For those who don’t know a surety bond is a contract between three parties – the obligee, the surety, and the principal. These instruments provide a guarantee that the principal will complete a series of tasks for an obligee.
This might sound like obscure stuff for small business owners seeking funding, but surety bonds can be useful for those in project-based businesses such as construction or information technology. The bonds are purchased from insurance companies and they provide a level of financial protection in cases on nonperformance.
If you think your business could benefit from these offerings, then read on as we will review what every business owner needs to know about surety bonds.
How Do Surety Bonds Work?
As mentioned, surety bonds are tri-partite contracts meant to cover risk. Using a real-life example, a surety bond might be required by a property developer when hiring a contractor to complete work at one of the properties they own. The surety bond would protect the developer if the work wasn’t completed correctly.
When this happens the property developer would file a claim against the bond and the insurance company which issued the bond would pay the damages. Doing so protects the contractor against additional losses and this can be handy in cases of disagreement over performance.
Surety Bonds are a cross between a line of credit and an insurance policy. This is because the principal will take out the bond and will pay a premium until the work is completed.
In fact, there are four types of surety bonds: Contract Surety Bonds, Commercial Surety Bonds, Fidelity Surety Bonds, and Court Surety Bonds. While the all have the same basic function, there are some differences.
For example, a Contract Surety Bond is used to guarantee that a contractor will complete the work as described in the underlying work agreement. In this case, the agreement will ensure the general contractor completes the work, pays for materials, and pays any subcontractors.
While a Commercial Surety Bond is usually mandated by governments for businesses operating in certain industries such as liquor stores. The third type of surety bond is a Fidelity Surety Bond which is used to protect a company against employee theft. These bonds will cover the loss of a customer’s money and in some cases fraudulent activity.
The last type of surety bond is called a Court Surety Bond. These are required by attorneys to protect against loss during a court proceeding and are meant to guarantee that attorneys fees will be paid during the litigation period. While another form of Court Surety Bond is used to protect an estate against the misdeeds of an executor.
When Will You Need a Surety Bond?
This will depend on the purpose of the bond and your industry, but a good rule of thumb is if you want to minimize risk and ensure compliance then you’ll probably need one. Another rule of thumb is to look at the size of the project – for example, government projects over $100,000.
As mentioned, these bonds can either be a requirement for a project or a business or are taken on as part of a risk management strategy. Regardless of the case, these bonds need to be taken out before the contract begins.
So, the answer to when you want to get a surety bond comes down to three variables. Is the bond required? Is it part of a risk management strategy? Has the contract started? If you answered yes to the first two questions and no to the third, you might want to get a surety bond.
What is the cost of a Surety Bond?
While the actual costs will depend on your situation, the cost of a $100,000 bond with a 1% premium would be $100 per year. Though this is just a rough idea, the final premium will depend on the size of the bond, the period, your credit score, and some even consider the strength of your management team or the performance of the business when calculating how much is due.
Another thing to know is that many bonds will limit the bonded amount to a value of the company’s equity. This is known as the bonding capacity and this is used not only for individual surety bonds but also to determine the limit for all the open bonds held by a company.
Finding a Bonding Provider
There are a few items you should keep in mind when looking for a bonding provider. These include licensing, bond offerings, premium rates, and their underwriting qualifications. Keep in mind, these products are offered by insurance companies but are usually purchased through agents, so a good place to start would be to talk to your insurance agent to find out which bond products they have on offer.