If you want to be a contractor, being licensed and bonded will have a major impact on your ability to work in the city and state where you live and work. Many state and local governments require that contractors who perform work above a threshold amount obtain licenses. One of the key requirements for licensing is to purchase a surety bond. If you learn that you need to purchase a surety bond to work as a contractor or to enter into a contract to perform work on a project, here is some information you should know about surety bonds and how they work for contractors.
What Are Surety Bonds?
Surety bonds are financial guarantees that are issued to ensure the individual or company who obtains the bond will perform work in a legally compliant manner and will avoid fraud and misconduct. A surety bond is a contract between the following three parties:
• Principal – The construction company or individual seeking the bond
• Surety – The bonding company that guarantees the principal’s ethical operations and legal compliance by issuing the bond
• Obligee – The government agency or project owner requiring the bond
If the principal’s bond application is approved, the surety company will require the principal to sign an indemnity agreement before it will issue the bond. The indemnity agreement provides that the principal will hold the surety harmless if a claim is filed against the bond. This means that while the surety company will pay a valid claimant up to the bond’s maximum amount for the claimant’s losses, the principal is legally obligated to repay the bond company in full for any amounts it has paid.
As an alternative to surety bonds, some licensing agencies allow contractors to put up the entire bond amount as security. However, most contractors instead choose to purchase surety bonds so that they won’t have to tie up so much money. For example, if you’re required to either post a $20,000 surety bond or the full amount in cash, you likely don’t want to have that much money tied up when you could instead use it for other business purposes.
There are many categories of surety bonds you will likely encounter as a contractor, including construction bonds and contract bonds. A construction bond is a type of surety bond that is required for you to legally work in specific cities or states. Depending on the licensing and permitting requirements of the licensing body, you might need bonds for each state or city in which you perform work.
For example, you might be required by one city to post a $20,000 bond as a general contractor to perform work on a project in the city’s jurisdiction. A second city might require you to post a $15,000 bond to perform work in the second city’s jurisdiction. If you want to work on projects in both locations, you would need to purchase the bonds required by each.
The second category of bonds you will likely encounter as a contractor is contract bonds. These are bonds required for you to work or bid on specific projects and include bid bonds, performance bonds, and payment bonds. The state or federal government might require you to post a bid bond before you can submit a bid to work on a public project. The bid bond serves as a guarantee that you will follow through and complete the contract at your bid price if you are awarded the contract.
A performance bond guarantees that you will perform work according to the provisions of your contract. Finally, a payment bond guarantees that you will pay your subcontractors and suppliers for their work and helps to protect the project owner by preventing subcontractors and suppliers from filing mechanic’s liens against the property’s title. Contract bonds are issued on a contract-by-contract basis and can be required by the project owner. You will need new contract bonds for each separate project on which you perform work if required by the project owner.
You can’t transfer surety bonds. When you obtain a surety bond, it is issued to guarantee your work for that specific bond. You can’t add additional obligations to an existing bond and must instead purchase a new bond for new obligations.
Are Surety Bonds Insurance?
While many contractors confuse surety bonds and insurance, they are different. Surety bonds do not protect you against liability. Instead, your surety bond will protect the government or private project owner that requires you to purchase the bond. If a bond claim is filed because of your legal or ethical violations, you will be liable for paying the surety up to the maximum bond amount. If you fail to pay a valid bond claim, the surety can pursue legal action against you to recover all of the money it paid on the claim as well as the surety’s legal costs.
The Bonding Process
To obtain a surety bond, you can go through a surety company and submit an application. The company will ask for some additional documents so that it can evaluate you and your business to determine your level of risk during an underwriting process. Some of the factors the underwriter will consider include the following:
• Your personal and business credit
• Your company’s available working capital
• Your experience handling projects of a similar size
• Any past misconduct or legal violations
• Your character and reputation
Your bond application will require you to undergo a credit check and an examination of your financials. If the surety company determines that you pose a low risk, you will likely receive a low premium quote. For contractors with excellent credit and strong experience, the bond premium can be as little as 1% of the bond’s face value. By contrast, if you have bad credit and a spotty history, you might be denied or have to pay a high percentage upfront of up to 10% to 15% to secure your bond.
The bonding process for getting a surety bond involves the following six steps:
1. Find out from the obligee about the type of bond you must get.
2. Contact a surety company and submit a bond application together with your financial documents.
3. Receive a free bond quote and determine whether to accept it.
4. Pay the bond premium to the surety company.
5. Sign the indemnity agreement.
6. File the bond documents with the government agency or project owner that required the bond.
While a surety bond might seem like just one more expense to add to your list, being bonded and licensed might expand your opportunities to contract and perform work on projects of a higher value. Once you purchase a bond, make sure to comply with the law and your contractual obligations to avoid potential bond claims.