Types of Factoring Financing – Recourse and Non-Recourse

In general, Canadian factoring companies offer two different types of factoring: recourse and non-recourse factoring. This article helps you understand how each of these programs works. We cover:

  1. What is factoring?
  2. Recourse factoring
  3. Non-recourse factoring
  4. How are problem payments handled?
  5. Which one is better?

1. What is factoring?

Factoring is a solution that allows companies to finance slow-paying invoices. It provides immediate funds, which improves cash flow and enables the company to meet its obligations. For a more detailed explanation of invoice factoring, read “What is Factoring?” and “How Does Factoring Work?

Every factoring agreement defines the finance company’s level of recourse if a factored invoice is not paid and becomes past due. Recourse can also cover other default events, but this article focuses only on what happens when invoices aren’t paid. The industry offers two types of factoring: “recourse factoring” and “non-recourse factoring.” We discuss how these factoring modalities work in the following sections.

2. Recourse factoring

Recourse factoring is the most common type of factoring used in Canada. In a recourse factoring transaction, the client retains the payment responsibility if an invoice is not paid for whatever reason. Therefore, the client must repay the factoring company if an invoice is not paid. Although the payment responsibility remains with the client, it is in the best interest of the factor to avoid situations where recourse is invoked, as it affects the client’s cash flow. Consequently, factors are careful in the due diligence to limit the risk of buying problem invoices.

3. Non-recourse factoring

Non-recourse transactions are slightly different. In a non-recourse factoring transaction, the client does not need to repay the factoring company if the invoice is not paid due to a customer’s insolvency. Invoices that are not paid for other reasons, such as disputes, still need to be paid back to the factoring company. This last point is very important and is often a source of confusion.

Different companies offer non-recourse programs in different ways. If you are considering this type of financing, review the agreement carefully and enlist the help of an attorney to ensure you understand the protections you are getting.

4. How are problem payments handled?

The due diligence and verification process is set up to minimize the chances of financing an invoice that does not pay as agreed. However, non-payment happens from time to time during the normal course of business.

In the case of a recourse agreement, all invoices that are not paid can be returned to the client. When this happens, the client has to return the advance and may have to pay additional fees. In a non-recourse agreement, the way these invoices are handled depends on the reason for non-payment and your contract details. Here are three common situations and an explanation of how a non-recourse factor may manage them.

a) Non-payment due to bankruptcy

A non-recourse agreement should protect you if your customer does not pay an invoice because they declare bankruptcy or insolvency. Some agreements stipulate that they will protect you only if the insolvency is declared during the 90-day factoring period. Lastly, keep in mind that factoring is not intended as an insurance product or a place to handle problem invoices. If you need credit insurance, consider working with companies like Atradius or Coface.

b) Non-payment due to credit issues

Some customers don’t pay an invoice because they have cash flow problems. They remain in business but don’t pay. In other cases, they may simply close the business without declaring insolvency. Every factoring company handles this situation differently. Some factoring companies may return the invoice and ask that the advance be repaid. Others may absorb the loss.

c) Non-payment due to a dispute

The most common reason for non-payment of a factored invoice is a customer dispute. Factoring companies want to avoid creating any potential problems with your customers. When there is a dispute, the factor usually refers the customer to the client so they can manage the situation accordingly. The factor will not try to mediate the situation. Consequently, they will also return the invoice and ask that the advance be returned.

5. Which type of factoring is better?

Many business owners may be inclined to think that non-recourse factoring is better than recourse factoring. After all, the line may protect against certain types of invoice non-payment. This argument is valid, though companies should keep in mind that non-recourse plans may also be more stringent in their financing criteria.

Factoring companies are very good at determining bankruptcy risk well before it happens. In most cases, bankruptcy risk becomes apparent in credit reports months before the actual bankruptcy. It’s unlikely that a factoring company would finance an invoice that has this risk, regardless of the type of recourse. Consequently, the protections offered by a non-recourse plan are probably limited to avoiding surprise bankruptcies. Ultimately, deciding which factoring plan is better for your company depends on your needs and risk tolerance.

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