Everything You Need to Know About Performance Bonds
Performance Bonds are guarantees to a project owner, that the contractor will complete its job according to the terms and conditions of the contract. The basic function of a performance bond is to provide financial protection to the project owner in the event of default on the part of the contractor.
Performance bonds are most commonly used to guarantee construction contracts however they are also used to guarantee supply contracts and service contracts. The majority of bond requirements are found in government contracts but bonds are also requested by private owners. Performance Bonds fall into the category of surety called “Contract Surety”.
How do I get a Performance Bond?
If you need a performance bond for a job, you’ll need to apply to see if you qualify. The qualification process is called underwriting, and there are items that are required if you want a bond underwriter to approve you. The following is a list of information that is needed to apply:
- Year-end financial statements prepared by a chartered accountant.
- Listing of the companies payables and receivables
- A bank reference letter
- Personal financial statements of the main shareholders
- Contractor Questionnaire often supported with shareholder resumes or other information that helps explain what kind of work you or your company have completed in the past.
When submitting your business financials to the surety company, you must include a balance sheet, income statement, cash flow statement, complete notes/disclosures and work schedules. When you’re applying for bonding, it is highly recommended you work with a CPA that is well versed in construction, as they know how to present your company properly to get bonded.
How much does a performance bond cost?
Generally, one can expect the cost of a performance bond to be in the range of 1% of the contract value. There are however multiple factors vary based on several factors.
- The first and main factor is the creditworthiness of your company. The stronger your company is financially and the more equity you have left in the company, the lower your rate will be.
- The second factor deals with the amount of bonded work you are performing. If you are completing numerous bonded contracts per year and are producing significant revenues to the bond company, it is easier to negotiate down your rate.
- The third relates to the type of work you perform. Simpler, less complicated work can often carry a lower rate than more complex design oriented contracts.
- The fourth deals with the requirements of the owner. Some owners will request performance bonds in the amount of 100% of the total contract price which carry higher rates. Others will only request a 50% performance bond, which naturally carry lower rates.
Performance bonds on longer term contracts have rates which are calculated in different ways and require more explanation.
Why do I need a Surety Bond Broker?
Your bond broker is your main line of communication between you and the bond company. It is their responsibility to help you gather all the relevant information you will need to make an application for bonding as well as keep your file updated and your Bond Facility in good standing.
What does a surety broker do?
- Reviews your financial statements and help you understand what bond limits you qualify for.
- Understands what information is required to satisfy the bond company.
- Prepares a submission to a bond company to qualify for bonding.
- Negotiates with the bond company with respect to rates, bond limits and indemnity required.
- Knows the marketplace and understands what terms are reasonable and competitive.
- Works with your accountant to help you increase your bond limits as needed.
- Has strong relationships with multiple bond companies providing you options if there is a need to switch bond companies.
- Prepares and executes bonds and helps calculate the cost of your bonding.
- Understands construction and acts as a consultant in many situations.
One Time Performance Bonds
We often work with contractors that don’t frequently use bonding but need it for one small construction project. In today’s market place, it has never been easier to obtain bonding for these types of situations. With automation and access to information, bond companies are better able to assess the credit worthiness of a contractor.
Small and simple one-off bond requirements can usually be done relatively easy through bond company’s online portals. The information required to submit an application is much simpler and the qualification criteria is based on personal and business credit. This is a big shift as bonding used to be an arduous process regardless of the size of the bond required.
Bad Credit Performance Bonds
It’s possible to get a performance bond with bad credit, but it will depend on the size of the contract and severity of your credit issues. Recently bond companies that specialize in higher risk bonds have emerged. If approved, the rates charged may be higher than normal and collateral security is sometimes required.
It is in these situations where a properly trained surety bond broker is essential. Credit issues are a red flag on your previous history of payments, and viewed as a higher likelihood of default on the contract or an inability to pay sub-contractors and suppliers.
What happens if I default on a performance bond?
In the event that the contractor fails to perform its obligation under the contract, the owner may make a claim under the performance bond. If the claim is founded, the bond company will then assume the responsibilities of the contract as per the terms and conditions of the contract. In the event of a default, the bond company may:
- Complete the contract involving the original contractor by providing any required financial, management or technical support.
- Re-tender to a new contractor and pay for the cost of completion in excess of the contract price.
- Pay to the owner the total amount of the bond.
- The bond company will look to you for repayment after a claim under the terms of the Indemnity Agreement.
What is an Indemnity Agreement?
A key difference between bonding and insurance is that in the event of a paid claim, the bond company will look to you to reimburse them. Essentially, an indemnity agreement is an agreement between the contractor and the surety bond company which says that in the event of a paid claim on a contract surety bond, the contractor will reimburse the bond company for the amount of the loss plus any other expenses incurred from the default.
Any and all bond facilities are written with indemnity agreements in place. The indemnity can be corporate, personal by the shareholders and sometimes spouses of the shareholders will be required to indemnify. The surety companies will generally try to have as much indemnity as possible. It is the broker’s role to ensure that a reasonable indemnity is ultimately executed.
Frequently Asked Questions
Over the years, we have noticed the same handful of questions being asked by our clients with respect to performance bonds. So, we thought we’d identify and answer the top 7 most frequently asked in a separate dedicated post.