Building a startup often involves doing business with people you have never met. You might be sourcing hardware components from a factory in Shenzhen or buying raw materials from a supplier in Brazil. In these scenarios, trust is the hardest currency to acquire.
The supplier does not know if your startup will be around in six months to pay the invoice. You do not know if the supplier will actually ship the goods if you pay upfront. This stalemate can kill a deal before it begins.
A Letter of Credit (LC) acts as the bridge over this gap. It is a formal document issued by a bank that guarantees a buyer’s payment to a seller will be received on time and for the correct amount. If the buyer is unable to make payment on the purchase, the bank is required to cover the full or remaining amount of the purchase.
How the Mechanism Works
#When you obtain a letter of credit, you are essentially substituting your company’s creditworthiness with that of a bank. This provides the seller with a high degree of assurance.
The process generally follows a specific flow:
- You apply for an LC at your bank, usually providing collateral or freezing funds.
- Your bank sends the document to the seller’s bank.
- The seller receives the guarantee and ships the goods.
- The seller presents specific documents proving shipment, such as a bill of lading, to the bank.
- The bank verifies the documents and releases the payment to the seller.
Substitute creditworthiness with the bank.
This mechanism ensures that you do not pay until shipment is verified, and the seller does not ship until payment is guaranteed.
Letter of Credit vs. Bank Guarantee
#These terms are often used interchangeably by new founders, but they serve different purposes. It is important to know the distinction when negotiating contracts.
A Letter of Credit is a payment instrument. It is intended to be used as the primary method of settling the transaction. The expectation is that the bank will facilitate the transfer of funds once the conditions are met.
A Bank Guarantee is a risk mitigation tool. It works more like insurance. It is only called upon if the buyer fails to fulfill their contractual obligations. In a normal transaction using a bank guarantee, the buyer pays the seller directly, and the bank never gets involved unless there is a default.
The Cost of Security
#While an LC provides safety, it introduces friction that startups must calculate carefully. Banks charge fees for issuing these letters, often a percentage of the total deal value. Furthermore, the bank will likely require you to fully collateralize the credit.
If you need a $50,000 letter of credit, the bank may freeze $50,000 of your cash until the deal is done. For a bootstrapped startup, tying up that much liquidity can be dangerous. It forces you to ask difficult questions about your cash flow.
Is the risk of the supplier defaulting higher than the risk of losing access to your operating capital?
Founders must weigh the security of the transaction against the operational flexibility of having cash on hand.