Recently, we had a prospective client of ours almost choose a merchant cash advance over our working capital line of credit despite it being nearly twice as expensive. Given that we spend a good portion of our time trying to help growing businesses avoid MCA, you can imagine this caused quite a bit of consternation among our team. After digging deeper, we learned that the borrower nearly took the MCA because it was easier to understand, even while knowing it was much more expensive.
As I started to explain to my team why our line of credit offer was “soooo much better,” I embarrassingly found myself talking in circles and thinking, in the words of Albert Einstein, “If you can’t explain it simply, you don’t understand it well enough.” And, if I couldn’t understand, how could my customer? So, I went back to the drawing board to once-and-for-all devise the simple explanation of what I knew to be true.
How are funds deployed?
Let’s assume that at any given time, your business needs between $25K and $50K of working capital to fund operations. You have two options:
Option 1: $50,000 MCA @ 1.14 buy rate for ~6 months repaying $57,000
Option 2: $50,000 LoC @ 24% APR and a 1% fee per draw
At first glance, Option 1 looks great. Perhaps you mistake the 1.14 buy rate for a 14% interest rate (its actually 53% APR in this example) or you think $7K isn’t so bad. Plus, it’s easy – one fixed payment every business day until you pay in full. However, because the MCA loan repays daily, the average principal balance – or the average funds available – during the life of the loan is only $21,500.
Compare this to a working capital line of credit that allows us to draw up to $50K as needed on the terms above. Although the interest rate and advance fees appear higher than the MCA, you are able to hold an average balance of over $38,000 on your line for same interest cost of $7,000.
In others words, you can employ 80% more capital with our line of credit than you could with an equivalent MCA.
Overall Interest Cost to Meet Your Minimum Balance Needs
Now, there is another problem with the MCA that we haven’t addressed yet – for more than half of its life, the balance is less than $25K, the minimum amount of working capital you need to operate!
So, as the balance on your MCA nears $25K, you start to ask yourself, where can I get an additional $25K of working capital? After all, your business needs swing between $25K and $50K throughout the month.
About halfway through your 1stMCA, your MCA provider comes back and says, “Boy, have I got a deal for you!” and he offers you a $25K MCA – same terms, same pricing. So, now you have $50K in capital again ($25K remaining from MCA #1 and $25K new from MCA #2), but you also have to pay $7K in interest on MCA #1 and $3.5K on MCA #2 – a total of $10.5K.
A few months later, both MCA #1 and MCA #2 are winding down and you find yourself below $25K, so what do you do? You re-up yet again with MCA #3. Boom, you’re back at $50K in capital, but now you have to pay a total of $14K interest across all 3 MCAs.
If you repeat this pattern, you will incur $17,500 of interest expense on 4 MCAs over a 6-month period to ensure that you always have between $25K and $50K of working capital available.
As you look at the utilization of your MCA (blue line above), you notice it looks a lot like a revolving credit line. So, what if you actually had a credit line to begin with?
Key Takeaway: Math Doesn’t Lie
Using the same line of credit from the first example, you can see that the average utilization of your revolving line is identical to the utilization of your MCAs. However, with the working capital line of credit would only cost you $7K in interest/fee expense during the six-month interval.
So, that financing product from Dealstruck that originally appeared to cost twice as much (24% APR v. 1.14 buy rate) will actually end up costing half over the life of the financing. In other words, for the exact same amount of capital over the exact same time period, our Dealstruck line of credit would have saved you $10.5K relative to using MCA.
Anything that seems too good to be true probably is. When it comes to understanding your financing options, you can spend a little time now or a lot of money later.