In today's topic, we talk everything about payment methods that have been frequently used in international or domestic trade. By evaluating the risks from both buyers‘ and seller's sides, you can have a sense of what can be your best payment term options depending on your role in the transaction.
When I first step into the business world, I was as naive as an 8-year-old. I thought people will obey what they promised and I thought everything will end in the perfect way as I thought it would be. But it soon turned out that I was betrayed by my thought-to-be "business partners" 4 times in a single month when I was just started! I lost my savings which I worked years to earn in a hard way. To reflect those bad memories, I realize that if I don't fail in the first place, it's so hard for me to pay attention to the warnings in the real world. So I wish everyone who read through this post could prevent the same nightmare happen to you in the future.
A verbal contract isn't worth the paper it's written on. -Samuel Goldwyn
When you are dealing with a new client or vendor, it's understandable that you don't trust each other, especially if you are not in the same country or you don't speak the same language. Thankfully, the people before us have paved the road in terms of how should the money flow between each party. All we need to do is learn from these routes and master them with real-world practice.
I list some of the most commonly used payment terms in international trade to give you a basic understanding of how each method works.
Cash in Advance
This is also known as pre-payment. In the contract, we also use "100% T/T" or "100% wire transfer upfront" to indicate this type of transaction. This is the most secure way for the seller to receive the payment upfront and the least favorable way for buyers to pay. But we have to admit that this is a very common way to pay especially if you have no credit history given to the seller and you are buying the commodities the seller currently has in-stock in an urgent manner. From the buyer's perspective, if you are buying the goods for one-time-only, at a small to moderate quantity from a reputable seller, this might be your only workable option. You may want to be very careful when placing the order online at a very large quantity though. If the trade value is over $10,000, we strongly suggest you sign a separate contract with the seller directly so that it can give you at least some kind of protection if the worst case scenario happens.
Letters of Credit
Letters of credit are very commonly used if both parties feel it's necessary to arrange the payment in a safe and fair way to each other. If the value of the goods you trade is over a certain amount and you worry about the risks that the other party may default in the transaction, we strongly suggest you take this route although it may cause extra time and fees. In most cases, the buyers should be the one to cover at least his fees accrued within his bank in his country or all the fees occurred in the LC transaction. If not, you can add your LC transaction fee that your bank charges into the quotation of the goods.
With a Letter of Credit, payment is made through both the buyer and sellers’ banks. Upon confirmation of trade terms and conditions, the buyer instructs his bank to pay the agreed-upon sum by both parties to the seller’s bank. The buyer’s bank then sends a Letter of Credit as proof of sufficient and legit funds to the seller’s bank. Payment is only remitted after all stated conditions are met by both parties and shipment has been shipped.
There are several kinds of Letters of Credit. When using L/C as a seller, you should pay attention that the type of the L/C, which should be irrevocable instead of revocable. Because if the L/C is revocable, the payer can adjust the terms without the permission of the payee later. And as a seller, if you don't trust the oversea's bank the buyer chooses and you're afraid of that bank may be delinquent on payment routed to your bank, you can ask your bank to become the guaranteed bank and get a Confirmed Letter of Credit instead of the regular Letter of Credit. In that way, your bank will have the responsibility listed in the contract to honor the payment even if the issuing bank defaults.
As the seller, you need to be very careful with the words the bank put on the L/C because if the document you submit later doesn't comply with the requirements on the L/C, even though there is only one word, or one name, or one date that is wrong or missing, it will be deemed as you failed to submit the required document and the bank may refuse to pay according to the clauses drafted on the L/C agreement.
Open Account
This is very common is you are dealing with monopoly buyers in the industry such as Walmart or Costco, who has a voice of say in today's world. In order to get their business, which the MOQ is usually at least hundreds of thousands of dollars or millions of dollars, you must agree with this type of payment method. Usually, this type of company has a high credit worthiness and won't default on your payment particularly because they have a professional account-payable team to handle their payments due to at least thousands of vendors every month, if not more.
The disadvantage side is also obvious to you as a seller- Your capital turnover is slow and you won't easily recoup the inventory cost if the buyer decides to return the goods or cancel the order later. So you need to look at the specific terms in the option pools such as NET 7/10/30/60/90, which means they will pay you 7/10/30/60/90 days after they receive the shipment from you. Sometimes the buyer will require the seller to add another 1% or 2% discount in the event that they pay you earlier than the contractual period. Additionally, if the overall economy is going down and many chain retailers are going bankruptcy, there is still a risk that you won't get your payment according to the schedule. So the business decision is ultimately up to you. If you want to win their business which I think you should in most cases, you'd better negotiate for the best term you can get which makes sense to your financial situation and overall risk tolerance.
There is another situation where the Open Account can be backed by the Standby Letter of Credit. If the buyer is default at payment according to the terms, the Standby Letter of Credit will come into effect and the buyer will have to pay banking fees and interest for the duration of the Standby Letter of Credit. So this may be your best bet when signing such a payment agreement.
Documentary Collections
If the buyer and the seller have been worked long enough to build up the trust and a good relationship, they usually will choose a less expensive method then Letters of Credit. Letters of Credit left the obligation of payment execution to the bank, who usually have a high credit worthiness than the buyer's company alone. But the cost of L/C is also on the expensive side. On the contrary, if the seller sees little of risks of the buyer and both parties want to further bring down the cost, they may mutually agree to use Documentary Collections (D/C) then L/C along time. With D/C, the payment obligation falls onto the buyer's side instead of their banks. If for some reason the buyer chooses not to pay although the seller has provided all the documentation to the bank, the buyer's bank does not have the obligation to pay the seller and the seller may have to bear the loss alone. In that case, the buyer is at default and the seller can only sue the buyer, not the buyer's bank.
Furthermore, there are two forms of Documentary Collections. 1. Sight Draft, which means Documents Against Payment, or simply D/P, which requires the buyer's immediate payment if the seller delivers the required documentation. 2. Time Draft, which means Documents Against Acceptance, or simply D/A, which the payment to the seller will be delayed to a future maturity date that both parties agreed in advance. In the context of D/P, if the buyer doesn't pay, the title of the goods won't transfer to the buyer and the buyer won't receive the goods. So the seller's risk is not getting the money he should collect although the title of goods is still in his name and most likely the goods haven't been shipped and the seller can cancel the shipment immediately. But still, if the same transaction is signed by Letters of Credit, the seller will get the payment from the bank whatsoever. So here, the seller's main risk is the potential added inventory. But in the context of D/A, it's entirely another case scenario. The buyer is required to sign the draft in order to get the documentation required to pick up the goods, but they don't have to pay instantly as the draft hasn't matured. Usually, the maturity date is after the buyer receives the goods and liquidates the goods. If the buyer chooses not to pay on the maturity date, the seller is at risk of not getting any payment at all, unless both parties agree to a new condition that requires the further revision of the conditions. In this circumstance, the D/A term is almost the same as Open Account. The few differences would be the bank still has the obligation to fulfill the process of assisting the payment process to the beneficiary although the bank itself is not responsible to pay out of their pocket when the buyer is at default, nor is the bank obligated to chase the buyer for payment if the buyer refuses to pay. But the advantage of D/A to Open Account is that the seller will get the accepted draft from the buyer, which becomes tangible legal evidence as proof that the buyer owes the money. Although in Open Account payment term, if the buyer chooses not to pay, the evidence of delivery of the goods may still be considered as the evidence that the buyer owes the seller, it may not be as strong as the accepted draft in D/A. And also, if the buyer doesn't pay, it would substantially harm the buyer's credit at the bank because the bank doesn't care the reason causes the buyer not fulfill contractual obligations and the bank may put the buyer on the blacklist or report to other credit bureaus.
Summary
In any case, the bank, as the intermediary party in the delayed payment term, has no obligation to check the quality and the quantity of the goods on behalf of their clients before issuing the payment according to the agreed schedule. So if the bank has the obligation to issue the payment to the seller as long as it collects the required documents, it may not be fair for the buyer to pay before actually seeing or checking the goods. So it's always best for the buyer to hire an independent inspection agent to check the goods at the exporting port before they sign the acceptance as this can minimize the potential risks that may follow on. But on the other side, if the bank has no obligation to remit payment when the buyer defaults, it's also risky for the seller in the event of the buyer doesn't pay. So it's important for the seller to fully evaluate the risks when agreeing to a specific payment term. Also, I can't emphasize enough the importance of signing a legally binding sales contract with adequate protection clauses to both parties because the last thing we want to see is to bring the legal action towards a foreign person or company. Although it can be enforced, it always takes significant time and financial burden on the plaintiff side, and the monetary loss and the extra expenses required to throw into a cross-border lawsuit may not be able to recover or reimbursed in full eventually to the party bears the damage even under such law enforcement.
In the end, we hope this post is helpful no matter if you're a seller or buyer in the trade business. If you have any questions, we're always here to assist you to evaluate your trade needs and help you pick the best payment solution to successfully place or get a purchase order while minimizing your risk. We also have a bunch of selections of escrow services, quality inspection service and other third-party services in a lot of countries, all of which are to assist you and add one more layer of protection should you need at any time. Please do not hesitate to contact us if you need a recommendation or assistance in regards to your trade concerns. At Avero Supplies, we thrive to provide trustworthy and honest trade advice to every one of our clients.
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