Financing Your Venture

Overview

Deciding to engage in an international business venture of any kind will necessarily involve some kind of financing. In most cases, small and medium sized companies will primarily be involved in import-export financing, which is generally handled by the international department of your bank. However, there has been an increase in the capability of smaller companies to become involved in more types of global business ventures with the growth of the Internet. Such business ventures will involve a wide variety of financing methods, some of which are becoming more complicated.

Import-Export Financing

Most companies that are newly entering international trade will do so via import or export transactions. There are three primary ways to finance an import-export transaction:

Letter of credit
Documentary draft or bill of exchange
Open account transactions

Letters of Credit

The letter of credit is the oldest known method of financing international business transactions. It has been in active use since the 12th century in Europe and may have been used in other parts of the world even before that. Basically, a letter of credit is a contract between the buyer and seller in a transaction that is assured by a third party that remains independent. In the beginning, merchant associations and shipping companies were the primary guarantors of the letter of credit. In today’s world, the bank is the guarantor of the letter of credit.

Many newcomers are immediately confused by the letter of credit. This is understandable given its complexity in the modern context. It is important to understand that the letter of credit, most commonly known as the L/C, is really a contract between the buyer and seller. Many believe that the banks are at fault for creating such complexities, but the reality is that both the buyer and seller in any transaction are trying to use the L/C not only as a method of getting paid, but also as a method of protecting their interests. Therefore, each party will add layers of complexity in order to protect their vested interests. These complexities can become even more profound when the L/C is used for actually financing the entire transaction.

Here is how an L/C works. My company, LaCasta Verde Trading Company (real company), wants to import umbrellas from Xiang Ho Trading Company in the People’s Republic of China. We contact Xiang Ho (fictional name) and ask for a price quotation by sending them what is commonly known as an RFQ, request for a quotation. Xiang Ho represents the Jiangsu Manufacturing Co. (fictional name), which actually makes the umbrellas. Xiang Ho will send me a price quotation CIF. This CIF price quotation, which is the most common and familiar price quotation, means that the price quoted for the umbrellas will include the actual cost (C) of the umbrellas (the price quoted by Jiangsu Manufacturing plus a commission or margin for Xiang Ho) plus the cost for insuring the cargo (I) and the freight cost (F) from the port of debarking, most likely Hong Kong in this instance, to the Port of Philadelphia or even to my warehouse in Philadelphia in some cases. This price quotation will come to me via fax or e-mail in a document known as a pro forma invoice, which is actually nothing more than a fake or mock commercial invoice that details the cost for the umbrellas. If I agree to the price, Xiang Ho will then instruct me to open a letter of credit on its behalf and it will detail its terms of sale. If I agree to the terms of sale, I will contact my bank and instruct it to open an L/C on behalf of Xiang Ho Trading Company or Jiangsu Manufacturing Co, depending upon the instructions sent to me. My bank, known as the opening bank, will then open a letter of credit on behalf of Xiang Ho, and then send it to the specified bank, probably in Hong Kong. This bank, often known as the notifying bank, will notify Xiang Ho that an L/C has been opened in its favor. In many cases, this bank will also confirm the L/C, and will therefore be also known as the confirming bank. That is, this bank will confirm the L/C, which is very important in order for Xiang Ho to get paid.

Once the L/C has been opened and confirmed, Xiang Ho now has confirmation. What this means is that Xiang Ho’s bank will pay it for the umbrellas once it has presented to the bank the specified documentation. This documentation is commonly known as the required documents and will vary slightly in form from country to country. Xiang Ho will then notify Jiangsu manufacturing that a sale has been made to LaCasta Verde Trading Company in Philadelphia and it will send instructions to Jiangsu as to what the packing requirements are and how the cargo should be marked for identification. Jiangsu will then pack the cargo according to these instructions, usually given by me the buyer and commonly known as shipping instructions. Its trucking company will pick up the shipment and deliver it to the port for shipment, once Xiang Ho has notified Jiangsu that it has arranged for cargo space on a steamship. Xiang Ho’s shipping department might have contacted the steamship company or its agent directly or it might have used a local freight forwarder for this task. When the cargo is loaded upon the steamship, the ship’s captain or first mate will then issue what is known as a bill of lading. The bill of lading will list the contents of the cargo, the name of the shipper, in this instance Xiang Ho or Jiangsu and the name of the company to receive the cargo, LaCasta Verde. This document, the bill of lading, commonly symbolized and known as the B/L, then becomes title to the actual cargo. That is, the bill of lading serves to show that its holder is the rightful owner of the cargo. Xiang Ho will then take possession of the bill of lading and it will take it along with the other required documents to its bank. Its bank will examine these documents to make certain that all of the documents comply with the L/C issued for this transaction.(these documents can include such things as commercial invoice, packing list, phyto-sanitary certificates, licenses for export, insurance documents, inspection certificates and will vary from one country to another) This process is handled by a documentation expert known as a documentation reviewer or letter of credit examiner. If the bank is satisfied that Xiang Ho has complied with the requirements of the L/C, it will pay Xiang Ho the amount specified in the L/C upon presentation of the documents and then send the documents onward according to the instructions in the L/C.

The steamship will then make its way to San Francisco and my cargo of umbrellas will be transferred to a railroad or a truck to make the journey across the United States to me in Philadelphia. In order for this to happen, however, the cargo must first clear U.S. Customs. To do this, LaCasta Verde will use what is known as a Customs House Broker. Normally, we will designate this broker in the shipping instructions that we originally sent to Xiang Ho. Once the shipment is cleared, its documents will then be forwarded to me or my bank for settlement. That is, ownership of the cargo is transferred to my company immediately if we have paid for the L/C already or have credit with the bank. If not, the documents are forwarded to my bank and I will receive them upon paying the bank. Once I pay the bank, it will then pay the bank in Hong Kong that paid Xiang Ho. When I pay my bank, that is when this L/C is settled, I will receive the documents that will entitle me to pick up my shipment. Both banks are paid a fee by their respective clients for arranging for this transaction via the letter of credit.

This is a very basic explanation of how an L/C works. There are variations on this basic premise and therein lie the complexities associated with the letter of credit. Some manufacturers will use the L/C as a financing tool by a process known as discounting. In this instance, a manufacturer will take an L/C to its bank and discount it that is it will receive slightly less than the face value of the L/C in order to be able to pay a supplier or otherwise be capable of fulfilling the order. Discounting involves the bank paying the seller in advance of shipping the products and that is why it is an important tool for actually financing global business sales because many manufacturers can’t fulfill an order without paying significant upfront costs for raw materials or components. Discounting allows these manufacturers to accept orders and helps them grow their businesses. Banks, of course, receive hefty service fees for acting as guarantors in this aspect of letter of credit transactions.

Documentary Draft

A documentary draft or bill of exchange is very similar to a letter of credit in as much as it is an agreement between a buyer and seller. (a simple check is the most familiar type of draft to most people.) In this instance, one party writes a draft, or an order for payment, in favor to another party. A seller would write out a draft in its own favor, that is to its own account. If I as the buyer accepted this draft, that is I signed to accept for payment, this draft would then become what is called a trade acceptance, a form of commercial paper that is both endorsable and liquid. My company, LaCasta Verde, accepted this obligation to pay a designated beneficiary a specific sum within a designated time limit. Documentary drafts are still widely used in many countries whose commercial law is based upon the Napoleonic Code. They were primarily used in domestic commerce as a way of facilitating transactions between individuals and companies who had faith in one another. In many countries, failure to satisfy a trade acceptance can lead to an immediate seizure of the personal assets of the acceptor. Use of documentary drafts in global commerce began as a result of trade between companies in countries whose commercial law is based upon the Napoleonic Code, but they were also used in the United States as well. In order for the documentary draft to work, a third party acts as a guarantor of the draft, that is this third party will guarantee payment of the draft upon presentation of the proper documents. While some companies would act as guarantors as a favor to special customers or clients, banks became involved as the third party. In certain letter of credit transactions, documentary drafts are also used as a backup to create additional assurance that the buyer will pay its obligations to the seller via the third party, in most instances a bank.

Open Account

Many companies do business with one another by way of what is commonly known as open account transactions. Here again, open account transactions are an agreement between the buyer and the seller. In this instance the seller agrees to grant significant credit to the buyer in order to facilitate greater flexibility and increase sales. Normally, the seller will try to ascertain the credit status of the buyer via commercial credit reports, bank references and trade references because of the inherent risk of default. Some open credit transactions in international trade are covered by export credit insurance.

Venture Financing

Global business ventures can also be financed via traditional methods such as syndicated bank loans, venture capital financing by private placement, strategic alliances, Initial Public Offerings, commercial paper such as bond offerings and government backed projects such as those guaranteed by the Overseas Private Investment Corporation (http://www.opic.gov)

The Internet has facilitated global business communications and therefore more companies are searching for international business opportunities. Due to the success of increasingly smaller companies, more businesses are not allowing their size to temper their competitive zeal. Import-export has been the traditional method of entry into international business, but more hybrid business ventures are beginning to become commonplace. Your choice of a method to enter global business will depend largely upon the strength of your ideas, the cohesiveness of your business and its strategic plan and the breadth of your global vision.