What is a Standby Letter of Credit and How Are They Used?
July 29, 2014
One of the least understood but most powerful small business financing tools is the standby letter of credit. While itâ€™s used fairly extensively by larger companies, many small business owners frequently wonder what a standby letter of credit is, and arenâ€™t aware of how it can help them and their enterprise succeed.
What is a Standby Letter of Credit?
A standby letter of credit, or SLOC, is at itâ€™s core a loan of last resort and a type of warranty for financial contracts. It is issued by your business bank at the beginning of a contract, and acts as a guarantee that if you fail to fulfill your obligations by the end of the contract term, the bank will make payment on your behalf.
Unlike most types of financing, the standby letter of credit is never meant to be used, instead functioning as a backstop to prevent contracts from going unfulfilled in the event that your company closes down, declares bankruptcy, or is otherwise unable to pay for goods or services provided.
Performance SLOCâ€™s and Financial SLOCâ€™s
Standby letters of credit come in two primary forms: the performance standby letter of credit and the financial standby letter of credit. The performance standby letter of credit works to ensure that work you have agreed to perform is performed in a timely and satisfactory manner.
For example, if you own an architectural firm and are contracted to build a museum, you may be asked to provide a performance SLOC that guarantees that you will finish the plans by the end of your contract term, and that the structure you design is sound and meets all requirements. If, for some reason, you are unable to finish, or your design is deemed unsafe or unbuildable, the SLOC will take effect and pay the museum a preset amount.
A financial letter of credit generally works on the other party in the exchangeâ€”in our example, the museum can be asked to provide a financial SLOC to your firm for the total amount of the project. If they fail to pay you after work is finished, the bank will issue payment to your business on behalf of your client.
These types of SLOCs are often required when performing international trade or other large purchase contracts where other forms of payment protections (such as litigation in the event of non-payment) can be difficult to obtain.
How to Obtain a Standby Letter of Credit
Obtaining a standby letter of credit is similar to obtaining a commercial loan, though with a few key differences. As with any business loan, you will need to provide proof of your creditworthiness to the bank.
Unlike a loan, the process for approval for a SLOC is much quicker, with letters often being issued within a week of all paperwork being submitted. Also unlike traditional loans, the bank will require a fee of between one and ten percent of the SLOC amount before issuing the letter. This fee is usually charged per year that the letter of credit is in effect. If the terms of the contract are fulfilled early, you can cancel the SLOC and not incur additional charges.
For small business owners, the standby letter of credit can be a powerful tool for establishing trust with suppliers and vendors. Obtaining an SLOC is proof that you and your company have good credit, and can put many suppliers at ease about providing you favorable financing terms. Furnishing a financial SLOC can often allow you to negotiate payment and financing terms with suppliers from a position of strength in order to get the best interest rates and payment schedule, while maintaining a good relationship with your suppliers.
If you provide services, on the other hand, offering to furnish performance standby letters of credit can be extremely useful to helping your business secure large contracts. Putting your clients at ease by being willing to guarantee your work financially can overcome many of the objections business owners face in the selling process.