How Merchant Cash Advances Work

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The costly funding is not for every merchant. Jim Amato, a former CPA who now owns a seven-employee wine store in Baltimore with $1 million in sales, considered a merchant cash advance to fund store renovations because banks wouldn't accept his liquor inventory as collateral. Bethesda (Md.)-based RapidAdvance offered him a $42,600 payment in exchange for collecting $59,788 of his credit card sales, which they expected to recoup in nine months by taking 18% of Amato's Visa (V) and MasterCard (MA) transactions. Taking the advance would be the equivalent of borrowing at about 50% APR. "Basically I would be in a loss situation immediately," Amato says. He passed.

Without commenting on Amato's situation specifically, RapidAdvance President Jeremy Brown says responsible merchant cash advance companies are careful not to retrieve so much money from a customer that the business won't be able to survive. "If you're operating under a very thin margin like a grocery store, for example, you have to be very careful with that retrieval rate," he says. Advance providers typically collect between 8% to 10% of gross sales, Brown says, but in the case of a low-margin business, they might collect just 1%. AdvanceMe has a self-imposed limit of retrieving no more than 9% of gross revenues, Lorimer says.

Bad Apple Worries

However, Brown and others in the industry readily admit that some merchant cash advance companies don't act responsibly. Industry leaders say they're trying to promote best practices to avoid attracting regulators' attention. (An AdvanceMe whitepaper describes the challenge: "Regulate ourselves, or someone is likely to do it for us.") To that end, Brown formed a trade group, the North American Merchant Advance Assn. last April. "They all consider a gunslinger to be a real risk for the industry," says Marc Abbey of First Annapolis.

Brown says he's particularly concerned about how merchant cash advances are represented by third-party brokers, who are a major sales channel for the industry. "We do worry about how they're presenting the product. Are they explaining it properly?" he wonders. Reports that out-of-work mortgage brokers are flocking to the merchant cash advance industry—a development one company announced in a press release in March—also raised concerns about responsible business practices.

Some critics say merchant cash advance providers are simply lenders skirting usury laws. Anat Levy, a Beverly Hills attorney, filed a federal class-action suit against AdvanceMe in May claiming that the company's advances are thinly disguised loans and should be regulated as such. AdvanceMe and other merchant cash advance companies say they do not ask for collateral or personal guarantees, and they assume the risk if a business fails. But Levy says business owners who take advances have to agree to "very broad, very ambiguous clauses" that can leave them on the hook if the business goes under. "If you change the pricing of your menus, you've breached the contract," she says.

AdvanceMe would not comment on the pending suit directly, but Lorimer called the idea that the company would pursue an owner's assets based on a menu change "absurd." Lorimer adds that three out of four customers renew their advances, and AdvanceMe has an interest in keeping them healthy. He says AdvanceMe wants to deal with businesses that are using advances to grow or improve their companies, not as emergency rescue funding. "If a business goes out of business, then we take the loss," he says.

Tozzi covers small business for BusinessWeek.com.