What it means
Imagine your company has won a contract to build a warehouse for a client who has never heard of you. The client wants comfort that if you walk away, they will not lose their money.
A letter of guarantee from your bank provides that comfort, because the bank agrees to pay up to a stated amount if you default. There are three parties.
The applicant is the customer who asks for the guarantee, the beneficiary is the party who receives it, and the issuing bank is the guarantor. The bank's promise is separate from the underlying contract, so if the beneficiary makes a valid claim in line with the wording, the bank pays and then looks to the applicant for reimbursement.
Guarantees come in many forms. A bid guarantee supports a tender, a performance guarantee supports the completion of a contract, an advance payment guarantee protects a customer who pays a deposit in advance, and a payment guarantee supports a promise to pay for goods.
Each has a defined amount, a start date and an expiry date. For the applicant, the guarantee costs money and uses up borrowing capacity.
The bank usually charges a fee expressed as a percentage per year of the guaranteed amount, and may ask for a cash deposit or other collateral. The guarantee is a contingent liability, which means a possible obligation that will only become real if a claim is made.
The wording matters enormously. An on-demand guarantee pays on the beneficiary's simple written demand, with little scope for argument, so applicants should negotiate the wording, the amount and the expiry date carefully and make sure the guarantee is returned and cancelled once it is no longer needed.
In practice
Real-world examples.
Example
A machinery exporter wins a $2,000,000 order from an overseas buyer, who asks for an advance payment guarantee. The exporter's bank issues the guarantee, and the buyer pays a 20% deposit with confidence that it will be returned if the machines are not delivered.
Example
A small contractor bids for a public building project. The tender documents require a bid guarantee equal to 2% of the bid value. The contractor's bank issues a $40,000 guarantee against a $2,000,000 bid, and the guarantee is released once the contract is awarded.
Example
A wholesale importer wants to buy goods on credit from a new supplier. The supplier asks for a payment guarantee so that it is paid if the importer fails to settle. The importer's bank issues the guarantee and charges a fee for the risk it takes.
Formula
Calculation
Guarantee fee = Guaranteed amount x Annual fee rate x (Months outstanding / 12)
Worked example: a construction company obtains a performance guarantee of $500,000 from its bank for a contract. The bank charges 1.5% per year, and the guarantee remains outstanding for 9 months.
Annual fee = $500,000 x 1.5% = $7,500.
Fee for 9 months = $7,500 x (9 / 12) = $7,500 x 0.75 = $5,625.
If the bank also requires a cash deposit of 20% of the guarantee, the company must set aside $500,000 x 20% = $100,000, which cannot be used elsewhere in the business until the guarantee is released.Case study
Seen in the real world.
Delta Ridge Construction is a fictional contractor that won a $4,000,000 contract to build a school. The client required a performance guarantee for 10% of the contract value, which came to $400,000.
The company's bank agreed to issue it for an annual fee of 1.2%, and asked for 25% cash cover. The finance director calculated the fee at $4,800 a year, and the cash cover at $100,000, which tied up cash that the company had planned to use for equipment.
The project overran by four months and the guarantee had to be extended, adding about $1,600 in fees. The finance director learned to build such costs into future bids. This is an illustrative story, but it shows how guarantees carry both direct fees and hidden cash costs.
Watch out
Common mistakes.
- Treating the guarantee as free. It carries a fee, may need cash cover and reduces the credit lines available for other uses.
- Forgetting to get it cancelled. If the original is not returned after the contract ends, fees may keep accruing and the bank may still show the exposure.
- Accepting vague wording. A badly drafted guarantee can be called on more easily or for longer than intended, so wording and expiry date need careful review.
Questions
People also ask.
Is a letter of guarantee the same as a letter of credit?
No. A letter of credit is a promise to pay for goods when documents are presented, while a guarantee is a promise to pay if the customer defaults on an obligation.
What happens if the beneficiary makes a claim?
The bank pays out in line with the wording and then recovers the money from the applicant. The applicant is therefore ultimately liable.
How long does a guarantee last?
Until its stated expiry date or until the beneficiary returns it. Many guarantees run for the life of the contract plus a warranty period.
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