Businesses often realize that they are unable to meet all of their financial obligations in terms of raising and maintaining adequate working capital. There are times when a business might even need financing in order to purchase a new piece of equipment or to meet payroll obligations. In situations such as this, business owners often resort to commercial bank loans—usually short and medium-term loans. It is a well-known fact that business owners have often made commercial banks and other traditional financial institutions their first point of call when seeking business funding for whatever reason. But, recently, there has been a decline—about 20 percent—in the overall commercial bank loans to small businesses in particular. The implication of this is that business owners have begun to explore alternative sources of business funding, notable among which is merchant cash advance. It is our purpose here, therefore, to discuss term loans in general and compare them with merchant cash advance with a view to helping small business owners decide which option is best for their businesses. Before proceeding, however, there is need to examine why small businesses have been facing significant difficulty in obtaining loans from commercial banks in the first place.
Why Are Small Businesses Looking for Alternative Sources of Business Funding
The topmost reason why commercial banks reject loan application by small businesses is that of bad credit. For good reason lenders always look at the credit history of a business in order establish the financial worthiness of the business. Apart from that, a good credit score shows that a business has proper management since that could be the only reason why the business has avoided bankruptcy and made previous payments in a timely fashion. On the other hand, banks would shrink from offering a term loan to a business that has poor credit since it shows that the business cannot make a sound financial decision and meet up with loan agreements.
Banks also closely consider the cash flow of a business before grating its loan request since it is the cash flow that will determine if the business will meet up with the monthly payments of the loan in question no matter how well it faired in previous ones judging from the credit score. But small businesses are known to often have cash flow problems and more so if the business is just starting out. This due to the fact that small businesses have to pay suppliers upfront before they, in turn, get paid for their products or services. So banks will typically not grant term loans to businesses with weak cash flow—which are, sadly, those in the majority. In addition, bank loans usually require collateral as a form a security against the loan and this another major area in which small businesses fail to meet up. Meeting the collateral requirements of banks is more often than not a daunting task for small businesses and as such getting loans becomes quite difficult.
What are Term Loans and how do They Differ from Other Bank Loans?
Term loans are credit that is strictly reserved for businesses; this immediately serves to distinguish them from another type of loan which are also issued by commercial banks, insurance companies, and other traditional financial institutions which may also have a period of maturity of more than one year. One other factor that serves to further distinguish a term loan from other forms of loans is that, although there is collateral security for the loan, the major factor that determines whether the loan would be granted or not is the probability of financial success of the business—as judged by the lending firm. Term loans are also easily differentiated from personal loans which are secured by mortgages in residential property and where the focus is on the financial worth and moral standing of the individual who doesn’t have to be an entrepreneur.
The collateral provided in business loans are of a special kind and cannot be liquidated to recover the loan in the event that the business fails except a further personal guarantee is obtained from the business owners by the commercial banks—unlike what obtains in another form of loans. Loans of the short term category are usually expected to be paid in less than 15 years, although it had been thought they merely provided seasonal capital and as such should be repaid in less than a year, current practice suggests otherwise. A term loan is, therefore, financial assistance offered to a business on which interest is charged at a fixed or variable rate. And every month a business is usually expected to pay the interest plus a portion of the capital over the period the loan is expected to last.
What is Merchant Cash Advance and how is it Different from a Term Loan?
A merchant cash advance refers to a commercial transaction between a business and a lender which is hereafter referred to as a merchant cash advance provider. In this transaction, a business agrees to receive a lump sum of cash from the merchant cash advance provider in exchange for a share of its future credit sales. What is apparent from this definition is that a merchant cash advance is not a loan—speaking from a technical perspective. It is also clear that only a business which accepts credit card payment can be eligible for a merchant cash advance. Because a merchant cash advance is not a loan it does attract interest as do term loans. What actually happens is that, since a given sum of money always has a higher value at some future date, the business sells its future credit card sales to the merchant cash provider at a discounted rate. This leads to what is known as factoring in a merchant cash advance transaction. This means that if a business requests a cash advance of $10000 this amount is factored by say 1.2 to give a total payback amount of $120000 which the business is expected to pay back.
A typical merchant cash advance transaction incorporates such terms as a holdback percentage which is the percentage of the daily credit sales of the business that is to be remitted to the merchant cash advance provider. In most cases, around 10 to 20 percent of the daily credit sales are set aside for redeeming the cash advance. This continues until the advance is fully repaid. From the foregoing discussion it appears that merchant cash advance has so much in common with a term loan; although that is quite true, there are salient differences which a business has to come to terms with before deciding which will be a better option. In order to highlight some of these differences, we shall take a look at merchant cash advance and term loans under different headings.
How Does Merchant Cash advance compare with Term Loans?
Nature of Terms
The terms of a merchant cash advance transaction are not usually fixed. For instance, the duration of the loan is no fixed and varies depending on the volume of credit sales even though merchant cash advance providers expect to recoup their investment in less than 18 months. And there are no rewards for quick payment of the advance neither is there any repercussion for failing to complete the payment after the expected time. In a term loan, however, the loan is expected to be repaid within a given period of time, failure to do so which attracts severe consequences can even cause a business to file for bankruptcy which would seriously affect the credit score.
A merchant cash advance by its very nature is unsecured. This means that a business assumes no risk for the money it borrows and all the risk is borne by the merchant cash advance provider. Even in cases where providers had managed to extract personal guarantees from merchants, and the business happened to fail, courts ruled in favor of merchants when the providers tried to make claims against the personal assets of the merchant. This is exactly the opposite of what obtains in term loans where a business has to provide collateral before the loan can be issued.
Timeliness and Documentation
Processing a merchant cash advance is something that takes a few business days. Provided that a merchant has met the requirements it takes the merchant cash providers a few days for a decision to be made. This is, in part, due to the minimal documentation that is required for an advance to be processed. The same cannot be said of term loans which often take weeks or even months before a feedback on the loan application is issued. Moreover, the chance of a merchant cash advance application being granted is much higher than that of a loan.
If one is to look closely at merchant cash advance one sees that it is clearly a better option than term loans especially for a small business in urgent need of financial assistance. Although there are objections to merchant cash advance because of its relative cost, what is not being said, however, is how the numerous highs of merchant cash advance more than compensates for its cost. In a nutshell, a business which is looking for a reliable source of business funding should not look too far from merchant cash advance.