What Is a Surety Bond?
A surety bond is a promise by a third-party guarantor to pay a specified amount if one party to a contract fails to meet their obligation. This protects the other party, typically a project owner or a supplier of significant assets, against losses resulting from the other’s failure to meet the obligation. Surety bonds can be required by law in many industries and professions, such as construction, freight brokerage, insurance brokerage, auto dealership, tax preparation, and others depending on the laws in your state.
For example, one of the most common types of surety bonds are performance bonds for construction projects. Federal law requires a performance surety for public works contracts over $100,000, and most states have similar laws. In such cases, the construction contractor is the principal, the bonding company providing protection is the surety, and the owner of the project is the obligee.
If the construction company is not able to complete the work, fails to meet project specifications, is unable to satisfy their debts, or otherwise suffers a disruption that leaves the project unfinished, the project owner can claim the bond. The surety company will pay the previously specified amount to the project owner to recoup their losses from the unfinished project.
Types of Surety Bonds
There are many different types of surety bonds, varying by industry and purpose, but they can be grouped into four main categories:
- License and Permit Bonds – License and permit bonds can protect consumers from loss by helping to ensure that businesses will adhere to laws and other regulations governing their industry. (Often the term “commercial bond” is used synonymously to mean “license or permit bond,” because license/permit bonds are the most common types of commercial bonds.) Many industries and professions require license and permit bonds. Some examples include auto dealers, contractors, and freight brokers.
- Contract/Construction Bonds – The most common use of contract bonds is in the construction industry, and there are three main types: the performance bond, as in the example above; the bid bond, which guarantees that a contractor is entering a bid in good faith and intends to abide by the terms of the bid; and the payment bond, which guarantees the contractor will pay covered workers, subcontractors, and suppliers. If the construction contractor fails to fulfill duties covered by the bond, the project developer can make a claim to recover its losses.
- Fidelity Bonds – A type of commercial bond that protects businesses from employee theft; usually used by companies with employees who handle large amounts of cash.
- Court Bonds – Court bonds help to ensure that individuals who have been appointed by the court to care for another or manage another’s assets will fulfill their fiduciary duties in accordance with the court’s expectations. Some common examples include guardianship bonds, executor bonds, and probate bonds.
Why Is a Surety Bond Important?
In any business where a significant financial investment is made, a project or a transaction can carry a great amount of risk for the obligee. With a surety bond, risk is transferred from the obligee to the surety firm. This is why those in construction, insurance, and other inherently risky industries often seek or require surety bonds.
Of course, surety firms need to be careful about the level and quality of risk they accept. Similar to the way banks process a loan application, a surety firm will likely consider your personal credit, your business credit, and your company’s financials when determining how large of a bond you can repay (in the case of a claim) and your annual premium rate.
How Do Surety Bonds Work?
The business need for surety bonds varies by industry and local, state, and federal law. Once you have thoroughly reviewed the business case and understand the requirements, contacting a surety and getting a quote is usually the first step. An underwriter will assess your financial health and accountability before deciding the maximum total amount they will guarantee and what it will cost you.
The cost of your bond will vary depending on the type, but annual premiums tend to be between 1% and 15% of the bonded amount. New business owners may face the higher rates depending on the length of their credit history. You will usually only need to repay the entire bond if it is claimed by an obligee. The surety will pay the obligee, but you will be expected to repay the surety.
If you are a new firm, the surety company will place greater weight on your personal credit when determining your bond line limit. But as your business grows, the business’s own credit and financials will become ever more important. In any case, the process of determining your bond limit is similar to determining eligibility for an individual bond: Surety underwriters assess your likelihood of defaulting on jobs and your ability to repay the bonds you have outstanding in case of claims. Factors they may consider include your company’s financial statements, working capital, outstanding loans, and, of course, business credit file.
Building and maintaining a strong business credit file can help you negotiate a larger bond limit and lower bond rates, so that you can increase your ability to buy more bonds, bid on multiple jobs, and grow your business.
Learn more about the basics of business credit to get started.
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