The Due Diligence Process in Factoring

Due diligence is the process of reviewing a client’s information to determine if they are a good candidate for factoring financing. One of the advantages of factoring is that the due diligence process is simpler and faster than the process for other solutions. This article covers:

  1. Basic due diligence
  2. How are accounts receivable secured?
  3. Contract provisions that preclude factoring
  4. Issues with back taxes
  5. How long does it take?

If you need more information, read “What is factoring?” and “How does invoice factoring work?

1. Basic due diligence

Factoring companies start the due diligence process by asking you to provide some basic information about your company. The information they ask for varies based on your industry and transaction size but usually includes:

  • Factoring application
  • Incorporation or similar documents
  • Identification of company owners/offices
  • Invoice aging report
  • Customer list
  • Customer contracts
  • Invoice sample
  • Tax information
  • Additional info based on your industry

a) Is the applicant a business?

Factoring is offered only to businesses and cannot be used to finance individual (retail) clients. The due diligence team will examine the appropriate provincial/federal records to determine that the applicant is an adequately organized business. Examples of acceptable entities include numbered and named corporations.

b) Are the invoices due from creditworthy customers?

The next step is to review the credit quality of the accounts receivable. This is done by examining the invoice aging report and running credit checks on the clients you want to factor. Credit checks are done using a credit bureau like Dun and Bradstreet.

c) Are there any issues?

Lastly, the factoring company must determine if anything could prevent it from financing the client. Potential issues include:

  • Invoices are secured by another party
  • Bankruptcy
  • Tax problems
  • Legal problems
  • Contractual provisions precluding factoring

A problem does not necessarily indicate that the account cannot be financed. It does suggest that additional diligence is needed to determine if there is a solution.

2. How are accounts receivable secured by the factor?

The main collateral for the factoring transaction is your accounts receivable. Factors run a PPSA search on your A/R to ensure your invoices are clear of liens. If your company is based in Quebec, the factoring company performs a hypothèque search instead of a PPSA search.

The searches determine if accounts receivable have been pledged as collateral to another entity or if they are encumbered by adverse actions such as lawsuits or unpaid taxes. Ultimately, the factoring company registers/perfects the General Security Agreement (GSA) if the searches come clear and if you choose to use their services.

3. Contract provisions that may preclude factoring

Most contracts have straightforward payment clauses that can be financed. However, some specific contractual terms may prevent the factoring company from financing invoices for that particular customer.

a) Guaranteed sales

A guaranteed sale is a type of transaction in which you guarantee your client that they will sell all your products. It usually allows your client to return any unsold product at any time and claim a chargeback. Financing an invoice tied to a guaranteed sale is difficult because the final value of the invoice is never known. However, you can overcome some of these issues if your client agrees not to return more than a specified percentage of the product.

b) Pay when paid

A pay-when-paid sales contract stipulates that your client will pay you if and when their end-client pays them. However, you don’t get paid if their end-client does not pay. Factoring companies perceive this arrangement as a credit risk because they never know if they will get paid. Contracts with this provision must be amended in order to qualify for factoring

c) Progress billing

Progress billing is a type of invoicing where the company gets paid based on a percentage of completed work. It’s common in some industries, such as software and construction. Most factoring companies won’t finance invoices subject to progress billing because they are difficult to verify and easy to dispute. However, some companies offer specialized construction factoring to subcontractors.

4. What happens if there are any back taxes?

Usually, once taxes remain unpaid for a certain amount of time, the CRA files a lien/security interest that encumbers your invoices. The only way to remove the encumbrance is to pay the CRA. This payment can be made in special circumstances using funds from your factored invoices.

5. How long does due diligence take?

The due diligence process can take anywhere from two days to two weeks. The actual work done by the factor takes about a day. You can speed up the process by providing all the required information as quickly as possible. Lastly, invoices have to be verified before they can be funded. This process can be done quickly as long as the factor gets the necessary confirmations in a timely manner.

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