Letter of Credit
A bank's guarantee that a specified payment will be made if defined conditions are met — shifting credit risk from the paying party to the issuing bank. In M&A, letters of credit (LCs) occasionally backstop earnout payments or seller note obligations when the buyer's creditworthiness is uncertain. Rather than requiring cash escrow, the seller accepts a bank LC guaranteeing payment. LCs cost the buyer commitment fees (typically 0.5-2% annually) but preserve cash compared to cash escrow.
Full Definition
A letter of credit (LC) is a financial instrument issued by a bank that guarantees payment to a seller or beneficiary upon presentation of specified documents, provided the conditions stated in the LC are met. In M&A and business contexts, letters of credit serve multiple functions: as earnest money substitutes, as tools to support seller financing arrangements, as guarantees for lease assumptions, and as instruments in international trade transactions that are being acquired.
In M&A transactions, letters of credit appear most frequently in two scenarios. First, as a substitute for a cash escrow when the buyer wants to limit cash tied up at closing — the buyer's bank issues an LC in favor of the seller that can be drawn if specific conditions are triggered (such as a breach of representations). Second, as support for seller-financed deals — the seller may require a standby letter of credit from the buyer's bank as collateral for a seller note, giving the seller bank-backed security rather than relying solely on the buyer's creditworthiness.
For lease assumptions, landlords sometimes require an LC instead of (or in addition to) a cash security deposit or personal guarantee. A standby LC provides the landlord with immediate access to funds if the tenant defaults, without requiring the landlord to pursue legal action first. For buyers with strong banking relationships, an LC can be a more efficient use of capital than a cash deposit.
In acquisitions of import/export businesses, understanding the target's existing LC obligations is essential. The business may have trade LCs outstanding — either commercial LCs (guaranteeing payment to suppliers) or standby LCs (guaranteeing performance to customers). These LCs may be tied to specific banking relationships, collateral arrangements, or covenants that the buyer must navigate as part of the acquisition.
Letters of credit have fees (typically 1-3% annually of the LC face value) and require the issuing bank to approve the buyer's creditworthiness. They also have expiration dates, document requirements, and strict compliance standards — presentations that don't exactly match the LC terms can be rejected.
Seller vs. Buyer Perspective
Sellers accepting an LC in lieu of a cash deposit or cash escrow are accepting bank risk rather than buyer risk — generally a superior position. However, verify that the LC is issued by a creditworthy, regulated U.S. bank and that the draw conditions are clearly and objectively defined. Vague or complex draw conditions create disputes about whether the trigger has occurred.
For seller-financed deals, requiring a standby LC from the buyer's bank provides significant additional security. It means the seller gets paid from bank funds immediately upon default rather than having to pursue the buyer through litigation. This is especially valuable when the buyer is a newly formed acquisition entity with limited track record.
Understand the LC's expiration date and automatic renewal provisions. An LC that expires before your indemnification rights expire leaves you unprotected during the tail period.
Buyers using LCs to replace cash escrows can preserve liquidity — but LCs tie up credit lines at their bank and require bank approval. Large LCs can consume a significant portion of a buyer's available credit, limiting flexibility for other financing needs post-close.
Negotiate draw conditions carefully. Overly broad or easily triggered draw conditions effectively give the seller the ability to draw the LC in disputed situations, creating leverage. Draw conditions should be tied to objective, unambiguous events: a final court judgment, a written demand with supporting documentation, or mutual written consent.
If you're acquiring a business with existing LC obligations, treat those as contingent liabilities. The LC represents a potential payment obligation that may crystallize post-close. Confirm which LCs are performance-based vs. payment-based, and understand what customer or supplier relationships they support.
Real-World Example
A buyer acquires an import business for $3.2M, using $1M in seller financing. The seller requires a standby LC from the buyer's bank as collateral for the seller note rather than a mortgage on business assets. The buyer's bank issues a $1M standby LC in favor of the seller for a 1.5% annual fee. This structure gives the seller bank-backed security and allows the buyer to avoid pledging business assets to the seller, keeping those assets available as collateral for the bank's senior acquisition loan.
Why It Matters & Common Pitfalls
- !Strict compliance requirements. LCs require exact document compliance for draws. A minor discrepancy in the presented documents can result in the bank refusing to honor the draw, leaving the beneficiary without recourse.
- !Expiration gaps. LCs expire. If the LC expiration date doesn't align with the indemnification survival period or the seller note maturity, there's a gap in protection. Always ensure auto-renewal provisions or matching terms.
- !Credit line consumption. LC issuance consumes bank credit availability. Buyers relying on their credit line for working capital or capex post-close may find their flexibility constrained by a large LC.
- !Vague draw conditions. Imprecisely drafted draw conditions create litigation risk when the beneficiary wants to draw and the issuing bank questions whether the conditions are met.
Frequently Asked Questions
What is a letter of credit in M&A?↓
When should a seller request a letter of credit?↓
Related Terms
Escrow
A portion of purchase price held by a neutral third party after closing to secure the seller's indemnification obligations — a buyer's cushion against post-close claims.
Seller Note
A promissory note issued by the buyer to the seller for deferred payment of part of the purchase price — the specific instrument through which seller financing is delivered.
Earnout
A portion of purchase price paid to the seller after closing, contingent on the business achieving specific performance targets — used to bridge valuation gaps and share post-close risk.
Personal Guarantee
A pledge by an individual (rather than an entity) to repay a debt if the business defaults — making the individual personally liable for the obligation. Personal guarantees extend lender recovery beyond business assets to the guarantor's personal assets. SBA loans require personal guarantees from owners with 20%+ ownership stakes. For sellers accepting seller notes, negotiating a personal guarantee from the buyer's principals is an important protection — without it, recovery is limited to business assets (which may be diminished if the business fails).
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Disclaimer: The information provided on this page is for educational and informational purposes only. It should not be considered financial, legal, or investment advice. Business valuations depend on many factors specific to each situation. Always consult with qualified professionals — including business brokers, CPAs, and M&A attorneys — before making acquisition or sale decisions. LegacyVector is not a licensed broker, financial advisor, or attorney. Data shown may be based on limited samples and may not reflect current market conditions.
LegacyVector Research Team
Reviewed by M&A professionals · Updated April 2026