One common criticism in the Merchant Cash Advance (MCA) industry is the lack of transparency around how Annual Percentage Rates (APRs) are calculated. Many financing companies argue that calculating or disclosing an APR is either too complex or potentially misleading for borrowers. However, the reality is that any competent financing provider should be able to provide borrowers with a clear understanding of the APR associated with their financing, as it directly reflects the expected return on the financing arrangement. After all, the rate that we expect the borrower to pay is the rate that we expect to earn.
Computing an MCA’s Estimated APR With A Simplified Example:
Let's consider a small business like a coffee shop. The MCA financing company decides to offer this coffee shop $100,000, which is about 10% of its projected annual revenue of $1,000,000. Instead of charging traditional interest, the MCA adds a 10% fee, meaning the coffee shop will need to repay a total of $110,000.
The repayment is based on a fixed percentage of the coffee shop's daily sales, often referred to as the hold rate. In this case, the hold rate is set at 11%. If the coffee shop makes $3,000 in daily sales, 11% ($330) will go toward repaying the financing. Based on these numbers, it will take approximately 333 days to repay the full $110,000. ($110,000 owed divided by $330 per day equals 333 days.)
Given that we know the financing amount ($100,000), the expected daily payment ($330), and the repayment term (333 days), the Estimated APR can be calculated similarly to a traditional loan with daily payments. In this case, we plug these numbers into the APR formula and see that the Estimated APR is 21%. It is straightforward to compute using only the cash flow projections we used to structure the deal.
Sophisticated MCA Providers Often Begin With An APR Target:
Of course, MCA companies not only can compute APRs, but we also sometimes start with an APR target in mind and adjust the terms we will offer in order to achieve that APR target. Let’s explain how this works, continuing with the coffee shop example.
When financing companies consider offering financing, we assess how much risk the transaction presents. For example, if we expect to lose about 5% of the capital we extend, we may target an expected yield (aka an Estimated APR) of 20%, to cover those losses, our cost of capital, our overhead expenses, and the return hurdle we’re seeking. For higher-risk small business borrowers where we expect an annualized loss rate of 20%, we may target an annualized yield of 40%. This is the core of the financing business—charging more than we lose.
MCA financing providers control three main variables: the dollar amount of the financing, the percentage of the business’s daily sales that will go towards repayment, and the fee. Different combinations of these three variables produce different Estimated APRs. By adjusting the dollar amount, hold rate, and fee, MCA companies can achieve our target yield—which is the Estimated APR from the borrower’s perspective. If we didn’t know the Estimated APR, we couldn’t operate effectively.
The fact that the borrower’s repayment behavior may diverge from the expected scenario in the APR disclosed before the financing does not make the APR any less useful for helping small businesses comparison shop. Financing companies rely on these expected repayment scenarios—our best guess about the future that we are investing in—to make our own business decisions about whether to offer the financing, what terms to propose, how we raise the capital we’ll lend out, how we prepare for losses, and so on. If the expected yield of a financing transaction is useful for us as we run our businesses, we can understand why knowing that expected rate can be useful for our small business customers to know as well!