If you want to run your own business, you have basically 2 options: start your own or take over an existing company. Operating an existing small business, either through purchase, franchising, or inheritance, can take the pain out of many of the challenges new businesses face, like building a customer base or having data on seasonal sales patterns.
Of course, the business you buy may not be running at an optimal level. Before buying a business, you should understand how to scrutinize existing businesses and how to strategize and leverage the strong elements of a business toward more growth.
In researching how to buy businesses, you’ve probably come across the concept of a “turnkey business.” This refers to a type of business for sale that’s ready for a new owner right away. Read more to learn what’s involved with turnkey businesses, why you might want to buy one, and what you should look for when comparing your options.
To be considered a turnkey business, a company must be fully functional and operating at full capacity. This doesn’t necessarily mean the business is profitable, but it can’t be majorly hindered by problems like broken equipment or missing infrastructure.
Of course, not every turnkey business exists in a physical space like an office or strip mall, but all are ready to continue operations upon purchase. Examples could include a restaurant under new management or a laundromat looking for a new owner. In some cases, the new owner might not change anything—one day, the business was making money for its previous owner, and today it’s turning a profit for you.
In many cases, though, there’s a reason that a business is put up for sale. Sales could be flagging, the seller might not want to run a business anymore, or the seller might need cash. Additionally, you might sense that there are ways you could expand the business better than the previous owner.
Alongside this, another advantage of a turnkey business is that the company’s proof of concept usually works. There could be issues with profitability, management, and sales, but you typically aren’t reinventing the wheel when you buy a turnkey business—most turnkey businesses are either running well in the moment or in the very recent past, or else you might have a plan about how you can make the company profitable.
A disadvantage to turnkey businesses, especially franchise situations, is that the business might already be locked into contracts and obligations that you aren’t interested in maintaining. However, if you buy the business, you’ll then be a party to these pre-existing agreements.
Purchasing a franchise location is another common way to buy turnkey businesses, although it’s also one that comes with some major restrictions imposed by a corporate entity—which is both an advantage and a disadvantage. Franchises are known among the small business crowd for their lower failure rate compared to small businesses overall.
You might also consider multi-level marketing (MLM) businesses, where you sign some agreements and pay for inventory—a type of turnkey business—but these types of companies remain controversial and have a shaky rate of success.
Like with all other forms of shopping, a very popular way to find turnkey businesses is to browse online. A quick Google search will pull up several platforms with businesses for sale in your city, state, or region. In this situation, all the due diligence is on you to make sure the purchase is worth the investment.
“Look at the existing infrastructure and make sure you understand everything that comes along with the purchase,” the Small Business Administration recommends. “Don’t be afraid to ask questions about contracts, leases, existing cash flow, and inventory. The more you know, the better equipped you’ll be to make a sound decision.”
When looking for a turnkey business, you should consider 3 key aspects: customer fulfillment, marketing, and sales ability. You should measure how well the company serves its customers so they’ll return with future business. Pay attention to how the company markets itself and how well its brand penetrates the marketplace. Finally, you should look at the sales ability of the company—how does it leverage its marketing toward actual sales?
Once you find a seller, you should hire a financial expert to do an appraisal so you get an accurate price for the company and its various assets, talent, customer networks, and other valuable elements. To make the sale, you will probably have to explore your funding options unless you have all the cash on hand. Online lending platforms like Lendio make finding loan options easy, so you can take your business to the next level.
Choosing your business structure is one of the most important decisions you’ll make for your business. And—for better or for worse—it’s also one of the first decisions you’ll make. While it’s possible to adjust your business entity down the road, it’s easiest for you to start things off on the right foot.
The entity type you choose doesn’t just add fun professional-sounding designations to your name, like LLC or Inc. Your business structure also impacts how you manage your business, pay taxes, keep records, find financing, and mitigate risk.
To put it in perspective, choosing a specific entity type could lower your taxes and reduce complexities. However, it could also open up your personal life to harmful debts and expensive lawsuits. These are the kinds of opportunities and consequences you’ll need to consider.
While we can’t make the hard decisions for you, we can give you all the information you need to make confident, educated choices regarding your business type.
However, due to the legal and tax ramifications surrounding choosing a business type, it’s always a good idea to involve an attorney and tax professional. These professionals will be familiar with your state’s specific legal nuances and help you make the best decision for your particular business.
This guide will walk you through the 6 types of business entities you should consider. We’ll talk pros, cons, and who benefits most from each entity type. First, let’s get on the same page with a brief overview of business entities and why they matter—then, we’ll get into the details behind each type.
There’s no “best” type of business entity. The right entity for your business will depend on your structure, size, scale, industry, comfort with risk, and personal preference.
Before we dive into deeper terms, let’s define a business entity.
A business entity is an organization formed by 1 or more persons to facilitate business activities or to engage in trade (buying and selling). Businesses are created at the state level, meaning that you’ll need to register your organization with your state and comply with the laws, regulations, and fees required.
Pass-through entities (or flow-through entities) are business types that treat business income as the owners’ personal income. Common pass-through entities include:
Most small businesses (around 95%) opt for the pass-through entity structure to reduce tax obligations and for their easy setup. However, owners will have to pay taxes on income they may never receive as individuals—for example, if the business’s profits remain in the business.
Your entity type impacts everything from your business’s name to your tax obligations to your legal liabilities. Here’s what to consider when making your choice:
There are a variety of business entity types to consider: everything from sole proprietorships to corporations to nonprofits and beyond. It’s a lot to weigh, so we’re going to limit our coverage to the 6 most common (and likely most suitable for small businesses) entity types:
Below, we’ll break down the nuances of each entity type—the good, the bad, and the ugly.
A sole proprietorship is the simplest and most popular business structure in the United States, with over 23 million currently in existence. It’s an unincorporated business owned by a single person (or a married couple). Because a single person owns it, you get complete control over every aspect of your business—you call all the shots.
However, with this complete control also comes total liability. That means you and your personal assets are at risk for any debt or lawsuit issues. It’s scary, but some industries and natures of work are less risky than others.
New business owners who work in an industry with little-to-no liability and who don’t own significant assets that could be claimed in a legal dispute should consider a sole proprietorship. If you’re looking to launch a solo-operated business, consider starting as a sole proprietor and changing your business entity down the road.
Examples of sole proprietors often include:
If you never register your business, then you’re considered a sole proprietorship. As a sole proprietorship, there’s no distinction between you (the owner) and the business—they are one and the same for all intents and purposes. You’ll report your business’s profit and losses on your personal tax return.
If you choose to remain a sole proprietor, you’ll never need to register your company unless you want to set up a retirement account or begin hiring employees. In that case, you’ll need to apply to the IRS for an Employee Identification Number (EIN)—the Small Business Administration (SBA) says “you need [your EIN] to pay federal taxes, hire employees, open a bank account, and apply for business licenses and permits.”
There are 2 main kinds of partnerships: general partnerships (GPs) and limited partnerships (LPs). A general partnership is essentially the same thing as a sole proprietorship, just with 2 or more owners. Each owner shares the business’s profits, debts, and liabilities.
As with a sole proprietorship, it’s not necessary to register a partnership—it’s the default entity type when multiple owners begin doing business together. This simplicity is often a big reason general partnerships form.
Business owners who trust each other and feel confident sharing profits, losses, control, and liabilities should consider a general partnership. If your business is young and you don’t have major personal assets to lose, a general partnership may make sense at the beginning. As you grow, you may want to consider changing your entity type in order to scale your business, reduce personal liability, and access equity financing.
All partners share a general partnership’s profit or loss and report them on their personal tax returns. They also share responsibility for debts and legal liabilities—this is known as joint liability. Joint liability means that each owner is responsible for the actions the partnership takes. For example, if your partner engages in illegal, criminal, or fraudulent activity within the business, you may be held responsible—even if you’re innocent and ignorant of the behavior.
Because each partner is considered equal in the relationship, they each have the authority to enter into contracts or deals on the business’s behalf. For this reason (and many others you may be imagining now), it’s crucial to choose a reliable partner you can trust.
A limited partnership is a more secure version of a partnership, and it requires you to register your business entity with the state. Limited partnerships have 2 types of partners: general partners and limited partners.
Because limited partnerships are a more formal business entity, you’ll need to register your business, hold annual meetings, and create a partnership agreement.
If you’re looking for equity financing and don’t want to form a corporation, a limited partnership can help you maintain more control of your business while also enabling you to pool resources and raise capital. This makes limited partnerships a great option for family-owned businesses or real estate companies that need combined resources but whose investors may not want to share liability with the company.
A limited partnership is still a pass-through entity, so it doesn’t pay taxes on business income. Instead, each partner claims a share of the business’s profit and losses that they report on their personal tax return.
The LLC business type was created with small businesses in mind. It gives owners the option to become a little bit more official and protect their personal liability in the process.
An LLC is a hybrid business type that combines elements of general partnerships and corporations. With an LLC, you separate your business identity from you and any other owners. This means you’re no longer personally liable if any financial or legal issues arise.
Plus, registering your business as an LLC gives your business an air of professionalism. The abbreviation “LLC” will now be included in the legal title of your business—pretty cool, huh?
While an LLC is a little bit more complicated than a sole proprietorship or partnership, it’s certainly less complex than corporations. You’ll still need to register your business and fill out some basic paperwork for your LLC, but you won’t have to maintain the intensive record-keeping and meeting-heavy regulations that C corporations and S corporations have.
LLCs are taxed as pass-through entities, meaning the owners will split their share of the profits and losses to report them on their personal tax returns. You get to choose whichever tax method is most advantageous (and applicable) to your business: sole proprietorship, partnership, or even corporation. On the downside, the LLC members will have to pay taxes on the business’s earnings, even if they never personally receive them.
Now, we enter the realm of corporations. A C-corp is a separate entity apart from the owners, and stockholders share business ownership.
Each stockholder has limited liability in the business, but they also have limited control. Stockholders elect a board of directors, and this board is responsible for making key business decisions (including choosing leadership). Corporations are legally required to have board and shareholder meetings, keep meeting minutes, and maintain more intensive bookkeeping records.
As a separate entity, C-corps must pay their own business taxes (owners do not report business profits and losses on their personal tax returns). As of 2018, all C-corps pay a flat 21% federal income tax. Corporations offer additional tax deductions—and you also mitigate self-employment taxes—but you will face double taxation if you provide dividends.
Consider registering as a C-corp if you want to sell ownership of the company in exchange for capital and want to reduce personal liability.
An S-corp is similar to a C-corp except for a few tax and regulation nuances. S-corps have the same limited liability as C-corps, but they’re taxed as pass-through entities, meaning you’ll report business income and losses on your personal tax return.
If you want the protection, structure, and available equity financing of a corporation with the taxation of a pass-through entity, an S-corp is the right entity type for you.
There’s no best business entity. You’ll need to examine the types, evaluate the pros and cons, and make the most advantageous decision for your business.
If you’re struggling to choose, consult a legal or financial professional. The money they can save you now by making the right decision is worth much more than their consultation fees—a lot more.
And remember—you can always change later. It’s generally easy and straightforward to progress from a sole proprietorship or partnership into an LLC or corporation—although the inverse can be a bit more tricky—but don’t let choosing your entity type slow you down from starting your business!
Reimbursable expenses are charges that you accrue when working for a client or an employer. They are the costs that come with completing a job or task. Instead of paying for those charges out of pocket, you will submit the costs to your employer or client for repayment—often with copies of the receipts.
Keeping track of reimbursable expenses is important if you want to save money and manage your business effectively. Let’s review some common reimbursable expenses and how to get paid for them.
You may encounter many examples of reimbursable expenses within your business. For example, if an employee travels to a conference for work, they can report the hotel stay and airfare as a reimbursable expense if they pay for those travel costs with their personal accounts. If an employee visits a print shop or picks up catering ahead of a staff meeting, these charges may also be reimbursable expenses.
Companies need to set clear guidelines for what counts as reimbursable. For example, most companies have guidelines for reimbursing mileage rates when employees use personal vehicles for business purposes. They also set per diem amounts for what employees can spend when they travel. These guidelines prevent team members from spending $200 at a steakhouse and then asking their employer to pay them for it.
Most businesses will ask employees to gain approval on costs before charging them. This prevents conflict between employees who have already spent the money and employers who didn’t approve the costs. Pre-approval can also speed up the reimbursement process.
Typically, each reimbursement invoice will have the same pieces of information for company review. These can include:
If you operate a business where you frequently reimburse employees, or if you seek out reimbursements from clients, consider downloading an app that specifically records business expenses.
There are tools like BizXpenseTracker and Expensify where you can scan receipts and record expenses while you are on the road. You can even auto-generate invoices and send them to clients from the app. This can save money and reduce the frustration of filling out invoices after a trip.
For example, let’s say you ask an employee to order business cards with a plan to reimburse them. The employee doesn’t profit from the business cards and doesn’t get any money from the process of buying them. They essentially loan your business money by paying for it out of pocket. You are not paying them a salary to purchase the business cards but rather repaying them for the cost of doing business.
Reimbursements should not be recorded as income because it will have tax implications if that is how it’s organized. Your employee is not earning higher wages because of the reimbursement, so it shouldn’t be considered income.
First, this is not actual income. You are simply paying employees back for your cost of doing business. Next, employees use their already-taxed income to pay for your business expenses. Adding taxes to that is double-taxation.
As an employer, it’s up to you to make sure you separate your reimbursable income from your wages. It may be convenient to combine invoices or include reimbursements in payroll, but this can make your taxes more complicated when you submit them. You can’t expect to remember which income is reimbursed, and your accountant won’t know either.
Instead, continue to pay employee wages as you normally would, even if your team members are owed reimbursements. Then, create a separate accounts payable account for team reimbursements.
Your accounting department can write checks to your employees (or deposit them directly from your account) in order to keep the funds separate. This way when you submit W-2 or 1099 forms in the spring, the business expenses won’t be part of the income.
Keeping separate accounts can also protect your business. If you are audited by the IRS, you can prove that your wages are accurately reported and your reimbursable expenses are organized and paid out.
With Lendio's software, we have auto-categorization features that can help you sort through your expenses. With just a few minutes each day, you can stay on top of your books. Try our service out to see how you like it—it’s free for small businesses.
As a business owner, you have a lot of financial matters to balance. Maintaining financial health, stability, and growth involves calculating many different metrics to make sure your business is on the right track to hit the goals you’ve set for yourself.
An important metric to track within this process is your business’s cash conversion cycle. This number can help you understand how well you’re managing the process of buying inventory, collecting payments from customers or clients, and then paying your vendors for that inventory.
Getting a better grasp of the cash conversion cycle and how it demonstrates the financial health of your business can help you stay on top of cash flow and inventory management, among many other important facets of your operations.
Let’s explore the cash conversion cycle, how to calculate it, what a good cash conversion cycle looks like, and why this metric matters to your business.
In other words, the cash conversion cycle tells you how much time is between paying for inventory and/or supplies and getting paid by customers or clients.
Typically, you only calculate your CCC if you run a business that regularly handles inventory or materials, such as a retail business or construction company.
You may also know this metric by its other names—cash cycle, cash-to-cash cycle, or net operating cycle. However, it shouldn’t be confused with the operating cycle, which is a different metric altogether.
Operating cycle refers to the total number of days between when you purchase inventory and when customers pay for the inventory. In contrast, net operating cycle (aka CCC) is the length of time between actually paying for the inventory and collecting the payments from customers who’ve purchased inventory. This timeframe can include net-terms with you and vendors or your customers.
Here are the 3 elements that make up the CCC formula and how to calculate them:
Days Inventory Outstanding (DIO): This number is the average time it takes to convert inventory into goods you then sell. Find the DIO by taking your average inventory for the period you’re measuring, divide it by the COGS, and then multiply by the number of days in the period you’re measuring.
That means the goal is to have as low of a CCC as possible to ensure the best possible financial health of your business. Having a negative CCC is even better because it means your cash isn’t tied up for long at all. In fact, there’s no time spent waiting to get paid.
However, it’s important to note that online retail businesses are more likely than others to have a negative CCC. That’s because these businesses typically use drop shipping, meaning they don’t hold inventory and don’t have to pay for inventory until customers pay them first. This process also helps e-commerce stores manage a lot of the working capital problems that come with traditional brick-and-mortar retailers.
Here are some elements that make up a good CCC:
You also can use your CCC to compare your business’s financial state to that of your competitors. It can give you a better idea of where you stand in terms of business practices and market share.
When your CCC is solid, it often means that you are managing your business operations, including inventory acquisition, turnover, and client or customer payments, well. That can make you feel more confident about the state of your business.
When you picture an accountant in your mind, what do you see? Perhaps it's someone studiously reviewing spreadsheets on a computer. Or you might envision a more hard-copy-reliant individual sitting at an oak desk surrounded by massive piles of papers. Regardless of the specifics, your image probably involves lots of numbers and documents.Truth is, there are 8 different types of accounting. Some are dedicated to helping small business owners prepare their taxes. Others have a passion for nonprofit work and know how to use accounting operations to put these organizations in a position to thrive. Others specialize in catching criminals. It’s safe to say that, yes, nearly all of them crunch numbers and deal with documentation.
While there may be common threads between the different fields of accounting, most accountants become specialists and don’t bounce around from one field to the other. The various branches involve enough nuances that it would be challenging to just decide that you wanted to start doing 1 of the others.
Some business owners tackle these financial accounting tasks themselves. Others use bookkeeping services.
“Tax laws often undergo changes and can be complex,” explains an accounting report from Rose Johnson. “Tax accountants ensure that companies and individuals comply with tax laws by filing their federal and state income tax returns. Some tax accountants also offer tax planning advice to help businesses and individuals save money in taxes. A career in tax accounting is challenging but also rewarding. A tax accountant career requires following a specific education and career path. It is important to understand the job requirements.”
With a tax accounting professional on the job, you can rest a lot easier when tax season rolls around. For starters, they will help you identify legal methods for lowering your tax bill. And when it comes time to file, you can trust that all the details have been handled with care.
Through cost accounting, you’re often able to identify areas that can be more efficient. When all your variable and fixed costs are broken out, you can see their correlations and where improvements can be made.
For example, you might realize that you’re paying too much for shipping. By dropping off packages earlier in the day and reusing shipping materials, you could begin to decrease these costs. Or your rent might be higher than market rates, so you could work on renegotiating the lease.
“Managerial accounting, also called management accounting, is the process of gathering, organizing, and reporting the company's financial data for the purpose of managerial decision making,” explains a tax analysis from The Balance Small Business. “Both financial accounting and cost accounting provide their financial data to management to assist them with decision-making. The reporting functions of financial and cost accounting are important to managerial accounting since raw financial data is summarized for the managers in report form. Using the data provided by financial and cost accounting together, management can look at a broader picture of the firm's financial performance.”
The better the accounting insights, the better the business decisions. Thus, managerial accounting is a critical way to analyze, forecast, budget, and ultimately strategize your business to a whole new level.
With fiduciary accounting, an accountant handles certain aspects of a business’s finances. Depending on the situation, the arrangement might involve receivership, trust accounting, or estate accounting.
Whether it’s fraud or a lawsuit, certain scenarios can require the assistance of these specialized professionals who know how to look for clues and reveal bad data. It’s fortunate that forensic accountants are around to help clear up some of the messes caused by those who don’t care about keeping their finances orderly and legal.
External audits are obviously conducted from the outside. A third-party evaluator comes in and checks for issues and areas of improvement, which isn’t necessarily as painful as it sounds. In many cases, an external audit can help you uncover new ways to improve your business and become more successful.
“Most accounting tasks these days are processed in a computer, so information systems have a huge impact on how accounting is done and what reports are generated,” says business bookkeeping guru Sheila Shanker. “Not only are accounting tasks performed at a high speed, they are also made easy to do for most businesses. Calculations are done automatically with fewer errors than manual accounting, greatly improving efficiency.”
As with other automated systems, it’s been shown that an AIS is exceptional for securely storing data and unlikely to make errors. Obviously, the human element of accounting is also important, so these systems work best in conjunction with other accounting professionals.
The Paycheck Protection Program (PPP) effectively kept the small business economy afloat over the last 15 months, pumping nearly $800 billion into an estimated 12 million businesses across the US. But the PPP loan money ran out just a month after the program’s deadline was extended in March, and those crucially important potentially forgivable loans are no longer available to help small businesses.
Recent months have still not been easy, even with the lifting of restrictions. While many businesses are reopening, the costs of reopening are making for anything but business-as-usual. Supply chains are broken, staffing is tremendously difficult, and this is not the dream reopening business owners had hoped for during the long slog of COVID-19 closures.
PPP is no longer available, but other forms of loans, microloans, grants, and debt relief are available to your small business. Most of these are administered by the government agency US Small Business Administration, and many are COVID-19 relief programs that offer loan forgiveness or other cost-cutting accommodations that take into account the current economic challenges. Let’s look at some PPP alternatives that could still offer your small business economic aid for any loss of revenue you’ve suffered under COVID-19.
The COVID-19 Economic Injury Disaster Loan (EIDL) “provides economic relief to small businesses and nonprofit organizations that are currently experiencing a temporary loss of revenue” because of the pandemic, according to the SBA. EIDLs had existed before COVID-19, but the program was recently bolstered to provide more economic help for small businesses. Traditionally providing loans of up to $150,000, EIDLs can now potentially triple in size to $500,000, and your first repayment date won’t be for another 18 months. While interest is charged on these loans, it’s a low fixed rate of 3.75% for businesses and 2.75% for nonprofits.
Other relief funds in the EIDL program may be available if you’ve already applied for an EIDL. The Targeted EIDL Advance Grant provides up to $10,000 to businesses with 300 or fewer employees, that can show a 30% loss in revenue for any 2-month period of the pandemic, and are located in a low-income community (you can use this map to determine your community’s status). Similarly, the Supplemental Targeted Advance could provide an additional $5,000 that does not have to be paid back, but it’s only for businesses with 10 or fewer employees.
This program has worked out pretty well, and most of the fund is still waiting to be awarded. According to the SBA’s mid-July figures, only $5 billion of the total has been awarded, though the SBA has received nearly $12 billion requested in applications. The funds may start to disappear fast.
It’s a reminder that as helpful as government relief programs can be, they can still be thwarted by legislative uncertainty. Private lenders may offer less confusion and red tape, and an online lending marketplace can help you find the right small business loan.
There are a number of factors you may want to consider before taking out a loan. Consider your business’s creditworthiness, whether you’ll be willing to offer collateral, and what your specific plans are for the loan. And do be ready to dig up and present a fair amount of bookkeeping documentation. But you may find other COVID-19 relief for your small business—and maybe without the headaches of previous loan programs.
Along with the growth and diversification of the US economy came the need for more organization and data relating to tracking registered businesses. The Department of Labor, Chamber of Commerce, and Census Bureau were all curious about the trends of businesses within different industries.
With these goals in mind, the government developed codes for company identification. Learn more about SIC codes and NAICS codes below.
SIC stands for Standard Industrial Classification and refers to a 4-digit coding system that categorized businesses based on their activities. These codes differentiate macro industries (like mining versus agriculture) along with smaller differences (like soy farming versus corn farming).
SIC codes were created by the United States government in 1937 to better analyze economic activity across the country.
NAICS codes are very similar to SIC codes. In fact, NAICS (North American Industry Classification System) replaced the SIC system for the most part in 1997. The NAICS code was developed as part of the North American Free Trade Agreement with the United States, Canada, and Mexico.
NAICS codes are 6-digit codes that identify your business type. You will use your NAICS code for a variety of purposes to identify your industry.
The US Department of Labor has a SIC code lookup tool you can use. You can either search by SIC code or enter a few keywords to find the SIC code you need. This database uses the 1987 version of SIC guidelines.
The NAICS Association has a code lookup tool and a company lookup tool. You can identify your newly formed company with this search system or look up codes for your existing business. The website starts with high-level categories and lets you drill down to specific industries and business types.
If you work for a modern business, you might not have a SIC code. You might just use the NAICS system. This is a self-identification system, so you can label your business as you choose. It is important to know your NAICS code to set up certain financial accounts and to report your business to the government.
A letter of credit is a statement by a bank or financial institution on behalf of a customer. This is typically used in B2B transactions when one company wants to assure another that it will pay the full amount agreed to in the transaction. When your business receives a letter of credit, it comes with the promise that the bank will pay the balance owed in full, even if the customer cannot.
A letter of credit can be used to move a sale forward. The letter recipient can rest assured knowing that they’ll receive payment, and the buyer can receive the goods they need to grow their business.
Learn more about the process of issuing and receiving a letter of credit during a sale.
A letter of credit is defined as “a statement issued by a bank to the buyer of a good stating that the seller will receive payment on time and in the correct amount.” You might also see the term “irrevocable letter of credit” to describe this financial concept.
Letters of credit are often used for major business transactions. When you’re purchasing thousands of dollars in goods, it helps to have the backing of a bank to prove that your vendor will get paid. If you don’t have the funds on hand to make the purchase, this letter can ensure that your vendor gets paid on time—given the net terms established in the contract.
Because small businesses typically don’t have a lot of working capital around to cover materials or inventory, they usually purchase on credit—and a letter of credit from a bank can provide peace of mind to vendors that they’ll be paid in full.
These letters are more common with international trade. When companies work with customers in different countries, they’ll receive letters of credit from banks—often international firms that specialize in trade—proving that the companies they work with are good for the money.
The most common source for a letter of credit is a national or international bank. These companies are used to working with large businesses and enterprises that engage in large-scale trade.
The letter of credit will often cover more than just the payment amount to the seller. It will also include important details that are relevant to the exchange of goods. For example, it will include when the business will receive payment (before the delivery of goods, after, or half-and-half) and when the seller will deliver the goods to the buyer. These terms were likely already discussed by the two companies involved, but the bank will work to confirm the details.
Like any other loan, there is a process to issuing letters of credit. The bank will conduct background checks on the buying company, check the credit of the business, and possibly ask for deposits as a way to hold the company accountable. These steps all reduce the risk levels of issuing a letter of credit and increase the chances of repayment.
While it can take time to issue a letter of credit, it still allows buyers to get the goods they need faster so they can continue operating their businesses.
Banks agree to issue irrevocable letters of credit because they profit directly from funding the transaction. This is no different from a bank issuing a loan or mortgage: they’re happy to provide the money because they benefit from the interest you pay on the loan.
The standard cost of a letter of credit is around 0.75% of the total purchase cost. For letters that are in the 6 figures (typically around $250,000), these fees can add up and benefit the bank. In some cases, the letter of credit commission could fall close to 1.5%.
The buyer typically picks up the costs associated with the letter of credit. However, the seller may receive some charges as well. These include charges related to wire transfer costs, courier fees, and bank fees. By the time the transfer is complete, the seller can expect to pay between 5 to 10 fees—most ranging from $25–$150.
On top of the fees, the buyer will typically need to put down a deposit on the letter of credit. This is usually around 1%. A deposit proves that the buyer is serious about repaying the rest of the money to the bank.
Letters of credit aren’t limited to international trade deals worth hundreds of thousands. You may be able to use this option as a way to buy materials and close deals with local vendors. If you need cash to complete business purchases, talk to your local bank—they can walk you through the letter of credit process.
Alternatively, you can look for short term loans and other funding choices to increase the capital of your business. Explore the online loan center at Lendio to find financial institutions that want to help you. Use our services to grow your business.