Businesses and organizations need a way to ensure that the vendors and contractors they hire to complete a job meet all obligations. Surety bonds can help. These legally enforceable guarantees allow one party to recoup payment if another party doesn’t fulfill a contract’s requirements. For example, a contractor may get a surety bond when bidding for a job to reassure a client that they’ll stick to their commitments and obligations.
We’ll explain more about surety bonds, their types and how small business owners can access and utilize these helpful tools to win contracts.
What are surety bonds?
Surety bonds are legally enforceable three-party written agreements that guarantee compliance, payment or performance.
Surety bonds help small businesses win contracts by providing the customer with a guarantee that the company they’re hiring will complete the work. Many public and private contracts only permit businesses with surety bonds to tender proposals.
A surety bond’s three parties
A surety bond involves three main parties:
Principal: The principal purchases a surety bond to guarantee they’ll fulfill an obligation for compliance, payment or performance.
Obligee: The obligee is the party that requires the principal to buy the surety bond to guarantee the obligation’s fulfillment. The obligee is typically the principal’s client or customer. It could also be a court or a local, state or federal government organization.
Surety: The business insurance company or surety company acts as a neutral third party in the transaction. The surety guarantees that the principal will perform the obligation and sends a bond certificate to the obligee. If the principal fails to deliver and the obligee files a claim that is deemed valid, the surety company will pay out the claim to the obligee.
How surety bonds work
While various surety bond types exist, here’s a typical scenario of how they work:
A neutral third party (the surety), acting as the bond’s issuer, guarantees that one party (the principal) will perform the terms of the contract for the other party (the obligee).
If the principal doesn’t fulfill the obligation, the obligee can file an insurance claim. If the claim is deemed valid, the surety will pay damages and the principal will repay the surety.
Besides surety bonds, contractors should ensure they choose business insurance that protects their interests, including contractor insurance policies.
Bid bonds: Bid bonds guarantee that a contractor has submitted a bid in good faith, will honor the bid’s terms and will provide the required performance. Bid bonds are usually 5, 10 or 20 percent of the amount bid. Bid bonds prevent contractors from submitting low bids to get a job and then raising their prices.
Performance bonds: Performance bonds protect a business owner from financial loss if the contractor fails to perform the contract in accordance with its terms and conditions, including its specifications and plans.
Payment bonds: A payment surety bond guarantee ensures the contractor will pay specified subcontractors, laborers and material suppliers associated with the project.
Did You Know?
Builder’s risk insurance and performance bonds have much in common. Builder’s risk insurance covers losses and damage during a construction, remodeling or installation project.
Other surety bonds
Other surety bonds may be used in small business projects and operations, including the following:
License bonds(permit bonds): Local and state governments often require license bonds when a contractor or business offers a service to the public. This bond guarantees the business owner will conduct their business in compliance with all local, state and federal regulations. Typically, license bond costs are 1 percent of the total bond amount.
Construction bonds: A construction bond or contractor license bond, is a type of license bond required to start a construction project. It provides assurance that the contractor will perform in accordance with the construction agreement.
Completion bonds: Completion bonds offer assurance that a contractor will complete a project on time, within budget and free of liens. Otherwise, a claim can be filed to compensate the obligee.
Payment bonds: Payment bonds guarantee that the principal will pay for all associated work in connection with the contract, including subcontractors and all required materials and supplies.
Ancillary bonds: Ancillary bonds guarantee that the principal stands by their work and will provide maintenance or corrections in a timely manner.
Maintenance bonds: Maintenance bonds guarantee a contractor will maintain a project to its agreed standards and specifications for a predetermined time following completion.
Fidelity bonds: Sometimes called Employee Dishonesty Bonds, these protect businesses from losses caused by employee fraud or theft. They’re most commonly used by businesses that handle cash and valuable assets.
Customs bonds: Businesses importing goods into the United States can take out a one-time bond for a single shipment or a continuous bond if they import goods regularly. These bonds guarantee that all due fees, taxes and duties relating to imported items will be paid to the government.
Utility bonds: If your business is in a specific location or consumes high levels of electricity or gas, your supplier may require you to have a utility bond as a guarantee that you’ll pay the bills.
After a principal buys a bond, the insurance company doesn’t assume the risk. In contrast, the principal holds all the risk and must repay the surety if it doesn’t fulfill the agreement.
Who needs a surety bond?
Various small business types deal with surety bonds. For example, a construction business may deal with surety bonds that enforce construction terms.
Generally, any business that works under a contractual agreement with another party or provides a public service, could be required by the obligee to obtain a surety bond.
The following surety bonds are often used within professional industries to meet specific obligations:
Auto dealer license surety bonds
Real estate broker surety bonds
Credit repair service surety bonds
Mortgage broker and loan originator license surety bonds
Public insurance adjuster license surety bonds
How much do surety bonds cost?
Although prices vary, the surety bond’s premium is usually a percentage of the bond’s coverage amount. Once underwriters review your application, they’ll assign it a risk category with an associated premium amount.
Several factors determine the final premium amount:
Several bond providers note that quoted contract bond rates usually reflect the bond’s size and the contractor’s financial stability, experience and reputation. Typically, contract bonds cost between 1 and 15 percent of the contracted amount. They may also be tiered based on the size of the bond.
The coverage level provided by commercial license and permit bonds ranges between $5,000 and $100,000. For contract surety bonds, the range is different and depends on the size of the construction project. You can expect between $50,000 and several million dollars. Surety bond requirements are greatest in Texas, California and Florida.
How do you find a surety provider?
Here are a couple of options if you’re seeking a surety provider:
National Association of Surety Bond Producers (NASBP): To help you find a surety provider, the NASPB offers the online Surety Pro Locator, where you select your state or country to find bond producers near you.
Small Business Administration (SBA): The SBA offers a Surety Bond guarantee program to help small businesses secure the bonds some jobs require (including bid, performance, payment and ancillary bonds). Similar to how the SBA partners with banks and credit unions to help small businesses get loans, the SBA partners with authorized surety companies to provide sureties to SMBs. It guarantees a portion of the bond to reduce risk to the issuer. To qualify, businesses must meet the SBA’s definition of an SMB and the contract should be no more than $6.5 million for non-federal contracts and $10 million for federal contracts.
Consider any potential surety bond provider’s financial health before purchasing. A surety bond provider without a robust financial base may struggle to meet its obligations. This situation could lead to missed or delayed payments that expose your business to financial liabilities and business lawsuits.
Surety bond FAQ
The time it takes to get a surety bond depends on the entity providing it. If time is of the essence, an online provider might be better. Online providers offer streamlined applications and can provide quotes faster and approve them on the same day if you complete the documentation quickly enough. You may even receive your surety bond as soon as the following day.
Tip: When applying for a surety bond, know what bond the obligee requires, its business name and the names and addresses of all parties in the agreement. Also, ensure you have your Social Security number on hand.
A surety bond’s validity period depends on the specific bond needed. Many surety bonds have a set term with an expiration date, which can be renewed for another term with a reevaluation of the principal and credit risk. This structure is typical for surety bonds needed for professional licenses or permits.
Typically, the set period ranges from one- to two-year terms for these bonds and the premium could increase or decrease upon reevaluation.
With contract bonds, the principal must renew the bond until the obligee releases it, usually at the job’s satisfactory completion. Upon renewal, there’s generally no reevaluation of the principal. During renewal, the principal must pay the premium or the account could end up in a collections process. After the bond is renewed, it’s active for 12 months.
Unlike insurance policies, surety bonds do not cover or protect the principal or purchaser of a bond.
Many insurance policies provide first-party protection to meet costs you incur and third-party protection to meet costs your client or the other party incurs. Surety bonds only provide third-party protection. In other words, the surety bond benefits only your customer, your supplier or the institution if you’re dealing with a federal, state or public sector client.
If you break the agreement covered by the surety bond, even unintentionally, they can approach the surety company as the obligee in the contract for compensation.
Businesses commonly describe themselves as being “bonded, insured and licensed.”
Here’s what these terms mean:
Bonded: Being bonded means a business has purchased a surety bond that protects a client against whatever eventuality is stipulated in the bond, such as failing to complete a job or not sticking to agreed-upon standards.
Insured: Being insured means that a company has purchased a business insurance policy. However, it does not describe the type of insurance purchased or specify what protection the policy provides to the business or its clients.
Mark Fairlie has written extensively on business finance, business development, M&A, accounting, tax, cybersecurity, sales and marketing, SEO, investments, and more for clients across the world for the past five years. Prior to that, Mark owned one of the largest independent managed B2B email and telephone outsourcing companies in the UK prior to selling up in 2015.