Invoice Factoring vs Merchant Cash Advances: Choosing the Right Funding Arrangement

eCapital Corp

Last Modified : Jul 26, 2024

Fact-checked by: Bruce Sayer

Over the past few years, increased regulations, a changing economy, and fewer profits have caused banks to tighten qualification requirements for loans, restricting credit access for small and medium-sized businesses (SMB’s).

In response to this increasing cash crunch, business owners are now seeking alternative financing solutions that are faster, more reliable, and better aligned with their business goals. Two of the most common solutions include invoice factoring and Merchant Cash Advances (MCAs). Both are relatively easy to qualify for and quick to process, expediting first funding to just a few short days once the application process begins. However, these two options differ greatly when comparing repayment terms and their associated risks.

In today’s business climate, any new funding options should be considered with severe caution – be sure you know what you’re committing to before you sign a funding agreement! Several funding options are available that could solve your cash flow challenges. Each comes with terms and conditions attached. Be sure to understand the possible consequences of each detail to your business. For example, MCA borrowers must often sign a Confession of Judgment to qualify. This signed document allows the MCA provider to go after your business unchallenged in legal proceedings to recover funds if you fail to make payment. Ultimately, they have the right to sue you and your business and can seize your business assets.

If you are deciding between invoice factoring and an MCA, a deeper understanding of the differences is critical. Let’s take a closer look at their similarities, differences, benefits, and functions to help you make a well-informed funding choice.

The Similarities and Differences of Invoice Factoring and MCAs

Invoice factoring and MCAs are alternative funding arrangements designed for SMBs in all stages of development. They are advanced funds based on company sales. Both funding arrangements are relatively easy to qualify for as they are not subjected to the scrutiny or regulations typically imposed on traditional small business loans. Although similar in this respect, they are, in fact, very different. Invoice factoring advances funds based on current sales, while MCAs advance funds based on future sales. Further investigation reveals that the financial implications of using these two financing arrangements are also very different. Read on to learn more.

How do These Funding Arrangements Work?

Invoice Factoring:

This financial arrangement is structured on selling outstanding invoice receivables to a factor (the funding company) in exchange for immediate cash.

Once a business delivers products or services and issues an invoice, the invoice is sold to the factoring company. Advanced funds equaling up to 95% of the invoice value are transferred to the business within 24 hours, often much quicker. Once the invoice is paid in full by the business’s customer, the factoring company transfers the remaining balance to complete the transaction.

MCAs: 

MCAs deliver a one-time lump sum advance to a business that needs an injection of funds immediately. The advance is based on projected future sales and can be used for whatever purpose the business chooses.

How Are These Funding Arrangements Costed?

Invoice Factoring charges a small fee that is deducted during the process of financing each invoice. The fee is based on the borrower’s volume of invoices, the average value of invoices, and customers’ overall credit score. Some additional fees may apply to offset administrative costs.

MCAs charge a factor rate on their advances. The factor rate is a multiplier, typically ranging between 1.1 and 1.5, and is applied to your initial funding to determine the repayment amount. The factor rate is determined by the MCA provider’s assessment of the business’s industry, the amount of time it’s been in business, and projected profits. Repayment of the initial balance, plus the factor rate, is due regardless of how fast the debt is repaid.

There are two main ways in which MCAs can be repaid:

• Percentage of Future sales: In this first repayment option, an agreed-upon percentage of the business’s credit and debit card receipts are withheld daily to pay back the MCA. This percentage, referred to as the “hold back,” is taken directly from the credit or debit card processor that clears and settles payments. A minimum daily payment amount is imposed, which could cause the percentage to go up on days of slow sales.
• Fixed Payments: The second option is to repay the advance daily or weekly with fixed payments taken directly from the business’s bank account. The business’s daily cash flow provides the means to meet this financial obligation.

The cost of financing for MCAs is considered to be high. For example, repayment of the initial balance, plus the factor rate and additional fees, can be much higher than the cost burden on credit card balances. Additional fees are also applied as part of the overall cost.

Regardless of the method, repayment continues until the advance is paid in full.

Benefits of These Funding Arrangements

Invoice Factoring leverages the value tied up in unpaid invoices to provide fast, easy-to-manage access to working capital. 

• Higher approval rating: Unlike MCAs and traditional loans, invoice factoring does not rely on projections, history, or revenue. Instead, it depends on the availability of unpaid invoices and the credit strength of the business’s customers. The business will likely qualify for invoice factoring if the company generates receivables to creditworthy customers.
• Immediate access to capital: Invoice factoring gives a business access to capital within 24 hours of submitting invoices for financing. Funds are transferred directly into the business’s account for immediate use.
• Reliable cash flow: Maintaining business stability is more manageable with reliable cash flow. Growth is more attainable with reliable cash flow. The more invoices a business generates to creditworthy customers, the more funds become immediately available, creating reliable cash flow.
• Efficient collections outsourcing: Because factoring companies buy invoices, they also take on the responsibility of collections. A team of accounts receivable professionals improves days sales outstanding and maintains healthy customer relations free of charge to the business. Under this arrangement, companies are relieved of the time, resources, and cost of chasing customers for payment.

MCAs leverage the value of future sales to deliver an immediate injection of cash into the business. 

• Good credit is not required: One of the main benefits of MCAs is that qualification does not need good credit since MCAs rely on the business’s projected cash flow.
• Speed of funding: The application process does not require extensive documents or financials. The main qualifier that MCA companies look at is the business’s daily/weekly payment processing statements. With good cash flow, a business can qualify quickly and receive funding in as little as a week, sometimes quicker.

Disadvantages of These Funding Arrangements

A business needs to be aware of the drawbacks of any financing arrangement to assess value and risk. Following are the key disadvantages to these funding arrangements:

Invoice Factoring:

• Client reliability: Before issuing capital, the invoice factoring company vets the business’s customer base to see how reliable their repayment histories are. If some of the business’s customers have a long record of late or delinquent payments, any invoices issued to them may be denied financing.
• Chargebacks: The standard invoice factoring arrangement is recourse factoring. Under this arrangement, any invoice financed but not paid by the business’s customer within the recourse period (typically 90 days) will be charged back to the business. However, chargebacks can be minimized by paying a slightly higher fee with non-recourse factoring.

MCAs:

• Confession of Judgement: Because a business owner must sign a confession of judgment(CoJ) to secure the financing, an MCA provider holds a sword over your head. MCA payments are due every day or every week – missed or underpaid installments are potential triggers for immediate termination of the contract and a recall of funds. Because of the CoJ, the borrower waives their right to assert any defense against a recall, allowing the lender to seize business assets without court intervention.
• Strained Cash Flow: MCA providers can access your primary business bank account. Payments are taken at least every week, sometimes every day! Automatic withdrawals from this account can be tough on cash flow, placing additional strain on capital management.
• Inflexible repayment schedules: If a business fails to meet any of its repayments during the MCA period or cannot complete the minimum payment due, then the MCA provider has the right to overdraw your bank account as a means to fulfill the obligation.
• Higher costs: MCAs are typically more expensive than other financing arrangements, with APR ranging from 70% to 200% or more! Exhaust all financial options before committing to an MCA – even carrying heavy credit card balances is less expensive and less risky to your business.
• Extra Fees: Although it differs from provider to provider, any business owner taking on an MCA should expect additional fees. These fees can range from administration fees, processing fees, and origination fees, all of which will be debited from your accounts soon after the contract is finalized. The costs can add up quickly, amounting to a sizable portion of your overall loan.
• Debt cycle potential: Finally, while applying and getting an MCA is straightforward, many MCA borrowers need a new advance soon after finishing the first round, mainly due to the facility’s high cost and burden on the business. As a result, MCA’s can potentially place the borrower in an undesirable and costly debt cycle.

Who Are These Funding Arrangement Best Suited For?

Invoice Factoring is an efficient financing strategy to stabilize cash flow and fuel growth. It is a cost-effective funding solution for businesses that generate invoice receivables from creditworthy customers. Invoice factoring is the ideal funding solution for startups, companies that struggle to smooth out their cash flow, and growing businesses.

MCAs are typically used as a last resort for small, quick financing arrangements that can be repaid in a short amount of time. It is best suited for businesses short on cash reserves but with regular debit and credit card sales. As a result, they may require an injection of cash to purchase inventory and equipment or launch a marketing campaign but lack the credit strength to qualify for bank financing. MCAs should be used only when all other financing options have been exhausted – heavy borrower liabilities endanger your business should you default on payments.

Non-Recourse Factoring

Another option to consider when shopping for invoice factoring is non-recourse factoring. Unlike traditional factoring, in non-recourse factoring, the factor assumes the risk of non-payment by the original debtor. If the debtor doesn’t pay the invoice, the business is not required to repay the factor. This method allows businesses to obtain immediate liquidity without the liability of potential non-payment by their customers. Not all companies that offer non-recourse factoring cover the same liabilities. You can find some things to look out for in our blog Top 8 Things to Understand Before Signing A Non-Recourse Factoring Agreement.

Conclusion

Both invoice factoring and MCAs are easy to acquire, providing fast financial relief for undercapitalized businesses. Yet, while both options deliver the same benefit of quick access to capital, the financial implications of using these two financing arrangements can be dramatically different.

Invoice factoring is the financing of individual invoice receivables. The collateral security for each funded invoice is the invoice itself. No other assets or securities are encumbered. If funding is disputed for any reason, the courts can step in to arbitrate a settlement.

MCAs are an entirely different funding arrangement with severe consequences if the terms of the agreement are not met. Able to maneuver quickly and unrestricted by court intercession, MCAs can overdraw your bank account and seize business or personal assets if repayment schedules are not met. For this reason, MCAs should only be employed as a last resort.

Finally, when you compare the cost of financing, you’ll find that invoice factoring costs substantially less than an MCA. The additional benefits of cost-free accounts receivable management, credit risk management, and industry expertise associated with invoice factoring further position it as the preferred funding option for many small and medium-sized commercial businesses conducting B2B business.

eCapital Corp

eCapital Corp. is committed to supporting small and middle-market companies in the United States, Canada, and the UK by accelerating their access to capital through financial solutions like invoice factoring, factoring lines of credit, asset-based lending and equipment refinancing. Headquartered in Miami, Florida, eCapital is an innovative leader in providing flexible, customized cash flow to businesses. For more information about eCapital, visit eCapital.com.