Invoice Factoring or Merchant Cash Advance?


We recently met with a distributor who, with back against the wall, is finding it difficult to decide whether to apply for a Merchant Cash Advance or sell its invoices to a factoring company. Initially, the distributor went online to search for financing options for his business and came across a vast number of Merchant Cash Advance companies and online lenders offering anywhere from term loans to daily repayment merchant cash advances.

Worried and confused with the many options he found online, the distributor knew he had choices to make to secure the future of his company.

In order to make a decision, the distributor needed to understand the impact each of the options would have on his business and its growth.

The Merchant Cash Advance

The Merchant Cash Advance is an advance on the future sales of your business. In this program, the merchant cash advance company looks at the average deposits of your business’ bank statements and the balance left over each month, along with your personal credit scores. All these information are entered into an algorithmic system which determines the risk for your company, the terms as well as the discount fee you will pay for the financing.

In today’s marketplace, the merchant cash advance companies offer terms ranging from 3 months to 36 months, with paybacks ranging from 12% to 45% depending on each company’s situation. These companies take a client from application to funding within 48 hours and typically debit your business bank account daily, weekly or monthly via ACH depending on your situation.

The Struggles behind Merchant Cash Advances

Merchant Cash Advances may not necessarily work for every business or every situation. It is important to understand the growth trend of your business and the average time it takes your business to collect from its clients. This would help ensure your company has the necessary cash flow to meet the daily, weekly or monthly payment the merchant cash advance company will draft from your account via ACH payments. For this distributor, most of his sales to his clients were on open terms, which meant his clients would take anywhere between 30 and 60 days to pay their invoices and the company was growing exponentially.

In the commercial finance arena, most finance companies and lenders typically pledge the collateral they are financing via what is called the Uniform Commercial Code (UCC). The UCC is a document whereby the lender pledges the collateral they are financing. The UCC works on a first-come-first-serve basis and the lender or finance company who pledges the collateral first will remain in first position. This implies they have first priority on the assets over any other lender or finance company down the chain.

What does this mean for your business? Simple! Depending on the finance vehicle you select for your business, the lender or finance company may pledge all the assets of your business. In the case of Merchant Cash Advances, they are considered a one-time advance with fixed payments either daily, weekly or monthly. In the case of our distributor, this could not work as:

  • They would get a one-time lump sum of cash to resolve temporary issues.
  • They would have to deal with the payment obligation while having the same struggles of their clients paying invoices between 30 and 60 days.
  • They would have no collateral to offer to other lenders or finance companies as the merchant cash advance would place a lien on all the assets of the business.

In the event this distributor would undergo a month of either low sales or low payment collections, it would make it an almost impossible task for this distributor to meet his daily, weekly or monthly payment obligation to the merchant cash advance company.

For merchant cash advance companies, one of the documents included as part of the agreements to its clients is a Confession of Judgment (COJ).  This basically allows the merchant cash advance company to enter a default judgment without the need to litigate in a court of law. In other words, you sign your own judgment before defaulting on your obligation.

Why Invoice Factoring?

Invoice factoring is an advance on a company’s open account receivable from its eligible commercial clients. In an invoice factoring transaction, your company obtains an advance on its open receivables of 80-90% of the outstanding balance of the eligible customers. An invoice factoring facility, in the case of the distributor, would provide an immediate advance on his invoices paid between 30 and 60 days from his creditworthy clients. This would allow the distributor to comfortably go through his normal sales cycle without putting a daily, weekly or monthly payment liability as each invoice would be paid directly to the factoring company by the end client.

How would I know my clients are creditworthy?

It is in the best interest of the invoice factoring company to ensure you sell to creditworthy clients who typically pay within the terms. This would enable them to run credit checks behind the scenes for your client to ensure they have the creditworthiness and a credit limit set for each one of your clients prior to funding each invoice.

Will my clients think I’m financially weak if I factor my invoices?

This is one of the most common misconceptions invoice factoring companies get when working with clients new to the system. Your clients may already see you weak when you rush them to make early payments or when you cannot supply the next order because of a pending invoice. Invoice factoring ensures you have the consistent cash-flow your business needs to fulfill your next orders. It also focuses your company on doing what it does best, while the factoring company handles the credit and collections side of your business.

In the case of our distributor, invoice factoring helped them enter new markets and sell to larger creditworthy clients who typically demand payment terms. Because they factored their receivables, they were able to re-focus their business in finding new and healthier clients, without having to deal with the burden of chasing payments.

In most cases, this may be the case since the merchant cash advance looks at “All” the income that passes through your business’ bank account (cash sales & sales on open terms) as supposed to only the eligible accounts receivable. Depending on your specific situation, your company may qualify for a higher funding amount than what you would get from an invoice factoring company. However keep in mind that invoice factoring is not a one-time funding vehicle.

Another thing to consider is that invoice factors also venture into financing your purchase orders to your suppliers as long as the product is pre-sold. Every situation is different and needs to be addressed taking into account the cash-flow cycle of each business. Invoice factoring can provide sustainable growth without adding liabilities to your business. And while at times the funding amount your business gets may be lower than that of a merchant cash advance, invoice factoring shortens your cash conversion cycle every month and provides sustainable growth without limitations.

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