Construction projects are complex. Ane tool that can be a lever for owners, lenders, and investors are contract bonds. They can also be used between any contractor and his lower tier subs. What is a surety bond?
A surety bond is an agreement between three parties:
- The Principal – The contractor responsible for completing the project.
- The Obligee – The project owner or entity requiring the bond.
- The Surety – The company that guarantees the contractor’s performance.
Surety bonds function as a financial safeguard (for the owner), ensuring that contractors fulfill their contractual obligations. If a contractor fails to meet their responsibilities, the surety steps in to compensate the obligee or ensure project completion. In simple terms, a surety bonding program is a form of credit. It is best to seek credit opportunities in good times. The contractor agrees to reimburse the surety for claims that are paid by the surety.
Types of Surety Bonds in Construction
- Bid Bonds – Ensure that contractors submit serious bids and will enter into a contract if awarded the project.
- Performance Bonds – Guarantee that the contractor will complete the project according to the contract terms.
- Payment Bonds – Ensure that subcontractors, suppliers, and laborers are paid for their work.
- Maintenance Bonds (also known as Warranty Bonds) – Provide a warranty on workmanship for a specified period after project completion.
Why Are Surety Bonds Important?
Surety bonds provide several benefits to the construction industry:
- Financial Protection – They safeguard project owners from financial losses due to contractor default. It is important to know that the protection is for the owner and not the contractor.
- Risk Mitigation – Contractors undergo financial and performance evaluations before obtaining a bond, reducing the risk of project failure. Owners can have great confidence in the ability of the contractor to complete the work.
- Legal and Contractual Compliance – Many public and private projects require surety bonds to meet regulatory requirements. We see bond requests more frequently on private projects and from general contractors from subcontractors.
- Trust & Credibility – Contractors with surety bonds demonstrate reliability and professionalism, making them more competitive in the industry.
Factors Influencing the Availability of Construction Surety Bonds
Sureties evaluate the following items to determine what credit they will afford:
- Financial health: Your financial condition determines what a surety will offer.
- Experience and Reputation: Sureties check references and your history of performing similar work. Your reputation is the most important intangible in surety underwriting. Do you complete your work on time and to the satisfaction of your customers? Have you previously done a job of this size and scale?
- Project complexity and risk: The project’s size, scope, and complexity influence bond availability. Does the project have unusual risks, such as environmental hazards?
- Market conditions: The overall surety bond market conditions may have an impact. In a competitive market with ample capacity, bond capacity may be higher. At the moment, sureties are eager to write bonds to diversify the overall risk profile of most insurance companies’ books of business.
Pros of Surety Bonds for Contractors
Surety bonds offer limited advantages for contractors but are a necessary tool for projects that require them. Here is how bonds can help contractors:
- Enhanced credibility and reputation: A contractor’s ability to post a bond for a given project speaks to a firm’s quality and reputation.
- Competitive edge: Surety bonds are often a requirement for bidding on more extensive and complex projects. Possessing ample surety capacity allows a contractor to increase their project opportunities and secure potentially lucrative contracts through their ability to bond new work.
Surety bonds are not without risks or costs:
- Potential financial liability- A bonded contractor will face financial liability when a bond claim is made against them. Due to the nature of the surety relationship, the contractor indemnifies the surety for any losses incurred.
- Time for the underwriting process- Sureties want access to all of your financial records and will usually require financial statements to be prepared by a CPA. They will check your references and reputation. You should evaluate whether this investment of time will generate good business opportunities or if it is a distraction from your core work
Important Concepts for Contractors
Financial strength: Surety bonds are a form of credit. Sureties focus on the financial strength of the contractor. Poor project management, bad estimating, and bad luck can deplete a contractor’s capital. This can happen quickly, leaving both the contractor and its surety in a dangerous spot. Have a plan to preserve cash.
- Have good contracts: Evaluate and negotiate your contract before signing it. Have your attorneys and insurance brokers review the contract. Demond a clear scope of work, adequate time, negotiate reasonable indemnity and insurance terms, have a fair dispute resolution provision, and look to include special clauses, such as escalation clauses.
- Over-extension of contractor: Do you have the resources to complete the work on time and on budget? Do you have the experience needed? Do you have the right partners to complete the project? Follow a disciplined go/no go process.
Document, document, document
- Change orders: Document all changes in writing promptly and with clarity.
- Project progress: Keep detailed records of project progress through daily logs and time-stamped photos. This documentation can be invaluable in supporting claims and resolving disputes.
- Financial information: Keep accurate financial records for your projects and overall. Document for pay applications, purchase orders, invoices, receipts, proof of payment, and releases. They will also be an important part of your CPA statement and your surety’s underwriting analysis.
- Create paper trails: Communicate in writing. Summarize conversations with emails. A paper trail protects your interests by creating evidence for disputes.
- Emphasize a culture of safety: Prioritize safety on your projects and document all safety efforts, including training, meetings, and incident reports. A strong safety record will mitigate risks, reduce operating costs, and protect your reputation.
Choose the Right Surety Partner
Select a surety broker with a solid reputation and who understands your industry and your business. You need an advisor whom you trust explicitly, who is willing to provide tough advice, and who will be your advocate. Ensure that the broker represents quality sureties with financial strength. Your surety should have a good reputation, strong financials, shown underwriting consistency, and be able to offer you the surety program you need. Work with people who manage the process with the skill that you put into your work.