Letter of credit

A letter of credit shifts credit risk from the party who would otherwise be trusted to pay onto a bank, which is generally seen as more reliable. Instead of a buyer or seller holding cash on account to backstop an obligation, the bank stands behind it, and the beneficiary draws on the letter directly if the triggering condition occurs.

Where it shows up in an SME deal

• Backing a purchase-price holdback instead of tying up cash in a lawyer’s trust account
• Satisfying a landlord’s security requirement on an assigned or new commercial lease
• Supporting a deposit on a letter of intent or definitive agreement without moving funds until closing
• Standing behind a guarantee to a supplier or franchisor as a condition of a transfer

What it costs and constrains

A letter of credit is not free — the issuing bank charges for it, and it typically reduces the amount a buyer can borrow elsewhere, because the bank treats the exposure as if it had already lent the money. It also usually requires the applicant to have, or pledge, funds or credit availability to back it, so it is a substitute for tying up cash directly, not a way to avoid tying up capacity altogether.

Standby versus documentary

The type most relevant to an SME acquisition is a standby letter of credit, which the beneficiary draws on only if the applicant fails to perform — the backstop that is meant never to actually be used. That differs from a documentary letter of credit used in international trade, which is drawn on as the normal way of paying for goods and is not typically part of a domestic business sale.