A landlord, an insurer, or a large customer asks for a letter of credit, and the business treats it as paperwork. It is not paperwork. It is a bank commitment that reduces the cash you can borrow, by the full face amount, for as long as it stays outstanding.
What is a standby letter of credit?
A standby letter of credit is an undertaking by a bank to pay a named beneficiary a stated amount on presentation of documents showing that the applicant failed to perform an obligation. It is a backstop. Everyone involved expects it never to be drawn.
The bank is not guaranteeing your performance. It is promising to pay against documents, which is a narrower and more mechanical commitment.
Standby vs commercial letter of credit
| Standby LC | Commercial LC | |
|---|---|---|
| Purpose | Backs a failure to perform | Pays for goods in trade |
| Expectation | Never drawn | Drawn as a matter of course |
| Triggered by | Documents evidencing default | Shipping documents |
| Typical use | Leases, insurance collateral, bonding | Import and export transactions |
A commercial letter of credit is a payment mechanism. A standby is a security instrument that happens to use the same machinery.
Why do beneficiaries want one?
Because it converts your credit into a bank’s credit. A landlord holding a cash security deposit has money that could be tied up if you enter bankruptcy. A landlord holding a standby letter of credit has a claim against the issuing bank, which is a different and much better position.
Insurers holding collateral for a large deductible workers’ compensation programme want them for the same reason, and this is where growing companies most often meet one for the first time.
What does it actually cost?
Two components. An issuance and annual fee, typically expressed as a percentage of face amount per year, and quoted by the bank based on your credit. Plus amendment, negotiation, and draw fees if anything changes.
But the headline fee is the smaller cost. The real one is what it does to availability.
Why does it reduce my borrowing availability?
Because the bank has taken on a contingent obligation to pay the face amount, and it reserves against your facility to cover it. A $500,000 standby letter of credit issued under a $3,000,000 revolver typically leaves $2,500,000 of the line available for cash draws, whether or not the letter is ever drawn.
This is the point businesses miss when agreeing to provide one. The company negotiating a new lease is often the same company that will need working capital in the same quarter, and it has just spent part of the line on the lease. The availability arithmetic is in borrowing base certificate.
What is an evergreen clause?
Most standby letters of credit issued for leases and insurance collateral renew automatically for successive periods unless the bank gives notice of non-renewal within a stated window, commonly 30 to 60 days before expiry.
Two consequences. It does not simply expire when your lease term ends, so somebody has to actively cancel it. And the beneficiary usually has the right to draw the full amount if it receives a non-renewal notice, which means an attempt to cancel can itself trigger a draw. Read the non-renewal mechanics before issuance, not at renewal.
What happens if it is drawn?
The bank pays the beneficiary and the amount becomes an immediate obligation of yours to the bank, usually funded as a draw on your line or as a demand loan. A draw is also, in most credit agreements, a serious credit event that will be reviewed closely.
The bank pays against conforming documents, not against the merits. Whether the beneficiary was entitled to draw is a dispute between you and them, after the money has moved.
How is it different from a guarantee or a surety bond?
A guarantee is a promise to answer for another party’s obligation and generally allows the guarantor to raise defences arising from the underlying contract. A standby letter of credit is independent of the underlying contract: the bank pays on documents alone. That independence is exactly what the beneficiary is buying.
A surety bond involves an underwriter assessing the risk of the obligation itself, and is common in construction, where the mechanics interact with the billing structure described in construction financing.
What should you negotiate?
Before agreeing to provide one, three things. Face amount, which is often set by convention rather than analysis and is negotiable. Step-downs, so the amount reduces as the lease seasons or the claims history proves out. And the expiry and non-renewal mechanism, so it can actually be retired.
Then confirm with your lender what it does to availability, before you sign the lease rather than after.
The short version
A standby letter of credit turns your credit into your bank’s credit for a beneficiary who wants certainty. It is cheap in fees and expensive in availability, it usually renews itself automatically, and the amount is more negotiable than most tenants assume.