Betting your Business
It’s unfortunate, but we regularly work with construction companies that have unintentionally bet their business. They do this by taking on risk where they didn’t expect. We work together to develop a plan to manage or mitigate risk on construction projects. This is done by a risk assessment as well as determining the most fiscally responsible option that ensures timely project completion, which is critical to a successful project - and a sound business. Instead of betting on a contractor (or subcontractor) who does not have the requisite level of commitment or financial stability creates risk because they could easily become bankrupt part way into the job – or not pay their subcontractors. Either way, the effects can be devastating to your bottom line. A common solution is surety bonds as they offer a great solution - providing financial security and construction assurance. The surety bonds provide assurance to the project owners that all contractors will perform the work and pay specified subcontractors, laborers, and material suppliers.
The top ten things to know about surety bonds:
1. About Surety Bonds.
A surety bond is a three-party agreement where the surety company assures the owner (called the obligee) that the contractor (or principal) will perform according to the terms of the contract. Many times, these are known as contract surety bonds.
The term surety bonds (or contract surety bonds) really covers a whole bunch of different types of bonds. These include such things as performance bonds, payment bonds, bid bonds and other bonds.
2. There are three main types of surety bonds.
The first is a bid bond. A bid bond provides financial assurance that any bid by the contractor has been submitted in good faith and that the contractor will perform according to the terms of the contract at the price indicated. They also will provide the required payment and performance bonds. The performance bond protects the project owner from a financial loss if the contractor fails to perform according to the contract’s terms and conditions. A payment bond gives assurance that the contractor will pay its subcontractors, or workers, and materials suppliers.
A performance bond is pretty standard in the construction industry and they are typically requested by the client. The client (owner) requires that a performance bond be posted so that they have some assurance that the project (or in case of a subcontractor, their piece of the project) gets completed. A performance bond is standard on a public works project.
A payment bond is very simple: a contractor gets a bond to ensure that the materials and subcontractors get paid. An owner really dislikes having the general contractor default (after being paid, of course) and then have to pay the subs and material vendors. This double-payment is not only costly, but also brings the project to a standstill as liens get filed and lawyers are involved.
3. About surety bond companies.
Large insurance companies have, as a subsidiary, a division that creates and sells surety bonds. The insurance companies use their historical knowledge of risk and actuarial knowledge to create surety bonds and pricing that reflect that knowledge. Unlike their traditional model, surety bonds are not created to compensate against unforeseen loss, but to prevent loss (this is one reason that the premiums are so low). So, surety bond companies prequalify each contractor or subcontractor based on their financial strength and expertise in the business. Each bond company uses a slightly different model to quantify the financial strength of the contractor. A good surety bond broker (think Swiftbonds) knows each surety bond company’s model and tailors the bond application and financial information to find the right company to write the surety bond.
Shameless plug: How do we know which companies to work with? It’s really simple (but not easy). We spend a lot of time getting to know the different surety bond companies. We deal with them and their formulas. We know which ones like credit scores, which ones like tangible net worth, which ones like cash flow and which ones like personal guaranties. We know how to work with the financial statements to provide the different companies with something that fits their formula. In essence, we work hard at this. You should worry about your business – not your bond or broker.
4. Government jobs.
The US government, since 1893, has called for contractors on federal public jobs deals to get surety bonds to guarantee that they will perform according to the contract terms as well as pay their subcontractors and suppliers. This regulation is referred to as the Miller Act, and requires a contractor on a government project to put up two bonds on deals surpassing $100,000: a performance bond and a labor and material payment bond. A corporate surety company issuing these bonds has to be listed as a certified surety on the Treasury Listing. Additionally, nearly every state, commonwealth, and the majority of community legal systems have passed similar regulations needing surety bonds on public jobs. These usually are referred to as "Little Miller Acts." Lately, private owners have also learned to handle additional risk by calling for surety bonds.
Ok, so why does it seem like everyone is trying to get their contractor/subcontractor bonded? It’s really a matter of risk. You see, in the last several years, a lot of long-time contractors have defaulted (or really slowed down their payments, which is almost as bad). Further, there is much more unforeseen risk, or perceived unforeseen risk, that the owner has to deal with. Because the owner is typically dealing with a bank (or investor) that is more skittish, they have to try and mitigate that risk. . Thus, they require more bonds.
The Detroit bankruptcy is a great example of unforeseen risk. Many contractors are not getting paid. Many contractors have completed work, they’ve paid their workers and are not out. Even those that will get paid are not getting paid timely. How long can you go without receiving payment on your contracts? This is just one example of loss. Many contractors have gone under not because they don’t get paid, but because they aren’t getting paid timely. So, the owners/investors/banks are trying to mitigate this risk by getting their contractors bonded.
5. Construction
Construction; risk is thy name. There is a telling statistic out there - of 853,000 contractors in business in 2002 only 610,000 were still in business in 2004 – that’s a whopping 28.5% failure rate. And don’t forget – those were the boom years.
That’s why there are surety bonds on all sorts of projects. Surety bonds offer assurance that the contractor is capable of completing the contract on time, on budget, and according to specs. When there is a surety bond in place, there is a smaller chance of default. Also, and just as importantly, the owner has some peace of mind that a sound risk transfer mechanism is in place. This way, the owner believes that the burden of construction risk has been shifted from it to the surety company.
That’s why there are surety bonds on all sorts of projects. Surety bonds offer assurance that the contractor is capable of completing the contract on time, on budget, and according to specs. When there is a surety bond in place, there is a smaller chance of default. Also, and just as importantly, the owner has some peace of mind that a sound risk transfer mechanism is in place. This way, the owner believes that the burden of construction risk has been shifted from it to the surety company.
6. Surety bond pricing.
The prices that companies charge for surety bond premiums can vary widely from one surety company to another. These prices tend to range from one-half of one percent to three percent of the contract amount. The price depends on the size, type and duration of the project as well as the perceived financial stability of the contractor.
For a bid bond, there is generally only a nominal charge, if there is one at all. The normal percentage fee is for the final bond, whether it be a performance bond, payment bond or maintenance bond. In many cases, a performance bond is written so that it includes payment bond or maintenance bond provisions.
A bond company is really looking at three things when they determine price (see below for more on underwriting): Credit worthiness; Capacity and Character. Credit - each bond company wants to know that you pay your bills on time and that you have created a consistent system of managing your projects. Incredible growth sounds great (and it is!), but what a bond company really wants to know is that your assets are greater than your debts and that you’re A/P is stable (look at your current ratio). Capacity – another thing that is import is your ability to take on new work. We’ve all seen those companies that go out and get a ton of work, cannot perform, and then go under. Character – this sounds like fluff, but it is really the most important piece. We’ve spoken with a ton of companies that say things like (we’re paraphrasing here): “we don’t really care about the company or contract, what we really care about is the person behind it all. If they are good, then we don’t have much to worry about. But if they aren’t good, then this won’t work – even if the contract is golden.”
7. Underwriting.
The surety company spends a lot of time underwriting (that is, assessing the risk) of each contractor. The owner of a projects appreciates this (in addition to the bond, of course) as it provides assurance that the contractor will finish the job. The lender to the owner and everyone else associated with the project is also assured that the contractor is able to translate the project's plans into a finished project. Most surety bond companies have been around for many generations. Their experience, expertise, and scrutiny in qualifying contractors is one of a bond's most valuable attributes. That is because a surety company satisfies itself that the contractor has:
the ability to meet current and future obligations;
experience matching the contract requirements;
the necessary equipment to do the work or the ability to obtain it;
a good reputation;
the financial strength to support the desired work program;
an excellent credit history; and
an established bank relationship and line of credit.
Shameless plug: this is where Swiftbonds really shines. We try and take the time to put our clients into the proper surety bond company underwriting process – not the one with the highest fee. So, we take into account your information and then determine who gets that information to get you a bid. We are able to do this efficiently (see our 2 hours or less! Application) as we are the experts in this area. Full disclosure: we don’t always get our clients a bond. We’ll try our hardest and work with everyone we can find, but sometimes we fail. Here’s what we promise, though: we’ll work like crazy trying to get you a bond.
8. Contractor Default.
Sometimes, a contractor defaults on their obligation to finish a job. It’s unfortunate, but it does happen. When a contractor defaults, the owner must formally declare, in writing, that the contractor cannot finish the job. The next step involves the surety, as they must conduct an impartial investigation before settling any claim.
The requirement of a formal default is that it protects the contractor. The contractor needs to know that they cannot be easily defaulted or improperly defaulted by the owner. When a default is proper, the surety has to live by the requirements within the bond contract. These options include such things as the ability to re-bid the job and find another firm to complete the job, hire another contractor as a replacement, or provide technical and/or financial help to the current contractor. Finally, they could just pay the bond.
Surety companies have paid over $9 billion due to contractor failure on bonded projects since 1992, according to The Surety & Fidelity Association of America, Washington, D.C.
9. Contractual Requirements.
Many times, a bond is required as a part of the bidding process. When a bond is required in the contract documents, it is the contractor's responsibility to obtain them. Most contractors include the bond premium amount in the bid and the premium generally is payable upon execution of the bond. Sometimes, the contract amount changes and the premium is adjusted for the change in contract price. These contract surety bonds should not be viewed as a cost, but instead as a wise investment — providing qualified contractors and protecting public owners, private owners, and prime contractors from the potentially devastating expense of contractor and subcontractor failure.
10. Bonds are a great idea to reduce risk!
After analyzing the risks involved with a construction project, consider how surety bonds protect against those risks. Owners, lenders, taxpayers, contractors, and subcontractors are protected because: the contractor has undergone a rigorous prequalification process and is judged capable of fulfilling the obligations of the contract;
Contractors are more likely to complete bonded projects than non-bonded projects since the surety company may require personal or corporate indemnity from the contractor;
Subcontractors have no need to file mechanics' liens on private projects when a payment bond is in place;
Bonding capacity can help a contractor or subcontractor grow by increasing project opportunities and providing the benefits of assistance and advice of the surety bond producer and underwriter;
Surety companies may prevent default by offering technical, financial, or management assistance to a contractor; and
The surety company fulfills the contract in the event of contractor default.
Conclusion. So, please take a minute to review your company and see whether you have any problems with getting or keeping a surety bond. Just remember, a little bit of planning in the beginning is much better than a lot of panic at the end.
Gary Swiftbonds | Our short bio
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