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A perennial challenge for any small business, even when they have a blue chip contract to execute, is finding the capital with which to finance the contract. Having maxed out on, or failed to secure any borrowings from friends and family often leads small business to the lender’s shop for a loan. Notably, the first stop is usually the bank, believing that a good business opportunity is all it takes to gain access to the bank’s vault. Lacking the collateral to secure the loan, even when the cash flow looks promising, leads to a failure of the loan application and inevitably anger, towards the bank.

Banks sell a variety of loan products but near certainty of cash flow and collateral are two major keys among others, needed to successfully access any of these products. Interestingly there are some products sold by banks that can help meet both these needs simultaneously. A Bank Guarantee is one of such products.
A Bank Guarantee (popularly called “BG”) is an assured promise provided by a bank, on behalf of its customer, to its customer’s supplier (counterparty) effectively undertaking to pay the counterparty an agreed contractual amount upon the satisfactory delivery of the agreed service or product.

 

BGs have long been a major financing tool for commercial companies, especially in the construction, real estate, oil and gas and general contracting businesses. A simple example illustrates how a BG simultaneously solves the twin challenges of collateral and near certainty of cash flow.

An Example

XYZ Limited has won an above average sized contract from a large company ABC Limited to supply the quarterly provisions required by its catering department. But ABC will only pay XYZ after the goods have been supplied and certified appropriate as per the purchase order. XYZ Limited neither has the independent capital to fund the supply nor suitable collateral with which to borrow money from a bank to enable it finance the contract. A request by XYZ for an advance payment was turned down by ABC who is, however, willing to issue XYZ with a Bank Guarantee from its banker for eventual payment, alongside the local purchase order given to it. Armed with this BG, XYZ walks into its bank and asks its bank to advance it a percentage of the total value of the BG to enable it to execute the supply and the bank grants its request.

Resolving the Collateral Issue

XYZ receives the financing it needs because the issuance of the BG has transformed the contract into an interbank transaction where the promise to pay is no longer between one company to another, but now rather between banks. ABC’s bank has issued the Bank Guarantee on behalf of ABC Limited because it knows that ABC has in place the money with which to pay XYZ at the completion of the contract between ABC and XYZ. XYZ’s bank knows that as a bank, ABC’s bank will keep its promise to transfer the money to XYZ’s account once the contract is satisfactorily completed. This promise by ABC’s bank as represented by the BG resolves the collateral issue.

Resolving the Working Capital Issue

The BG also has a face value equal to the value of the contract being financed and by going to their bank, XYZ is attempting to realise a percentage of that face value for cash (this is called BG Discounting) and by so doing accesses the working capital it needs to execute the contract and get paid for it. As part of the process of ensuring that the contract is fulfilled according to its terms, XYZ’s bank will create some conditions which XYZ must meet before releasing the funds. It could, for instance, insist on the appointment of an agent to monitor the entire purchase and delivery process.

Of course, the value of the transaction must be commercially viable to XYZ’s bank before it commits resources to it. It is important to note that an interest will be charged on the funds provided to XYZ in the discounting process and this interest payment will continue until ABC makes payment for the fully executed contract. The percentage of the value of the contract made available to XYZ through the discounting process will normally be such that its interest and principal repayment does not jeopardise the entire contract value. However not all BG transactions require funds to be disbursed and where this is the case, fees and not interest is charged.

As small business expand, it is inevitable that they will require additional working capital, and understanding how Bank Guarantees can help them achieve this goal is critical to their success.