It’s a common scenario. You’ve won a contract to develop a customized piece of equipment, and your international customer has given you a $100,000 advance so you can buy materials, hire extra staff and get started on the project. All she wants in return is a standby letter of credit in the same amount, as assurance she can recover her money if you don’t fulfill your obligations.
It all looks great on paper, but how much money do you really have to cover your upfront costs? The surprising answer is zero, or close to it.
Financial institution wants collateral to post standby letter of credit
The challenge arises when you go to your financial institution to get the standby letter of credit. Just like your customer, the financial institution doesn’t want to take a risk (especially for a transaction occurring outside of Canada), so they will ask you to post collateral in the same amount to secure the letter of credit.
In other words, the $100,000 advance you got from your customer is now tied up as collateral for the standby letter of credit, leaving you with little to no extra cash to actually start the project.
Don’t worry. There’s a way to get around this—to have your cake and eat it too— which I’ll explain in a moment. First, it might help to have a better understanding of how letters of credit work.
What is a standby letter of credit (SBLC)?
Letters of credit are commonly used in international trade, so it’s a good idea to start building them into your exporting plan early on. As the name implies, a letter of credit is a “letter” issued from a financial institution that guarantees payment. There are several different kinds. In international trade, standby letters of credit (LCs) are usually used, as these identify requirements that must be fulfilled before the money in trust can be claimed by either a seller or a buyer. While the example above involves protection for your international customer in case you fail to deliver the product or service promised (called a performance SBLC), it can also be used to protect you, guaranteeing payment if your buyer defaults (called a financial SBLC).
Letters of credit are legal documents and can be quite complex, so get expert counsel and be sure you understand every requirement. As a seller, the SBLC will specify at what point the funds can be released to you from the bank, what obligations you need to fulfill before that happens, and what proof you need to provide that each obligation has been satisfied. For example, you may need to complete a stage of the project in 30 days, provide proof of shipment, or produce a certificate of inspection of goods by a third party. Failure to fulfil any particular step could result in a loss of funds, as the bank must then pay out the money in trust to your buyer’s bank.
How do you get a SBLC?
To get a SBLC issued, you apply for it at a financial institution that offers this service, typically for a fee that is a percentage of the SBLC’s value. Once you’re approved, the issuing bank holds the specified amount of funds in trust.
As mentioned, however, your financial institution will want to protect itself and will likely ask for collateral or freeze part of your finances to issue the SBLC, especially if you’re a small or medium-sized business.
Contact your local EDC rep before you head to the bank
As promised earlier, here’s how you can get your SBLC and have your working capital too. At EDC, we have something called a Performance Security Guarantee, or PSG. A PSG provides a guarantee to your bank that covers 100% of the amount of the SBLC, essentially taking away the risk for them and transferring it to EDC. This means no collateral or frozen funds are required by the bank, and you can use your advance payment or access your working capital to complete the project.
Even better, with pre-approved PSGs built into your SBLC strategy, you can go after new business and bid projects and grow your company faster, knowing you’ll have more capacity to issue SLOCs. You can also give your suppliers better payment terms and build loyalty.