Finimpact

Pros

Provides greater financial security to the buyer when dealing with transactions, especially in international trade situations.
Allow a small business owner to purchase a large amount of goods or services even if business credit hasn’t been fully established.
Whether you are the buyer or the seller, a letter of credit can be customized to fit the needs of both parties.
Allows a small business owner to make a payment without having to make a personal guarantee or enter into a verbal agreement.

Cons

Obtaining the letters can be time consuming and require an enormous amount of documentation.
There are risks on both sides, including an additional fraud risk.
There are fees involved, ranging from a percentage paid to the bank, to courier and wire transfer fees.

Risks In Letters of Credit Transactions

There are risks to be aware of before entering into a letter of credit transaction:

  • One risk involves fraud, and it could occur on both sides of the transaction.
  • It is possible for a buyer to submit fake documentation to an issuing bank.
  • It’s also possible for a counterfeit letter of credit to be issued.

As such, you might want to look into the distinction between letter of credit vs line of credit.
To reduce the risk, be sure to read through all documentation thoroughly, review any typos or language substitutions, and reach out to your bank with any questions.

There may also be risk associated with the issuing bank. If a small business owner is unfamiliar with the issuing bank in the buyer’s home country, then the owner can request a confirmed letter of credit. This is essentially a second bank that agrees to pay the amount if the issuing bank can not cover the amount for whatever reason, and can reduce this risk.

How to Get a Letter of Credit as a Small Business Owner

As a small business owner, the letter of credit process will begin with a bank or third-party financial institution. If you are purchasing a letter of credit, you will need to provide specific documentation to the issuing bank. The bank will review your creditworthiness and business history before offering approval and may look to see if you have any existing loans such as a revolving line of credit.

Sample Letter of Credit

The sample below is an example of an irrevocable letter of credit found with the Texas Department of Licensing and Regulation.

<BANK LETTERHEAD>

Date: <DATE>

Issued By: <NAME AND COMPLETE ADDRESS OF BANK>

Beneficiary: Texas Department of Licensing and Regulation

P.O. Box 12157

Austin, TX 78711

Applicant: <NAME AND COMPLETE ADDRESS OF SERVICE CONTACT PROVIDER APPLICANT>

Irrevocable Letter of Credit Number: <NUMBER>

Amount: <$ AMOUNT>

Effective Date: < DATE>

Expiration Date: <DATE>, or any automatically extended period thereafter.

We hereby issue our irrevocable letter of credit number <NUMBER> in your favor for the account of <NAME OF SERVICE CONTACT PROVIDER APPLICANT> for a sum not to exceed <$ AMOUNT>.

This irrevocable letter of credit is given as security for the benefit of a party who may suffer damages resulting from the failure of <NAME OF SERVICE CONTACT PROVIDER APPLICANT> to meet or perform its obligations under Texas Occupations Code, Chapter 1304, or the rules or regulations pertaining thereto.

We will honor your draft at sight drawn on <NAME OF BANK> in an amount not to exceed <$ AMOUNT> in the aggregate. Drafts hereunder must be marked “Drawn Under Irrevocable Letter of Credit No. <NUMBER>”, and must be accompanied by a written statement from you stating that <NAME OF SERVICE CONTACT PROVIDER APPLICANT> failed to meet or perform its obligations under Texas Occupations Code, Chapter 1304, or the rules or regulations pertaining thereto. Such statement is to be signed by an authorized official of the Beneficiary.

It is a condition of this irrevocable letter of credit that it shall be automatically extended without amendment for an additional period of one (1) year from the original expiration date and each future expiration date, unless at least sixty (60) days prior to the then current expiration date, we send notice in writing to you that we elect not to automatically extend this irrevocable letter of credit for an additional one (1) year period. Notification will be sent to the Beneficiary at the address above and to the attention of “Compliance Division--Service Contract Providers Program.”

We agree that we shall have no duty or right to inquire as to the basis upon which Beneficiary has determined to present to us any draft under this irrevocable letter of credit. Any draft(s) drawn under and in compliance with the terms and conditions of this irrevocable letter of credit will be duly honored. Multiple and partial drafts are permitted, not to exceed the aggregate amount of this irrevocable letter of credit.

Drafts on the irrevocable letter of credit shall be submitted to: <NAME, ADDRESS AND PHONE NUMBER OF CONTACT PERSON AT THE BANK.>

______________________________

Signature of Authorized Bank Official

______________________________
Title of Authorized Bank Official


______________________________

Printed Name of Authorized Bank Official

______________________________
Date

TDLR Form SCP 005 (6/2010)

How a Letter of Credit Differs from a Business Line of Credit


Here is how a letter of credit is different from a business line of credit:

  • Depending on your role in a transaction, a letter of credit means you guarantee to make the payment to a vendor or you are guaranteed to receive a payment from a buyer.
  • A business line of credit allows you, the small business owner, to borrow money to use for business expenses based on whatever amount you have been approved for.
  • It may not be necessary for a vendor to request a letter of credit from you if you are able to provide funding for the transaction up front.

If you are considering a business line of credit, Fundbox offers flexible solutions for small businesses with 12- or 24-week repayment terms. Your business may qualify for up to $150,000 in revolving credit, which means you can make larger purchases for inventory, staffing, real estate, or whatever else your business needs.

About the Authors

Sara Coleman

Written by: Sara Coleman

Freelance Financial Writer

Sara Coleman is a freelance writer with several years of experience covering personal finance topics such as insurance, loans, credit cards, budgeting and more.

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Chip Stapleton

Reviewed by: Chip Stapleton

Finance Manager

Chip Stapleton is a Series 7 and Series 66 license holder, CFA Level 1 exam holder, and currently holds a Life, Accident, and Health License in Indiana. He has 8 years of experience in finance, from financial planning and wealth management to corporate finance and FP&A.

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Somer G. Anderson, Ph.D.

Fact checked by: Somer G. Anderson Ph.D., CPA

Accounting and Finance Professor

Somer G. Anderson has been working in the Accounting and Finance industries for over 20 years as a financial statement auditor, a finance manager in a large healthcare organization, and a Finance and Accounting professor at Maryville University.

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