By Todd Bryant

Being an entrepreneur, you’ve got a thousand tasks on your plate. If you’re just launching a new business, one of the things you may need to take care of is obtaining a security instrument.

And you may think: yet another complicated thing to handle, but in fact, it’s easy to grasp the function of this legal requirement, and how to obtain it. In many cases, local, state or even federal authorities require individuals and businesses to provide a security instrument as a part of getting a professional license.

The most typical security instruments that you may need to provide are surety bonds and letters of credit. Usually you are given the choice to obtain one of the two. So how to decide what’s best for your startup?

Here is an overview of the ways letters of credit and surety bonds function, so that you can make the most appropriate choice for your case.

In which cases do you need a security instrument?

Both surety bonds and irrevocable letters of credit are risk management mechanisms. The purpose of these instruments is to guarantee that the party obtaining them will adhere to certain legal framework, or will meet contractual obligations.

In the case of entrepreneurs, you’re likely to need a security instrument when applying for a professional license. This is a typical requirement that authorities include in order to ensure protection for the general public against potential illegal activities you may engage in while conducting your operations. In such cases, a harmed party can demand a reimbursement by making a claim against your surety bond or letter of credit.

How do letters of credit function?

There are three entities involved when a letter of credit is issued. On one hand, your business is the buyer, then there is the beneficiary who is protected by the letter, and the financial institution that provides it.

When you obtain a letter of credit, the institution has to block the required amount from your financial assets. This means you are not able to use the money for the duration of the letter.

In order to get a letter of credit, you typically need to pay about 1% of the amount. However, there are also the freezed finances, which means you have less liquidity in this period. In some cases, you may need to provide a collateral. In general, letters of credit tend to limit your business’ credit capacity. They are also included in financial statements as contingent liabilities.

In case of a claim against you, the financial institution is required only to check the documentation and can then release the claimed amount to the beneficiary. This can be made before the expiration date of the letter of credit.

How do surety bonds work?

For surety bonds, there are also three parties that are bound by a contractual agreement. Your company is the principal of the bond, the obligee is the entity requiring it, and the surety is the bond provider. The surety bond is a guarantee that you will perform your obligations under contracts and will follow any applicable rules and regulations.

Getting bonded does not entail freezing of your assets. You have to cover a bond premium, which is based on your personal and business financials. If you have a good credit score and the rest of your finances are in good shape, the rates are between 1% and 5% of the required bond amount. They may be higher than the immediate cost of a letter of credit, but bonds do not limit your credit capacity. Furthermore, typically bonds are not included in your financial statement as a contingent liability.

As for claims, if you get one, the surety that bonded you will thoroughly investigate the case. You will not be left alone in handling disputes. Only if and when a claim is proven, you will be required to pay the claimant. The maximum penalty is the bond amount you’ve posted. This means there is an additional protection for you against fraudulent claims. As with letters of credit, with bonds you are also fully liable for the costs on proven claims.

Have you used surety bonds or letter of credit when getting your license, or in other cases when required by an authority? Please share your experience in the comment section below.  

Todd Bryant is the president and founder of Bryant Surety Bonds. He is a surety bonds expert with years of experience in helping business owners get bonded and start their business.

Decision stock photo by fizkes/Shutterstock