Merchant Cash Advances Carry the Risks of Payday Loans for Businesses

Inside Subprime: Nov 21, 2018

By Lindsay Frankel

In the decade since the last financial crisis, there has been explosive growth in the merchant cash advance industry. That’s because there was a demand for small business lending not being met by traditional banks. Proponents say merchant cash advances provide small businesses with access to credit in times of need, but thousands of lawsuits and defaults indicate that the $10 billion industry has many parallels to the payday loan industry, which is notorious for preying on financially desperate people.

Technically, merchant cash advances are not loans. Instead, the company funding the advance will provide cash to a business against future revenues. Essentially, the funder purchases a percentage of future credit card sales and the business owner gains immediate capital. The borrower pays back the advance either as a percentage of credit card sales or in fixed daily or weekly payments based on projected sales. While merchant cash advances are easy and fast to obtain, they carry high annualized interest rates just like payday loans.

Because merchant cash advances are considered sales and not loans, the companies that provide them are unregulated. While many states have capped interest rates on payday loans, a New York State judge ruled in 2016 that merchant cash advance companies are not lenders and are not subject to state usury laws. Just like payday loan borrowers, small business owners on shaky financial ground can become trapped in a cycle of debt as a result of taking out a merchant cash advance. And exorbitant interest rates and fees aren’t the only parallel between merchant cash advances and payday loans – companies that fund these advances have also been called out for their aggressive collection practices and misleading or unclear terms.

Just like payday loan firms, funders are given access to merchants’ bank accounts, from which withdrawals are made. And because borrower fraud is rampant in the industry, many merchant cash advance companies require merchants to sign a “confession of judgment,” which is an agreement for the merchant to accept damages should they fail to pay back the advance. Once the funder files the COJ, they can freeze the merchant’s bank accounts or even take possession of the merchant’s assets. “They tell you it’s unsecured and then they come after you,” said one frustrated business owner.

While not all business owners become unhappy with their agreements, there is plenty of evidence that merchant cash advances can cause more financial harm than good. The industry admits that borrowers who renew their agreements provide an essential stream of revenue to merchant cash advance companies. But renewed agreements can quickly spiral into a debt trap for small business owners.

According to one lawsuit, Antelope Valley Community Clinic, which provides healthcare resources to underserved populations, took a $250,000 advance. After taking out a larger advance to cover the previous one, Antelope Valley ended up owing $674,550 to the first provider and only netting $382,500 after the fees associated with the advance. Antelope Valley wasn’t the only company to end up buried in debt; Shane Heskin, a Philadelphia lawyer, calls the problem “a national epidemic.” Since taking a case for his father-in-law, Heskin has received an overwhelming number of requests for help from small business owners around the nation.

Like payday loans, merchant cash advances should only be used as a last resort after business owners have exhausted all other options. While there is growing criticism of the industry, a move towards stricter oversight is unlikely. As long as merchant cash advances remain unregulated, small business owners need to be aware of the risks and make sure they clearly understand the terms of an agreement before signing.

For more information on scams, payday loans and title loans, check out all of our state-by-state Financial Resource Guides.