Why Do Merchant Cash Advances Cost So Much? Here are four legitimate factors as to why this emerging financing tool is so pricey.

When I first came to observe the alternative financing business in 2008, the press tended to be extremely negative about merchant cash advances (MCAs). From blogs in the New York Times to articles in Bloomberg Businessweek, funders were lambasted for charging inordinately high interest rates. While I think the perception is changing, it's worth explaining the factors that contribute to the high rates charged.

Let's break down what an alternative finance provider needs to cover within that 30 to 40 percent factor rate (technically, this is a discount rate, which is present value cash versus future payout, rather than an interest rate), so as to come out ahead. Counterintuitive though it may sound, it's not a given that funders are making money hand-over-fist, and they could easily lose their shirt. They are simply covering their level of risk, and even advancing monies at a 50 percent rate, as this Forbes article explains, some funders actually manage to lose money.

Related: Case Study: How a Merchant Cash Advance Worked in a Pinch

As I see it, there's a handful of components that add up to the 30 to 40 percent factor rates on MCAs. For the following illustration, let's assume a 40 percent rate.

1. Commission: cost of acquisition

The cost of acquisition of the customer alone is about a quarter of that 40 percent. This is the commission paid to the independent service organization that brings in the merchant to the funder. That's 10 points of the 40, or 25 percent, of the funder's total factoring rate. If the funder is selling directly to merchants, given today's sky-high marketing costs, acquisition can take a bigger chunk out of the 40 percent -- more like 12 to 15 points (the industry average cost of acquisition for a $30,000 advance is $2,600).

2. Underwriting

A large portion of underwriting is in operations -- overhead, personnel, etc. For a funder with advanced underwriting technology, the slice of the pie may be as low as 3 to 6 percent, but for a lower tech, more personnel-intensive firm, it's more like 5 to 10 percent. At the best of times, this amounts to 7 or 8 percent of the funder's gross profit margin.

3. Cost of capital

For smaller independent funders, what it costs to amass enough capital to provide MCAs can be huge -- up to half the factor rate, or 20 percent, of the whole advance. As funders are able to gain from experience, historical data, infrastructure and technology, this number can go as low as 8 to 15 percent.

Then there's the wild card that the deal itself can under perform when the merchant takes longer to pay back than the originally agreed-upon term. Let's say the payback on a six-month advance goes out to nine or 10 months -- what happens? First, the merchant, originally priced for a six-month repayment cycle based on the underwriting assumptions and risk factors, drastically expands the funder's risk level. He also depletes the MCA company's available facility. The monies that would have been paid back and cycled into another advance are no longer available to the funder, who is nevertheless paying for the cost of that capital even as it's underperforming. And the potential for default increases the further the advance goes out. All this risk has to be priced into the factor rate.

Related: Getting a Merchant Cash Advance Is Easy But Repayment Can Be Onerous

Depending on how the alternative funder's financing is organized, the company might have a capital call from the senior lender -- and they then have to put up capital to take that amount off the line. Depending on the covenants for the funder's facility, the MCA company may then have to set up a reserve, which must be in cash. And if the defaults climb, they could eventually render the company insolvent.

4. Bad debt

The biggest chunk of the 40 percent factor rate could potentially be bad debt: MCAs that default. The write-off rate can cost the funder a whopping 8 to 20 percent off the entire portfolio, depending on how well the company has managed risk overall. There are many ways that default can manifest itself. For example, there's outright fraud. It could also come from an entire industry sector performing weakly, funding programs that were not well conceived or risk not properly priced.

The bottom line is that alternative funders are lucky to come out ahead after all of this. To achieve their return and minimize their default risk, they have to get the entire mix right: pricing risk, factor rates, turnaround times, period of the advance, programs, systems and collections. Which is like dancing on the point of needle.

Related: Choosing a Lender? Watch Out for These Costly Traps.