(Disclaimer: Payability is NOT licensed to offer loans and does not offer any lending options at this time. Instant Advance is a capital advance designed for eCommerce businesses and Instant Access is a factoring solution for marketplace sellers. The information shared on loans is intended for educational purposes only and not intended to be financial advice.)
As a growing business owner, there’s usually a lot riding on your ability to secure funding and keep your business running. You need cash on hand to help invest in that next round of inventory, run marketing, pay off unexpected shipping costs, or just manage daily expenses as you ramp up sales.
When looking for capital (cash), two common funding options are loans (term, SBA, bank, etc) and cash advances. But, choosing between the two can be overwhelming. There’s a lot of information to absorb and misconceptions to sort through as you compare.
Merchants ask us questions like these all the time: What type of funding can I qualify for? Why are cash advances more expensive than traditional loans? Why not just go to the bank? Why would I ever need a capital advance if I qualify for or already have a bank loan?
To answer these questions and more, here’s our definitive guide on loans and cash advances. With the right knowledge, you can feel confident about picking the best funding option that sets your business up for success. And, the option that’s best for you might even surprise you!
Finance Terms Used
We know that reading and learning about finance is difficult because of all the unfamiliar terms used. If you need them (most people do!) here’s a quick list of terms used in this post and what they mean. Otherwise, skip ahead to learn the difference between a loan and a cash advance!
Capital: Cash (both capital and cash are used interchangeably in this article)
Debt: Capital that is owed or due
ROI: Return on Investment (ROI) is a ratio that compares the gain or loss from an investment relative to its cost. A high ROI means you gained a large return on a small investment.
Collateral (or assets): Financial assets you own like your house or car. Collateral can be used to secure financing as you pledge to give your assets up if you can’t repay it.
Credit Score: Providers often use credit scores (based on your credit history) to determine your level of risk when deciding to fund you. A higher credit score should indicate that you’re more trustworthy to pay back the funds.
Unsecured: Funding that is issued based on the customer’s creditworthiness, rather than by any type of collateral.
Secured: Funding backed by collateral that is used as payment to the capital provider if you don’t pay back the capital.
Underwriting: Underwriting is how capital providers determine the level of risk for an investment, and whether to accept or reject an applicant for financing.
Purchase of Future Receivables: A third-party funder provides financing by buying your future earnings or sales at a discount.
Interest: The rate you repay for the amount borrowed. For example, if a merchant receives $10,000 in funding from a capital provider, and it’s paid back at 2% interest, the merchant will pay $200 in interest ($10,000 X 0.2) + $10,000 for $10,200 total.
Capital (or Cash) Advance: A third-party funder provides an upfront sum of cash for a purchase of future sales or receivables at a discount. This is not a loan as the capital provider is actually purchasing a portion of your future sales outright.
Fees: A payment made to the funding company in exchange for financing.
Comparing Loans vs Cash Advances
Before you take on any funding, it’s best to understand what your options are and their impact on your business.
What is a Loan?
A loan is capital (cash) borrowed from a bank, credit union, or online lender that you agree to pay back over predetermined terms like set monthly payments and interest rates. When you receive a loan, you’re also taking on debt, meaning you owe capital to the lender.
Like most financing options, there’s different types of loans like:
- Lines of credit
- Home equity
When comparing loan options, you should also note if it’s secured or unsecured. A secured loan requires you to pledge collateral like your house or car. In the case you can’t pay back the loan, your collateral is used as payment to the capital provider.
Advantages of Loans
- Low interest rates (can be lower than credit cards)
- Low monthly payments
- Long payment terms like 3 to 10 years
- Widely available from traditional providers like banks
Disadvantages of Loans
- Require you to pledge collateral like your house (mixing your personal finances with your business)
- Can take weeks or even months to process before approval
- Low approval rates for new businesses
- Personal credit score is the main factor in approval and funding amount
- Rely on outdated underwriting processes (how the capital provider determines whether to give you money)
- More risk on the merchant and less risk on the capital provider
What is a Cash Advance?
A cash advance is not a loan or debt. Instead, a third-party capital provider buys your future receivables (i.e. future eCommerce sales) at a discount. Then, you pay back the capital provider along with a flat fee based on a percentage of your sales.
Advantages of Cash Advances
- Fast and simple online applications
- Approval rates based on health of your business
- Often have no personal credit score checks
- Doesn’t require collateral
- No fixed monthly terms, based on a percentage of your sales meaning you pay less during months with less fees
- Less risk on the merchant and more risk on the capital provider
- Can be used alongside other funding / financing
Disadvantages of Cash Advances
- Can have high fees
- Short payment terms
- Can be a cash flow constraint
How Cash Advances Work
Here’s an illustrative way to learn how cash advances work (and differ from loans):
Let’s say I go to a car lot with 100 cars on it worth $2M and I tell the dealership that I want to buy all the cars for $1.8M in cash right now. I also know that I can’t drive all 100 cars off the lot by myself in one day. So we agree that every day for 100 days, I’ll come to the lot and drive off one of my cars that I already bought.
The dealer would probably agree to this, and here’s why: Suppose a tornado hit the dealership lot after the 5th day. At this point, I only drove off 5 cars and there’s still 95 cars remaining. So if that tornado destroys the rest of the cars, then I have lost 95 cars I already paid for and the dealer is at no fault. Because I take on most of the risk for paying upfront, the dealer is willing to give me all the cars for a sizable discount at $200K ($2M — $1.8M = $200K).
But, now let’s imagine that the tornado never happens. Instead, one day I come to pick up a car and there’s a big barbed wire fence and lock around the lot that prevents me from taking my cars. This would be unacceptable and breach of contract. As the cars are already mine, it’s unfair to stop me from taking what I already paid for.
To bring it back to cash advances, the money you receive from a cash advance is not a loan. It is the discounted purchase of your future sales. Just like in the car lot example above, a capital provider is buying in bulk the eCommerce sales you’re expected to make. They’re absorbing all the risk if you don’t make your future sales as expected and can’t pay them back, which is why they can purchase them at a discount. And, when/if you do make sales, they can collect a percentage of your sales over that time period since they already purchased and own them.
What Financing Options Matter to eCommerce Businesses
When it comes to cash advances, there’s a lot of misconceptions like they’re just for struggling businesses or people with bad credit. Here’s why that’s not true and how cash advances like Payability Instant Advance are actually built to meet the unique needs of eCommerce merchants.
1. Quick and Easy Applications
Time is money. Applying for a traditional loan can be a long and tedious process, whether you get approved or not. Most businesses though don’t have weeks to get the funding they need. Imagine it’s your busy season and you’re selling out even quicker than you expected. You need money ASAP to ensure you don’t miss out on an opportunity for sales.
With cash advances, online applications are quick and easy. You can be approved in as little as 24-hours so there’s little to any interruptions for your business. At Payability, we can get eCommerce businesses up to $250,000 in 24 hours with no credit checks.
2. High Approval Rates for Wide Variety of Businesses
The truth is that many businesses struggle to get approved for traditional loans. Traditional lenders like banks tend to use outdated underwriting processes that favor large, established businesses. They’re looking for merchants with 2+ years of business history, tax history, or collateral available to back the loan with. If you’re a new and fast-growing venture, you don’t always meet those requirements.
Capital providers issuing cash advances though are flexible and focus on the current state of your business. If you’re a healthy business bringing in sales, then you’re likely to get approved (no matter what your personal credit score is).
3. Use Cash Advances Alongside Other Funding
Another great advantage of cash advances is that you can use them alongside traditional funding. Maybe you already have a loan or line of credit and just need a small boost in cash. A cash advance can be a quick and fuss-free way to secure that extra capital you need.
4. Keep Your Personal Finances Separate from Your Business
Traditional loans can require you to pledge capital like your house to secure the funding. This can mean that you’re now mixing your personal finances with your business. In the worst case scenario that your business goes under, then your personal assets are on the line. In other (direct) words, troubles in your business affairs can follow you for years in your personal life.
So Why are Capital Advances so Expensive?
Capital advances are a great alternative to keep your personal and business finances separate from each other. While they do tend to be more expensive and short term when compared to traditional loans, cash or capital advances work with a wider array of businesses and take much of the risk involved with funding SMBs off the business owner and on to the capital provider. Since the capital provider is assuming more risk by not requiring collateral, only collecting on the sales you make, and working with businesses that banks may not see as credit worthy or large enough, they do have to charge more for funding.
Why Short Term Financing Works Best for Some Businesses
While long payment terms may always seem like the way to go, that’s not always the case for every business, business model, or investment. If you’re investing in a vehicle, building, or something that’s going to last and continue to add value to your business for years to come, then a term loan or equipment financing that you can pay off for as long as your business is benefiting from this investment is the way to go. But, in the case of an eCommerce business, for example, that’s taking out financing to invest in inventory that they’ll flip in three weeks or marketing that will only have an immediate impact on sales, it doesn’t make sense to be paying off inventory over the course of two years when you flipped it in three weeks. So a cash advance with shorter payment terms may be a better fit as you’ll only be paying for funding for the time that it’s benefiting your business rather than adding an additional liability to your business that you’ll be paying long after you’ve sold that inventory or ran that marketing campaign.
So, sometimes it’s best to pay an investment off over a long period of time and sometimes it’s best to get in and get out.
How to Choose the Best Funding Option for Your Business
Choosing the right financing strategy comes down to your unique needs. As you compare though, here’s the most important factors to consider:
Amount: What is the maximum amount of funding you can receive? How much capital do you actually need?
Approval Rate: How likely are you to be approved for the funding? Are you a new business with limited history?
Approval method: Is approval based on your personal credit or the health of your business?
Speed: How quickly will you receive the funding? Can you wait weeks for approval?
Cost: What will the financing cost you? Will you pay interest over time or fees? How long do you have to repay the capital providers?
Risk: Does the financing require you to put up your own assets like your home or car? Is it worth tying your personal finances into your business?
ROI: Return on investment; How many additional sales/profits do you stand to make by putting outside funding to work?
Just remember that choosing the best strategy depends on your needs today and your plans for growth in the future!