What Is a Letter of Credit? A Guide For Small Business Owners in Colorado
Running a business in Colorado often means managing relationships that stretch across borders—sometimes across oceans. Whether you’re importing specialty materials, purchasing equipment, or closing a deal with a vendor overseas, trust is key. But trust alone doesn’t pay the bills. That’s where a Letter of Credit steps in.
This financial tool can help reduce risk in large or international transactions, giving both buyers and sellers peace of mind. If you’re expanding your reach or navigating unfamiliar markets, understanding how a Letter of Credit works could make all the difference.
Understanding the Basics of a Letter of Credit
So, what is a Letter of Credit? Simply put, it’s a written commitment from a bank—your bank or the seller’s—that guarantees payment to a seller once specific terms are met. The bank only releases funds after the seller submits the required documents proving they’ve fulfilled the agreement. If you’re the buyer and something goes wrong, the bank steps in.
In banking terms, the LC full form is “Letter of Credit.” Though the name sounds formal, it’s just a tool to keep your business transactions safe and structured.
Types of Letters of Credit
Banks don’t take a one-size-fits-all approach when it comes to Letters of Credit. They offer a few different options, and the one that makes the most sense usually depends on how your deal is set up. Here are some of the most common types you’ll run into.
- Commercial Letter of Credit: Used for day-to-day trade transactions, this version makes sure payment is made once the seller provides documentation like invoices or bills of lading.
- Standby Letter of Credit: Acts more like insurance. It only kicks in if one party fails to meet its obligation—say, if a supplier doesn’t deliver, or a buyer defaults on payment.
- Revocable vs. Irrevocable: A revocable LC can be altered or canceled without warning. Most businesses prefer irrevocable LCs, which can’t be changed without everyone’s agreement.
- Confirmed vs. Unconfirmed: A confirmed LC adds a second bank’s guarantee (usually the seller’s bank) in addition to the issuing bank, offering even more security in high-risk markets.
Every type of letter of credit offers a different level of protection, and the best option really comes down to the details of your agreement. It depends on how much you trust the other party, the size of the transaction, and whether you’re working with someone overseas or a new supplier who doesn’t know your business yet.
How Does a Letter of Credit Work?
Here’s a Letter of Credit example that’s easy to visualize.
Let’s say you own a small manufacturing company in Pueblo. You’re ordering machinery from a supplier in Germany. The supplier wants assurance you’ll pay once they ship, and you want confirmation that they’ll deliver what they promised.
Here’s the basic Letter of Credit process:
- You and the supplier agree on a sales contract.
- You request a Letter of Credit from your bank, including the deal’s details.
- Your bank issues the LC and sends it to the supplier’s bank.
- The supplier ships the machinery and submits the required documents (like a shipping receipt) to their bank.
- Their bank confirms the documents meet the LC terms and forwards them to your bank.
- Your bank releases payment to the supplier, using either your funds or a credit facility.
It’s structured, transparent, and it’s safer than wiring money upfront and hoping for the best.
Benefits of Using a Letter of Credit
The biggest advantage of using an LC is the trust it builds. Sellers get a bank-backed guarantee of payment, while buyers don’t have to release funds until certain conditions are met.
Here are some other advantages:
- Lower risk in unfamiliar or high-risk markets
- Better negotiating power for businesses with limited credit history
- Less of a need for prepayment or large deposits
If you’re working to increase your credit score, consistent, successful LC transactions can help demonstrate financial responsibility.
Things to Watch Out For
First of all, they’re not free, and banks typically charge a percentage of the transaction amount. You’ll also need to submit detailed documents, and any discrepancies can delay payment or result in fees.
Setting up a Letter of Credit takes coordination and patience, and if you’re working with a tight deadline or an urgent shipment, this might not be the best route to take.
It’s important to keep in mind that Letters of Credit don’t cover everything. If your business is financing the purchase with a loan, remember that it won’t apply to any complex renovations requiring permits, as those fall outside the scope of funding backed by a letter of credit.
When Should Your Colorado Business Use a Letter of Credit?
If you’re doing business with unfamiliar vendors, negotiating across time zones, or sourcing expensive goods, Letters of Credit can give you leverage. They’re especially common in international trade, construction, and manufacturing—any field where large amounts of money move before goods are delivered.
Even within the U.S., businesses use LCs to formalize deals with vendors they haven’t worked with before. They’re also used in state contracts or to meet performance guarantees, giving small businesses a way to compete with larger firms.
The bottom line is that if the stakes are high and trust is still being built, an LC might be your best bet.
How to Get a Letter of Credit
Before you even apply, you’ll need to get your books in order. Understanding accounting basics is so important. You’ll need to put together a balance sheet, create a profit and loss statement, and make sure your cash flow supports the transaction.
When you’re ready, you’ll need to:
- Talk with your bank’s commercial or trade finance team.
- Present the purchase agreement or invoice.
- Decide on the right LC type.
- Provide collateral, if required—often in the form of cash or securities.
- Pay the setup fee, usually a competitive percentage of the transaction value.
Smaller banks might not offer Letters of Credit, so it’s worth shopping around or asking for a referral.
Where Energize Colorado Can Help
Applying for a Letter of Credit can feel intimidating the first time. That’s where Energize Colorado steps in. We work with small businesses across the state to improve financial literacy, connect with trade-savvy lenders, and understand the tools that can help you scale.
If you need help structuring your financials, preparing the right documents, or figuring out if an LC is the right tool for your next deal, we’re here. And if an LC isn’t the fit? We can help you explore alternative funding options that don’t require permits or collateral-heavy backing.
Our mission is to make sure Colorado’s small businesses don’t miss out on opportunity simply because the paperwork feels too complex.
Final Thoughts
So, what is a Letter of Credit? It’s not just a piece of paper, but it’s a structured way to protect your business. A letter of credit gives you control, clarity, and credibility.
As long as you have good guidance, clear documents, and support from Energize Colorado, a letter of credit could be the exact tool you need to confidently take the next step.