By: Lisa Trymbiski on March 8th, 2023
The Ins & Outs of Construction Surety Bonds
For building contractors, the requirement to get a contractor bond can seem like yet another expense and an additional obstacle to deal with. However, getting a contractor bond is a license condition in many states, counties, and cities. If you want to get your license so that you can legally operate your business, you might first have to purchase a contractor bond. Beyond the license requirements in many state and local governments, it is important to understand how bonds work, the types of construction bonds you might encounter, and their advantages and disadvantages.
What Are Contractor and Construction Bonds?
A contractor bond is a type of surety bond that is commonly required by state and local licensing bodies as a condition of obtaining a contractor license. The bond is issued as the culmination of an agreement between the following parties:
- Principal - The contractor that needs to post bond
- Surety - The bond company that approves the bond application and issues a bond as a guarantee the principal will comply with the laws and conduct business ethically
- Obligee - The governmental licensing body that requires the bond
In addition to contractor license bonds, building contractors will likely encounter other types of bonds that are project-specific. While a contractor license bond will follow the contractor from project to project, other bonds might be required by both public and private project owners. Typically, you might encounter one or more of the following bonds that are specific to certain projects:
Bid bonds - These bonds might be required before you can participate in a bidding process for a project and guarantee that you will enter into the contract and complete the contract at the bid quote if your bid is selected. If a contractor refuses to perform the work at the agreed-on price, the bid bond reimburses the project owner for the difference between that bid and the next lowest one up to the bond’s penal sum.
Performance bonds - These bonds might be required to guarantee the contractor will perform the work as described in the contract so that the project owner will be financially protected if the contractor fails to perform as promised.
Payment bonds - These bonds might be required to guarantee the contractor will timely pay the subcontractors and suppliers for their work and supplies. A payment bond protects the suppliers and subcontractors by ensuring they will be paid, and it also protects the project owner against potential mechanic’s liens that might otherwise be filed to secure payment.
Why Are Surety Bonds Required?
Surety bonds might be required to accomplish the following two things:
- Ensuring that a contractor who engages in misconduct that results in financial harm to a client will be held accountable
- Ensuring that a party harmed by a contractor’s misconduct can receive financial compensation for their losses
Many states require contractors to post bonds by law, and construction contracts might also mandate construction bonds before they can contract for certain projects. Construction bonds and contractor license bonds are common because they incentivize contractors to comply with their contractual obligations and the regulations and laws that govern the construction industry.
The main reason why surety bonds are required is to reduce the risk that contractors will violate the terms of their contracts or fail to pay for their obligations.
What Surety Bonds Cover
Many contractors believe surety bonds aren't worthwhile because they don't protect the party that is required to purchase the bond. Instead, surety bonds protect the party that requires the bond. A party who is harmed by the contractor can file a bond claim if the bonded party fails to perform as promised, follow the law, follow through on bids, or pay the subcontractors and suppliers for their work and supplies. While it is true that a construction or contractor license bond won’t protect you against liability, having a bond can still help you secure contracts and build trust in your business.
Cost of Surety Bonds
The following things factor into a surety bond’s cost:
- The required bond amount and type
- The state in which the bond is issued
- The principal’s personal and business credit standing
- The stability of the contractor’s business
- The business’ experience handling similar projects in the past for project-specific bonds
When a contractor applies for a surety bond, the bond company will complete an underwriting process to evaluate risk. If the applicant has good credit, experience, and a stable business profile, the bond company will likely assess their risk as low and provide a bond premium quote that will only be a small percentage of the bond’s maximum penal sum. Depending on the type of bond, the bond premium might be as little as 1%.
Pros and Cons of Surety Bonds for Contractors
Surety bonds offer the following pros for contractors:
- Getting bonded allows contractors to meet their legal and project-specific requirements.
- Bond requirements help to keep shady operators from engaging in contracts.
- Having a bond helps to build trust with customers and opens up more potential work for contractors.
Surety bonds also come with the following cons for contractors:
- A bonded contractor must pay for the bond and will also be responsible for paying valid bond claims.
- A lapse in a bond can result in a license suspension or the invalidation of a contract.
- Required renewals can add ongoing expenses.
Potential Issues for Sureties
Sureties also face some potential issues when underwriting bonds for contractors. When there is an economic downturn, surety companies face the risk that a contractor will become insolvent and default on their contractual obligations. When a surety issues a bond, it requires the contractor to sign an indemnification agreement through which the contractor agrees to hold the surety company harmless if the contractor fails to perform as promised or breaks the law.
If a contractor becomes insolvent and defaults on a contract, the project owner can file a bond claim with the surety company to recoup its financial losses up to the bond’s penal sum. When the bonded contractor is insolvent and files for bankruptcy protection, the surety company might not be able to recover what it is owed from the bonded contractor following the contract default. For this reason, reputable surety companies typically have reinsurance agreements to insure them against this type of scenario.
While there are both drawbacks and advantages to surety bonds, they are something you will likely have to get during your career as a building contractor. Being bonded does offer several benefits, even though your bond won’t protect you against liability, including the ability to engage in more lucrative contracts and expand your customer base. As long as you ensure that you meet your contractual obligations and comply with the relevant laws and regulations, you should be able to avoid bond claims and accelerate your business’ growth.
Lisa Trymbiski is the manager at Bryant Surety Bonds, leading a team of talented professionals assisting clients in the surety bond industry. Education, superior service, and compliance are her top priorities in the completion of a successful business transaction.