Using a third-party letter of credit to get bank financing.
You've got a prototype for a nifty new product. You've lined up the outside contractor you want to make it. But nobody wants to front you the money for production costs. The banks want nothing to do with it. So how on earth do you get the money? Chuck Duke, president of Connect One, which sells music-on-hold systems, found one way to break that logjam. His solution: a letter of credit from a third party.
Duke had presented his financing predicament to three local banks in Indianapolis. Since both his and his partner's assets were already pledged to other loans, the banks balked. Connect One needed someone who could guarantee payment to the manufacturer for the first batch of products (around $125,000), no matter how slowly the units sold. He and his partner worked out a deal with members of his partner's family, who owned a local service business; the family agreed to pledge the necessary assets for a letter of credit.
The deal worked like this: Based on the collateral of the service business, a bank issued a letter of credit to Connect One's supplier. The supplier got a guarantee of payment from the bank within six months, regardless of whether or not Connect One had the funds. In other words, if the product flopped, the bank would pay. And what about Connect One's obligation? Well, it would convert its agreement into a five-year note from the bank, backed by the family business's collateral (although Duke and his partner committed to writing that they'd be the ones who'd make the payments).
As it happened, the new product wasn't the smash Connect One had hoped for. A shortfall of around $30,000, notes Duke, is now being paid off on a five-year basis, at a floating interest rate. Not bad, says Duke, who's gearing up to launch an updated product. "Remember, we didn't have many options. If we hadn't done this, we'd be nowhere." -- Bruce G. Posner