Merchant cash advances (MCAs) have become a popular financing option for small businesses that need quick access to cash. Unlike traditional loans, which require regular fixed payments, MCAs allow businesses to repay the borrowed amount through a percentage of their daily sales. However, despite their appeal, there are risks involved, particularly if a business defaults on an MCA.
In this article, we’ll explore what happens if you default on a merchant cash advance, what steps a lender can take, how a default can affect your business and personal finances, and ways to avoid it.
Understanding a Merchant Cash Advance (MCA)
Before diving into the consequences of default, it’s important to understand how MCAs work.
A merchant cash advance is not a loan but rather a lump-sum payment that a business receives in exchange for a portion of future sales. The repayment is typically made by deducting a percentage of the business’s daily credit card or debit card sales, often referred to as a “holdback.” This makes MCA repayments flexible since they’re tied to the volume of sales.
However, one downside to MCAs is their high cost. The factor rate, which is used to calculate how much you’ll repay, can be steep. This results in a total repayment amount that can be significantly higher than the amount advanced.
Reasons for Defaulting on an MCA
Small businesses may default on a merchant cash advance for various reasons:
Poor sales performance: If your sales drop significantly, you may struggle to make the agreed-upon repayments. Since the repayments are based on sales, businesses with seasonal or inconsistent income might find it difficult to keep up.
Over-borrowing: Some businesses take on more debt than they can handle, particularly if they have multiple cash advances or loans. The pressure of high repayment amounts may eventually lead to default.
Unexpected expenses: Emergencies, such as equipment breakdowns or property damage, can drain a business’s cash flow and make it challenging to meet financial obligations.
Business closure: If a business closes permanently or temporarily, it may not have the income necessary to make repayments, which can trigger a default.
Immediate Consequences of Defaulting
When you default on a merchant cash advance, the consequences can be severe. Unlike traditional lenders who might provide flexibility or loan modification options, MCA providers tend to have stricter penalties. Some of the key repercussions include:
Increased Fees and Interest
Most MCA contracts include provisions that impose additional fees or penalties when a business fails to make timely payments. These fees can be hefty and further compound the debt. Additionally, your factor rate could increase, leading to even more costly repayments in the future.
Legal Action
MCA agreements typically include a “confession of judgment” clause. This allows the lender to bypass the usual legal process and obtain a court judgment against you without a hearing if you default. Once the lender has this judgment, they can take actions such as freezing your business accounts, garnishing your wages, or placing liens on your property. The legal process can escalate quickly, and you may lose assets before you have the opportunity to negotiate or present your case in court.
Collection Actions
MCA providers may use aggressive collection tactics to recoup the money you owe. This can involve frequent calls, emails, and letters demanding payment. Some providers may sell the debt to a collection agency, which can further escalate the harassment. Additionally, these agencies may charge their own fees, making the total debt even larger.
Damage to Your Business Credit
A default on an MCA can severely damage your business credit score. Once a default is reported to the business credit bureaus, it can make it much harder for your business to obtain financing in the future. Lenders view a default as a red flag, and you may face higher interest rates or be denied financing altogether if your credit is affected.
Damage to Your Personal Credit
While MCAs are typically structured as business financing, many MCA agreements require the business owner to personally guarantee the debt. This means that if your business defaults, the lender may pursue your personal assets as well. This can lead to a negative impact on your personal credit score, and the lender may also garnish your personal wages or place liens on your personal property.
Long-Term Impact of Default
Defaulting on a merchant cash advance has long-lasting consequences for both your business and personal financial health. Here’s how the default can affect you in the long run:
Difficulty Securing Future Financing
As mentioned earlier, defaulting on an MCA can damage your credit profile, which may make it difficult to secure future loans or advances. Lenders and financing companies are less likely to work with businesses that have a history of default. This means that even if your business recovers, it may not have access to the funds needed to grow or manage day-to-day operations.
Legal Liabilities and Ongoing Collections
Even if a judgment is rendered against you, the lender may not immediately collect the full amount owed. This can result in ongoing collection actions, wage garnishments, or legal judgments that follow you for years. Lenders can continue to pursue the debt until it’s paid off in full, which may involve seizing business or personal assets.
Bankruptcy Risk
If your business is overwhelmed by debt, including from an MCA default, you may be forced to consider bankruptcy. While bankruptcy may offer some relief, it comes with its own set of consequences, including further damage to your credit and potential liquidation of your business assets. Bankruptcy should only be viewed as a last resort, as it can have long-term implications for both your personal and business finances.
How to Avoid Defaulting on an MCA
While the consequences of defaulting on an MCA are significant, there are steps you can take to avoid this situation:
Carefully Review the Terms of the Agreement
Before accepting a merchant cash advance, it’s crucial to fully understand the terms of the agreement. Pay close attention to the repayment structure, factor rate, fees, and default clauses. Ensure that your business has enough cash flow to cover the repayments, even during slow sales periods.
Plan for Repayment
Create a repayment plan that aligns with your business’s sales projections. By staying on top of your sales figures and expenses, you can adjust your spending and revenue targets to ensure you have enough cash flow to cover your repayments.
Explore Alternative Financing Options
Before opting for an MCA, consider other financing options that may be more cost-effective. Business loans, lines of credit, or even crowdfunding can provide lower-cost alternatives. While these options may take longer to secure, they can be more sustainable for your business in the long run.
Communicate with Your Lender
If you foresee trouble making payments, it’s essential to communicate with your lender early on. Some lenders may be willing to negotiate new terms, restructure the repayment plan, or temporarily reduce the holdback percentage. The sooner you address potential repayment issues, the more likely you’ll be able to avoid default.
Conclusion
Defaulting on a merchant cash advance can have devastating consequences for your business and personal finances. From legal action to damage to your credit, the fallout from an MCA default is severe. However, by understanding the risks, planning your repayment strategy, and communicating with your lender, you can avoid default and keep your business on solid financial footing.
