If you want to become a construction contractor or are already operating within the industry, you will likely encounter surety bonds.
Depending on your state and the size of the projects you intend to complete, you might be required to secure a contractor license bond before you can obtain a contractor’s license. Several other common types of surety bonds might be required before you can perform work on public or private projects. Since surety bonds are especially prevalent in the construction industry, it is important to understand them and why they are important to you as a construction contractor.
What Are Surety Bonds?
A surety bond is a legal agreement through which the work and legal compliance of a contractor are guaranteed. The following parties are involved in a contractor bond:
- Principal — The contractor who must get a bond to perform work on a project or obtain a license.
- Obligee — The public entity or private party that requires the contractor to be bonded.
- Surety — The bonding company that guarantees the contractor’s performance and compliance with the law by issuing a bond.
Many people confuse surety bonds with insurance. However, there are distinct differences.
Surety bonds do not provide liability coverage to the bondholders. Instead, they protect the obligee and the parties with whom the contractor does business against the contractor’s potential misconduct.
When you purchase a contractor bond, the surety will require you to sign an indemnity agreement through which you will hold the bond company harmless in the event of claims against your bond.
If you break the law, fail to perform according to your contract or engage in other misconduct, a claim can be filed against your bond by the government or the party you have harmed.
When a bond claim is filed, the bonding company will investigate to determine its validity. If it determines the claim is valid, the surety will pay the claim up to the bond’s face value. However, you will have to repay the surety in full for all amounts paid on your behalf or face legal action.
Types of Bonds Used in Construction Projects
There are many different types of construction bonds that you might encounter as a construction contractor. These are the most common types:
- Contractor license bond — A bond required as a licensing condition by a state’s licensing body before a contractor’s license will be issued.
- Bid bond — A construction bond required by governmental entities for projects worth more than a threshold amount before a contractor can bid on a project.
- Performance bond — A construction bond that can be required by governmental entities for contractors on projects worth more than a threshold amount or by private project owners to guarantee the contractor’s performance of the contractual duties.
- Payment bond — A construction bond that might be required by project owners that guarantees the contractor will pay suppliers and subcontractors for their work on a project.
While not all states require contractor license bonds, many do. These are bonds that must be purchased as a licensing condition before contractors can secure licenses to operate in those jurisdictions. Even if a state doesn’t require contractor licensing, some counties or municipalities might have their own licensing and bonding requirements.
Under the Miller Act, contractors that want to perform work on public projects valued at $100,000 or more are required to secure bid bonds, performance bonds and payment bonds. Bid bonds guarantee that the contractor with the winning bid will follow through with the project even if they forget to include something in their bid or learn that others submitted substantially higher bids for the same work.
Performance bonds serve as a guarantee of the contractor’s performance of their contractual obligations and help protect project owners against risk. If a contractor fails to perform under the contract, the project owner can file a claim against the bond instead of incurring significant losses caused by the nonperformance.
Payment bonds help protect project owners against potential mechanic’s liens that subcontractors and suppliers might otherwise file against their property when a general contractor fails to pay them for their work.
They also protect subcontractors and suppliers by guaranteeing they will be paid on time. If a contractor fails to pay, the subcontractors and suppliers can file claims against the contractor’s payment bond to secure payment.
Why Contractors Need Surety Bonds
Surety bonds are required to protect project owners and the public against a contractor’s potential misconduct or legal violations. As a contractor, you might view a surety bond as a cost of doing business. You might need surety bonds to obtain a license so that you can operate your business. In some cases, getting a contractor license bond is necessary if you want to perform work worth more than a minimal amount.
Construction bonds, including bid bonds, performance bonds and payment bonds, will be required before you can perform work on federal projects worth more than $100,000.
Many states have similar laws that require these types of bonds for work on state projects worth more than a threshold amount.
Many private project owners also require performance and payment bonds before they will agree to do business with contractors. Getting bonded serves as a prequalification and demonstrates that your business is stable and law-abiding, which can help you expand your business and work on successively bigger and more valuable projects.
How to Obtain a Surety Bond
To get a surety bond, you will first need to identify the types of bonds that you need. You can then submit an application for the bonds you need to a surety company. The company will want to learn more about your business and experience before it will approve your application. As a result, you will likely need to submit additional documents to support your application, including the following:
- Audited financial statement
- Business and personal tax returns
- Profit and loss statements
- Business structure and organization documents
- Resumes of the shareholders
- Bank letter of reference
- References from suppliers and subcontractors with whom you have done business in the past
Once you have submitted your application and supporting documents, your application will be sent through an underwriting process. The surety will evaluate your credit, experience and reputation, among other factors. If it decides that you pose a minimal risk, you will likely receive a low premium quote. You won’t have to pay the entire face value of the bond. Instead, you will have to pay a bond premium, which is a small percentage of the total bond amount. With good credit and experience, you might have to pay as little as 1% to secure your bond. If you have bad credit, however, your application might be denied, or you might have to pay as much as 10% to purchase your bond.
Because surety bonds are commonly required in the construction industry, you need to understand how they work and why they are required. While getting a surety bond might seem like one additional cost to add to your list of expenses, being bonded might expand your business opportunities and may be a requirement before you can legally operate your business.