For many construction industry professionals, surety bonding presents a challenge. We receive phone calls on a daily basis from clients and prospects alike, many of which have been asked to provide a bond but don’t know where to begin. Although most have experience with license bonds (required to maintain an active license), there is much confusion surrounding surety products. Thus, by writing this article, we hope to provide clarification surrounding the topic. We believe it is extremely important for contractors to understand the basics of surety bonding, and where to turn when help is needed.
First and foremost, it is important to understand the structure of a surety bond, which is a contract among at least three parties, as defined below:
1. The principal – this is the primary party of the contract (in this case the contractor) who will be performing a contractual obligation.
2. The obligee – this is the party who is the recipient of the obligation, and
3. The surety – who ensures that the principal’s obligations will be performed.
If you are a construction professional, there are two categories of bonds that you may come across. The first is a commercial bond (guarantee per the terms of the bond form), such as license/permit and union bonds. As many of you are aware, contractor state license boards across the country require a bond be filed in order to keep an active license. The bond ensures that a construction professional is qualified to do business and will abide by whatever state laws, statutes, ordinances or regulations are required. Further, in states such as California, license bonds are rated primarily on the credit history of the principal. Many question why, but the answer is simple: if the surety pays a claim made against the principal, the principal is required to pay the surety back (think of the bond as collateral). There is no better measure to assess the probability of payback than credit, thus the reason for heavy credit underwriting. If the company entity is a corporation, partnership, or LLC, the owner(s) must personally indemnify the surety, thus taking full responsibility to return monies if a payout is granted.
The second category is a contract surety bond (guarantee a specific contract). These deal with the performance at some or all stages of a construction project. Any federal government construction project that exceeds $100,000 is required to have a performance bond. Such requirements differ between state and local municipalities; in my experience, there are local cities that require contract bonds on projects as low as $20,000.
There are several different types of contract bonds that you should familiarize yourself with prior to entering into a contract. They include:
1. Bid Bonds – A bid bond is due at the time a bid is submitted and provides financial assurance that the bid has been submitted in good faith. In addition, the bid bond ensures that the contractor intends to enter into the contract at the bid price and provide the required performance and payment bonds if awarded the contract. Although the surety may only provide a bid bond at 10% of the amount bid, they underwrite on the total value of the contract, since future performance and payment bonds will be issued if the job is awarded. If the contractor does not proceed at the bid amount, the guarantor (surety) will pay the obligee the difference between the contractor’s bid and the next lowest bidder. Once paid, the surety will recover the payment amount from the contract.
Similar to license bonds, a bid bond is underwritten based upon the principal’s (and owner(s) if a corporation, partnership or LLC) credit, since payments against the bond are recovered. Furthermore, underwriting becomes more complex as contract values (or bid contract values) increase. In many cases, surety companies offer “express”, and “easy” underwriting procedures for contract values equal to or under $300,000. Most max out around $200,000, and some as low as $100,000. Once such levels are met, additional information is needed for bond approval. Such documents include personal and business financial statements (some CPA prepared), complete long length applications, verification of cash on hand, credit line/investment account information, work is progress reports, references, resumes, and even set aside statements / additional collateral. Most sureties do not charge for a bid bond, but it is becoming more frequent that they do.
2. Performance Bonds – Once a project is awarded (in many cases to the low bidder), a performance bond is issued. These bonds protect the owner (obligee) from financial loss should the contractor fail to perform the contract in accordance with its terms and conditions. By issuing a bid bond, a surety is generally guaranteeing that the principal (contractor) can secure a performance bond, as long as the bid amount is close in value as initially underwritten. At this stage of the process, a premium is due and may range from .5% (higher valued contracts) to 4% (smaller contracts). In order to issue the performance bond, along with the payment bond (described below), the surety will ask for bid results and a copy of the final contract.
3. Payment Bonds – This bond comes together with the performance bond, and in some cases is referred to as a labor and material bond. The payment bond guarantees that the contractor will pay certain subcontractors, laborers, and material suppliers associated with the project. The premium for such bonds is included in the cost of the performance bond; there is not a separate price associated with payment bonds.
4. Maintenance Bonds – Maintenance bonds are not as commonly required but normally guarantee against defective workmanship or materials for a specified period.
5. Subdivision Bonds – A subdivision bond guarantees that a developer, builder and/or individual landowner will complete improvements made to a subdivision property. This bond, required by cities, counties or states, usually guarantees that improvements will be made at the expense of the developer and principal of the bond. Such improvements include streets, sidewalks, curbs, gutters, sewers and drainage systems.
Although you may come across other types of bonds, those explained above are most prevalent within the construction industry. As economic conditions continue to change, I have witnessed many construction companies shift into bidding new types of projects. For these companies, and many others, surety bonding will impact growth and overall success. It is important that you look into bonding before you decide to bid projects, as you may spend valuable time and resources before knowing your bonding capacity.
License bonds are, in most cases, a quick and easy underwriting process. Within a few minutes, we are able to offer multiple options, with various years and payment plans. You may even find it convenient to price your license bond here. If the premium seems out-of-line, give us a call, as we are happy to seek additional options.
Contract bonds, on the other hand, can be more complicated. Call us in advance, before you bid projects. By doing so, we will determine what contract values are realistic targets for your company, and will customize a bonding program to meet your needs. Depending upon your credit, experience, and levels of assets your bonding capacity could be much different than anticipated.