Merchant Cash Advances – A Trap for the Unwary

Small business owners should think carefully before taking out merchant cash advances, which is a form of financing that is heavily marketed. Small businesses, like any other business, need cash to run. It can be difficult, though, for some small businesses to get access to financing when they need it. Whether this is because they have poor credit, the amount they need to finance is too small, or some other reason, small businesses often find that traditional financing sources, such as banks, do not want to work with them. Some small businesses turn to merchant cash advances. While merchant cash advances may seem like regular loans, there are many important differences to watch out for.

First, many merchant cash advance companies take the position that their product is not a loan at all, but a purchase of the small business’s accounts receivable. This is an important difference because borrower protections such as usury laws may not apply if the merchant cash advance is a purchase instead of a loan.

Second, merchant cash advances can be very expensive. Not only is the interest rate often very high (and difficult to figure out), but there are often hidden fees that can cripple a small business in unexpected ways. For example, one contract we recently reviewed had a $5,000 fee if the small business obtained any other “funding or loans” without the merchant cash advance company’s consent. Under such a broad provision, the merchant cash advance company could argue that using a company credit card or ordering inventory on credit violates the contract and incurs the $5,000 fee.

The same contract also charged a fee of 5% of the outstanding loan amount each time the small business requested a reduction of the required payment, even for a limited time period. So if a small business finds the payments unaffordable and tries to negotiate a settlement, the merchant cash advance only becomes more unaffordable. This would also arguably apply to each request, regardless of whether the merchant cash advance company agrees to the request.

Third, merchant cash advance contracts may have other unexpected terms. Some contracts have “confession of judgment” clauses. These clauses allow the merchant cash advance company to get a judgment against a small business that defaults, often in a court far away from the small business’s home and without giving any notice to the small business. The merchant cash advance company can then begin taking steps to collect its judgment. Often, the first time a small business learns about the judgment is when it discovers that its bank account is frozen. By then it may be too late: it is very difficult in some courts to get relief from judgments by confession.

There may be legal options available to small businesses that would bring better results than taking out a merchant cash advance. For example, a FactorLaw lawyer may help negotiate a workout with an existing lender or pursue an assignment for the benefit of creditors or chapter 11 bankruptcy reorganization. Similar options may be available for small business that have already taken out an unaffordable merchant cash advance and are looking for a way to deal with it. We encourage you to e-mail or call us before you make the decision to take out another merchant cash advance.