When small businesses seek funding, they often encounter two seemingly similar options: Merchant Cash Advances (MCAs) and traditional loans. Although both involve obtaining capital upfront, they operate on fundamentally different principles, and the legal classification of an MCA versus a loan carries significant implications.
In disputes over whether an agreement constitutes a usurious loan or a legitimate commercial transaction (e.g., an MCA), courts consider three primary factors:
1. Reconciliation Provision
A legitimate MCA typically includes, or should include a reconciliation provision, allowing payment adjustments based on the merchant’s actual receivables. This provision ties the repayment amount to the fluctuating revenue of the merchant. If the business experiences a downturn, repayment obligations decrease proportionally. This flexibility is a hallmark of a true receivables purchase agreement, as it reflects the shared risk between the parties.
In contrast, loans often mandate fixed repayments, regardless of the borrower’s financial performance. Such rigidity suggests the presence of a debt instrument rather than a purchase agreement.
2. Finite Term
Traditional loans are structured with a defined repayment schedule and a finite term. The borrower is expected to repay the loan by a specific date, typically with interest.
MCAs, on the other hand, do not have a strict end date. Payments are supposed to be drawn as a percentage of receivables, continuing until the agreed-upon amount has been remitted. This open-ended structure aligns with the MCA’s nature as a contingent purchase of future receivables rather than a time-bound debt obligation.
3. Recourse in Bankruptcy
Another critical distinction lies in recourse. Under a legitimate MCA, if a merchant declares bankruptcy or ceases operations without generating receivables, the funder assumes the risk of non-collection. The absence of recourse against the merchant’s other assets underscores the transactional nature of the agreement as a purchase of future revenue.
Conversely, loans typically include recourse provisions, enabling the lender to pursue repayment through other assets or legal means, regardless of the borrower’s financial state.
Case Law Perspective
Recent rulings, such as LG Funding LLC v. United Senior Properties of Olathe, LLC, 181 A.D.3d 664 (2d Dept 2020), and Kapitus Servicing, Inc. v. Suburban Waste Services, 2024 NY Slip Op 33511(U), provide valuable insights into how courts assess these agreements. In both cases, courts evaluated the presence (or absence) of the three factors to determine whether the agreement was an MCA or an impermissibly usurious loan.
Why Does the Distinction Matter?
The classification affects both the rights of the funder and the obligations of the merchant. Misclassifying an MCA as a loan could expose the funder to usury laws, potentially invalidating the agreement or imposing severe penalties. On the other hand, treating a loan as an MCA could deny merchants the protections traditionally afforded to borrowers under the law.
Conclusion
Understanding the differences between MCAs and loans is essential for both businesses seeking funding and funders offering financial products. At its core, an MCA is a risk-sharing agreement that adapts to the merchant’s financial health, while a loan represents a fixed financial obligation backed by legal enforcement.
For businesses considering either option, consulting with legal and financial professionals can ensure compliance with applicable laws and help avoid costly disputes.
