What is a Surety Bond?
In order to understand why you need a bond, we have to start with what is a bond. Bonds are essentially a product, similar to a guarantee that helps to transfer risk and mitigate risk for parties in business dealings. There’s all sorts of types of bonds out there, but the most common bonds you will most likely run into on a day to day basis are typically payment bonds and performance bonds.
What are payment and performance bonds?
Let’s start with the performance bond. A performance bond is a bond that guarantees the performance of some underlying obligation. A payment bond doesn’t necessarily guarantee a performance of an obligation, it guarantees payment. Usually payment and performance bonds partnership together, people will obtain both a payment and performance bond.
What do bonds cost?
The first question everybody asks is how much do they cost and who pays for them. Performance and payment bonds are typically factored into the cost of the overall project. If it’s a hotel being built, the overall construction budget for the hotel would include the costs for the bonds. They can cost anywhere from 1% to 3%, and even beyond, of the overall contract price.
How does one typically qualify in order to be able to get a bond?
Bonds usually go through the same process as you would for obtaining financing or credit – the three C’s: character capacity and credit. Before a surety is going to write you a bond, that surety is going to look at your character.
- Are you a good person?
- Do you have a criminal record?
- Have you been in business for a long time?
- Capacity: Do you have the capacity for the underlying obligation?
- Can you undertake it?
- Is it too aggressive?
- Are you a little bit over your skills for that project?
They are going to look at your business operations, how much backlog you have. Are you paying your bills, things of that nature when it comes to your character plus capacity. And then number three, of course is credit. Do you have good credit? Most charities will run your credit to make sure that you don’t have bankruptcies, foreclosures, tax liens, things of that nature to qualify.
Keep in mind that once you sign up for that bond, it’s likely going to be guaranteed by personal indemnity. A lot of people don’t realize that bonds are a personal guarantee through the bond underwriting process.
It is very important, if you’re going to obtain a bond, to actually read the bonds themselves to understand what is in those bonds. A lot of times bonds contain what they call conditions precede, which are certain things that must be satisfied before the bond can be called on.
What are alternatives if I don’t qualify or if I don’t meet the three C’s?
Typical alternatives to bonds would be to guarantee that payment of performance, some form of security, could be cash. Anytime you could put cash in an escrow account, your customer may accept that in lieu of a bond collateral. Another one in the banking arena is letters of credit. Can you qualify for a letter of credit? Can you call your bank and satisfy the banking requirements for a letter of credit? If you can do that a bond may be unnecessary. If you can’t get any of those, another option in lieu of a bond would be to personally guarantee the contract. Typically, we do not recommend that. We don’t want corporate debts and obligations to become personal debts and obligations of yours. But we have seen situations in which in lieu of a bond customer will accept a personal guarantee from their other customer on the underlying contract in replacement of a bond because they cannot qualify for a payment and performance bonds.
In closing, what do all of these products, the cash, the collateral, the letters of credit, the personal guarantees, all have in common? They are again, risk mitigation, risk avoidance tools, just like a bond. So it’s very, very important that as your understanding suretyship and understanding bonds and what it takes to get a bond to qualify for a bond that you look at the wide and broad spectrum of products out there that can serve the need for mitigating or transferring that risk downstream to ensure that you have a successful underlying contract.