated that "money is money"…. And the risk of recharacterization presented by the DWC is real. The MCA industry is well versed in legal recharacterizations in other contexts, and tactically, any time the MCA industry tries to characterize a transaction as a sale of receivables, it does not follow the rules applicable to sales of goods. In short – tension between the MCA industry and the courts results from MCA providers’ unwillingness to concede that these are loan transactions. One of the easiest ways to attack borrowers who engage in MCA transactions is to attack the MCA transaction and ask the court to find that the MCA transaction is a disguised loan.
A merchant cash advance agreement ("MCA Agreement") may provide that the MCA provides a lender a right of first refusal on any financing obtained by the borrower for the term of the MCA Agreement’s term. In this way, the lender could have a first right to receive repayment before other creditors, thus decreasing the chances the lender will be repaid in full. If a business defaults on loan payments, the remaining creditors may take sole control of business assets. Then, the MCA provider might have access to significantly fewer business assets than was originally contemplated. This can create a steep discount on recovering the principal amount of the loan if the borrower defaults on its reobligation.
An MCA may also provide for an imposition of fees on the borrower that far exceed the typical fees associated with loans. For example, a loan may incur late fees if the lender fails to pay their loan on time, whereas an MCA Agreement may allow the MCA provider to retain a portion of the borrower’s daily receipts until the total amount is satisfied. The amount the MCA provider may withhold is not limited to any set percentage of the borrower’s daily receipts. These provisions may effectively double the lender’s return on investment (i.e. the fees may be the equivalent of an additional 50 percent or more of the original investment).
Navigating an MCA Agreement
Businesses considering an MCA should read the agreement carefully. The document will include a clause that entitles the lender to repayment of the advanced amount, plus a "factor amount," over the course of several months. However, the proportion of the repayment that is attributable to the advanced amount contracts over time. Because the repayment is tied to sales, the amount repaid each day may fluctuate.
Some MCA agreements even stipulate that if the agreement is terminated, be it through default or otherwise, payment of the entire balance becomes due immediately. Doing so may expose the business to greater liability than anticipated and should be negotiated out of the agreement if possible.
Further, the prepayment penalty is a major point of contention between lenders and businesses in MFA agreements. Some loans have been structured such that the prepayment penalty is actually higher than the original factor amount itself. That is to say, if the business stops paying and then accelerates payment, the lender will profit more from the prepayment penalty than it will by passing off the loan . Defining the penalty so that the penalty is capped at the factor amount, as opposed to being a variable amount based on how many payments are remaining on the original loan, will benefit a business more down the line.
Additionally, many MCAs require that businesses agree to automatic data backups, tracking systems, and payroll integration. This interferes with the rights of small businesses to select their own financial software. Furthermore, if an employee violates that personal financial information, the business may remain liable. Negotiating with the lender to allow the use of a program of the business’s choosing will keep costs low and promote employee privacy.
While the factors discussed above pose a risk for businesses later on, the benefits of MCAs should not be overlooked. Money received through an MCA is largely unregulated and readily available. Given that many banks are not lending to small businesses, MCAs can be the only option for additional funding.
For any business considering an MCA, consulting with financial and legal professionals is key. A financial expert will be able to show a business if and when they will be able to pay back the loan. The business can then negotiate terms or decide against taking out the loan entirely.
MCA Agreement Versus a Traditional Loan
MCA agreements differ significantly from the more traditional bank loan in fundamental ways. According to the United States Small Business Association, SBA loan volume has increased from $8.2 billion in 1994 to $24 billion in 2008. While this is an impressive rate of growth, it is also important to remember that it means that the vast majority of businesses obtain financing elsewhere.
As analyzed in this post, obtaining a bank loan is not necessarily a simple process. Banks often require information that small businesses find hard to provide. Also, as stated in Investopedia: The average interest rate charged on a business loan is determined by several factors, including credit profile, the health of the business and its financial history. However, different types of loans will have varying rates, depending on the type of collateral that is offered. For secured loans, the amount of capital required for a down payment is typically 20%. The lender can capture this equity with title commitments.
All of these requirements create a system in which certain small businesses have a greater advantage over others. With different risk profiles and varying credit histories, some small businesses have the ability to pay a much lower rate than others.
As a result, financing at reasonable rates sometimes eludes small businesses. In these cases, or if the business needs financial resources immediately (for a new opportunity), the small business owner may turn to an alternative financing agreement.
While bank loans are "one-size-fits-all" solutions, alternative financing products, such as MCAs, take other factors into consideration. In many cases these products are priced higher than more traditional financing options, but they may be more advantageous in the right situation. With an MCA:
What happens when a small business owner enters into an MCA agreement? The lender allows the merchant to borrow a certain amount of money or purchase (or lease) new equipment. In return, the merchant pays back the loan by giving the lender a certain percentage of his or her daily credit card and/or debit card sales. Payments are tied to sales, in that the merchant pays more when revenues are high than when they are low.
For merchants who have drastically fluctuating cash flows, an MCA agreement may provide them with the best terms. For example, if an owner has a seasonal business with major swings between months, a bank loan could be a costly option since the monthly payments would be the same amount regardless of the business’s sales. This would create a risky proposition for the owner since the owner would not have adequate cash to fulfill his or her obligations to the lender during lean months.
Implications of MCA Agreements
The enforceability of an MCA Agreement depends on the transaction, the parties, and the applicable law. Despite the inherent risks, an MCA Agreement is not necessarily destined for invalidation. The outcome of a challenge to the enforceability of an MCA Agreement will be case specific. This section analyzes legal considerations of business owners looking to enter into an MCA Agreement, and is also applicable to lenders who want to know the risks associated with extending an MCA Agreement.
In determining whether an MCA Agreement or the charges therein are subject to regulation as a "loan" or whether the agreement is in essence a sale with a "discount" based on future receivables, courts will look to the "true" nature of the transaction. Factors that have been considered include the agreement terms, the conduct of the parties, control over collateral, intent of the parties, and how the agreement is documented. These factors will vary by state, and this section summarizes judicial treatment of MCA Agreements in Wisconsin, Louisiana, New Jersey, the Southern District of New York, and the Eastern District of Pennsylvania.
In Wisconsin, courts may find a sale or an equipment lease of receivables in an MCA Agreement to be a usurious loan. In Wisconsin, an age old precedent has been used to invalidate agreements where "the true and dominant intention and character of the contract is or was a loan." Lacking newer precedence, it is unclear whether a modern Merchant Cash Advance Agreement will be considered a sale or a usurious loan. Although, one recent decision dealt with this issue and held that such an agreement is a loan. However, in the absence of newer precedence, the Court’s analysis may only be controlling in the U.S. District Courts in Wisconsin.
Louisiana has a different approach, and relies upon the "dollar a day" analogy in determining whether some MCA Agreements are loans. In Louisiana, courts have long considered a loan to stem from the charging of interest "but at the rate of one dollar upon one hundred for the time of one day as follows." Similar to the introduced Wisconsin precedent, this analogy creates a bright line dividing loan agreements from sale/discount agreements. If the deduction of fees is more than 1%, the transaction will be treated as a loan. A decision finding an MCA Agreement is a loan rather than a sale is currently pending consideration before the Louisiana Supreme Court.
New Jersey is similar to Wisconsin with respect to its treatment of an MCA Agreement as a loan agreement. For New Jersey courts, a causation analysis is the proper framework for determining whether a transaction will be treated as a loan. Specifically, it considers whether the merchant was forced to repay a loan by extracting amounts from its bank account irrespective of its actual sales or receipts, made with unreasonably high charges for a return of the money. A broader analysis would include looking at whether the agreement is a disguised security.
The Southern District of New York also applied the causation analysis in determining whether an MCA Agreement was a loan. The court held that the MCA Agreement was a loan, and expressed in the alternative, that if it was a sale, the seller was paying a usurious price for the money advanced.
Finally, in the Eastern District of Pennsylvania, after considering various state and federal authorities, the Court held that an MCA Agreement with an effective interest rate of nearly 200% was unenforceable with respect to the principal.
Final Review of MCA Agreements
In essence, MCA Agreements have the same purpose as any business financing instrument: to enable a business to meet its financial obligations and grow. However, the hidden costs within the MCA Agreement terms, especially the very high daily payment and the "unwind" calculation of the outstanding balance (which is to be paid on the last day of the loan period), may result in an onerous repayment structure. The types of defaults and events of default in the MCA Agreement could hamper a business’s continued viability if it enters financial difficulty . In addition, the less commonly known subsection of the MCA Agreement – restricted activities during the term – may be the element that packs the largest punch. The restricted activities could severely limit the business’s ability to continue to operate or take advantage of growth opportunities.
The important thing to keep in mind when entering into an MCA Financing arrangement is clarity regarding each of the above issues, and an open line of communication with your attorney and financial advisor.
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