Vendor Guaranties in Combination with Factoring

Occasionally, we are asked if factoring companies can issue letters of credit. The answer to that question is of course. Anybody can issue a letter of credit. The better question is who would accept a letter of credit written by a factor? Before answering that question, let’s discuss letters of credit in a little more detail.

The two most common types of letters of credit are “standby irrevocable letters of credit” and “documentary letters of credit.” The standby letter of credit is a payment guaranty most commonly found in domestic transactions in which the vendor expects its customer to pay for goods within the credit terms offered and is relying on the letter of credit only as a guaranty by the bank on which the letter is drawn. The documentary letter of credit is an instrument of payment generally used in overseas transactions in which a vendor is placing goods on a merchant vessel headed abroad and is expecting payment directly from the bank on which the letter of credit is drawn. Simply put, a documentary letter of credit is a primary repayment source for a seller of goods whereas a standby letter of credit is a secondary repayment source, kicking in only if the buyer defaults on its payment obligation to the seller.

Any company can write a letter of credit on behalf of another for the benefit of a beneficiary company. Letters of credit are generally written by banks, who issue them on behalf of their customers. Why is this? Simple. At least until recently, banks were viewed as stable and able to honor their letters of credit if and when called upon to do so.

If a client asks its factoring company to issue a letter of credit and the factoring company is willing to consider the request, it is likely the factoring company’s bank will issue the letter since the vendor may not be familiar with the factoring company’s credit. If the vendor is comfortable or familiar with the factoring company’s credit, it is likely to accept a guaranty as opposed to a letter of credit.

Many factoring companies are willing to write guaranties for the benefit of their clients to facilitate a sale and purchase of goods that will give way to a factoring transaction. Such guaranties are typically less costly that a letter of credit, because they are less time-consuming and offer more “outs” than a letter of credit. Vendor guaranties and letters of credit are popular when transactions are “back-to-back,” where the factoring company’s client is able to turn inventory into accounts receivable immediately. Let’s examine this more closely.

Say you sell a phone system to a Fortune 500 company and receive a purchase order for $500,000. Your customer will utilize their own IT staff to install the system, so your job is done when you (or your vendor) delivers the system to your customer.

Now, say your vendor has the phones you need to fill this large order. The phones will cost you $400,000, so if you complete this transaction, you make a tidy $100,000 gross profit. But there’s just one hitch: You don’t have the kind of track record with this vendor that would allow them to ship you (or your customer) an order of this size without you sending payment in advance.

Interstate Capital might suggest that we issue a guaranty of payment to your vendor. We would charge you a small fee to guaranty your vendor that we will pay them if you fail to when the bill comes due. Your vendor can check out Interstate Capital’s credit and decide for themselves if we’re good for the guaranty. If so, then off we go. If not, we will get our bank to put up the $400,000 standby irrevocable letter of credit, which will serve the same purpose.

In the meantime, ICC will factor your $500,000 invoice upon verification from your customer that they received the phone system, and we will reserve from the advance a sufficient amount to cover the guaranty or letter of credit. Typically, we will pay your vendor immediately to extinguish the liability. You may also find that you may be able to negotiate a discount with your vendor, perhaps a percentage point or two, if we can pay the vendor within 24 hours of delivery. The discount, if any, reduces your cost of financing the transaction with Interstate Capital. You then receive your gross profit when your customer pays the invoice, minus the financing cost.

Some vendor will not accept a letter of credit or a vendor guaranty. In such extreme situations, Interstate Capital can arrange for the prepayment of the goods, in which case we typically involve a strategic partner that specializes in purchase order financing and inventory financing to handle that end of the transaction. Once the goods are delivered to your customer, Interstate Capital will generally factor the invoice and reserve sufficient funds to pay off our strategic partner. You receive your gross profit after the strategic partner and Interstate Capital are paid, minus the financing cost.

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