The Due Diligence Process in Factoring

Before providing financing to a client, a factoring company must review some of the client’s information to determine if they are a good candidate for receivables financing/invoice discounting. This process is commonly known as due diligence. Basically, for a company to be a good candidate for factoring they must:

  • Invoice commercial clients with good credit
  • Have gross margins over 10%
  • Have no encumbrances against their receivables
  • Have no serious tax liabilities or legal problems
  • Not be at risk of immediate insolvency

Basic due diligence

After reviewing the application, one of the first things that the underwriting group does is review the commercial credit of your customers. We can only finance invoices that reliably pay in net 30 to net 60 days terms. This review is done first because it’s the most important requirement for a transaction. Without solid invoices, the transaction will most likely fail.

The next step is to check that your business is properly organized and established as a numbered corporation, named corporation, or similar business entity. Once that review is complete, the team verifies that taxes are up to date and checks for potential actions against the business.

Securing the accounts receivable

Since the main collateral for the transaction are your accounts receivable, the factoring company performs a PPSA (Personal Property and Security Act) database search. This process determines if accounts receivable been pledged as collateral to another entity or if they are encumbered by adverse actions such as lawsuits or unpaid taxes. If the search comes clear, the factor registers/perfects their General Security Agreement (GSA).

This step can sometimes confuse clients. If they are selling their receivables to a factor, why should the factor file a lien? A lien is filed because an invoice is an intangible financial right, rather than a durable good. Filing a lien is the only method to see who has a claim on an invoice and to secure a claim. Note: the province of Quebec has a slightly different process and uses a hypothèque instead.

Contract provisions that may preclude factoring

The due diligence team also reviews your contracts to make sure that there are no provisions that could interfere with the financing process. The two most common provisions that cause problems are guaranteed sales and pay-when-paid clauses.

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 the option to return any unsold product, at any time, and claim a charge-back. 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 to not to return more than a specified percentage of product.

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

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. In special circumstances, this payment can be made by using funds from your factored invoices.

How long does due diligence take?

Although this process may look complex, it con be done fairly quickly. At Commercial Capital LLC (Canada), we do our best to expedite the due diligence process to ensure a smooth and quick funding. Often, the time it takes to finish the due diligence depends on the complexity of the opportunity. In general, we can complete the process a couple of days after receiving all the required information, though this timeline can vary by province.

Get a quote

We can provide you with a competitively priced factoring quote. For information, Please call (877) 300 3258.