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Surety Bonds for Construction

Welcome back to our construction accounting series! Things are going really well for our construction company now!. We have internal controls in place for Job Costing and committed costs, and we’ve bought some more equipment. Our company is doing some amazing work in the construction space. Now, we have decided that we’re going to venture into the world of federal contracting. And to get started on that, we are going to bid for the federal library going up right here in Portland. 

Before we start, it looks like this project is going to require some bonding. So, let’s take a look at what exactly a surety bond is. 

At its core, a surety bond is an agreement between three parties: the contractor, the project owner, and the surety company. In this case, the project owner is the federal government, but in some cases it could be a county, local, or state jurisdiction. The project owner doesn't even have to be governmental; many types of commercial projects will also be bonded. However, residential projects are rarely bonded. 

Now, the surety company’s obligation in this agreement is going to change based on what type of surety bond we're talking about. There are lots of different types of surety credit bonds in this world but we're going to focus on three of them: bid bonds, performance bonds, and payment bonds.

The first we're going to talk about is a bid bond. Now, a bid bond is an assurance that the bid submitted by the contractor has been submitted in good faith and that the contractor intends to enter into the contract at the price that they bid, should they be the low bidder. It's also an assurance that the contractor will provide the other two types of surety bonds when asked. Now, this is not just any type of agreement; this is a financial assurance. So in this case, the surety’s obligation is that if the contractor does not enter into the contract after winning it, they will submit a penalty of 5 to 10% of the bid value. So, for example, if a contractor submits a bid for $100,000, wins the bid, and then decides for whatever reason that they are not going to enter into a contract, they will face a penalty of 5 to 10% of that bid value. That's 5 to $10,000 on a $100,000 bid. 

Now, for the sake of looking at the next type of bond, let's say the contractor accepts the job. When they return the signed contract, they're also going to be asked to provide a performance bond. A performance bond is an assurance that the contractor will perform the work in the contract as specified. If they do not, the surety company will step in and hire a new contractor to complete the work to fulfill the obligations of the contract at 100% of the contract value.

A performance bond is rarely issued without a payment bond. Sometimes you'll hear this referred to as a labor and material bond. In this case, the surety company is guaranteeing that the contractor will pay subcontractors, materials, suppliers, laborers, their own staff, all those costs that are associated with the project. And, if they don't, the surety company will step in and pay those bills at no additional cost to the project owner, again, up to 100% of the contract value. 

Now, you may be thinking that surety is insurance, and it's really easy to see why because most of the time a surety company is an insurance company. But, to be very clear, surety is not a type of insurance. 

The biggest difference between surety bonds and insurance is this: if you have a claim on an insurance policy, your insurance company pays the claim. Your insurance company does not go back to you asking you to reimburse them for the money they spent on an insurance claim. With a surety bond, that’s not the case. When a surety company goes through the underwriting process with the contractor, they make a contract or something called a general indemnity agreement. In that agreement, the contractor promises to pay back the surety company any and all funds that the surety company pays out on a claim. Company owners have to sign off on this agreement personally, so surety companies can also come after owners themselves to get this money. 

So, for example, if our construction company won a bid and signed a contract, but didn’t finish all the work in the contract, or didn’t pay our subcontractor for concrete, our company or our boss would be on the hook for all of the money the surety company paid! These are pretty high stakes.

Now, we’ve done some research and have found that bonding can be very difficult for contractors to get because often it goes through a strict underwriting process that’s comparable to getting a loan. The underwriters are going to make sure that the contractor has the capacity to perform the work, and that they have the financial strength to get in and get the project started. They'll also look for good banking relationships. So if they need a line of credit or some sort of funding for this project, they'll know that that's available to them. And they're going to look at WIPs that we learned about before. Surety companies want to make sure that contractors aren't overextending themselves. Let’s take a look at this list from Western surety company, a well known surety underwriter in North America. This list provides us with a little bit of insight on how surety companies view a contractor's success. These are 10 successful traits they look for when they provide bonding. So many of these items can be solved or improved by an ERP solution, like those provided by Trimble. Let’s take a minute to read through this list. 

An ERP solution can make a big impact on at least half of these points. A point like number 6, “superior communication between head office, field staff, and clients,” can be aided by a solution like Trimble’s Office Team Field offering.  ERP solutions can make a big difference with listing number 9, too. While ERP solutions can’t get rid of uncontrollable factors, they can provide insight into uncontrollable factors so that construction companies are not completely blindsided.

Through our research, we have learned that surety is an awfully big can of worms for a contractor to open up. But now we have all the information we will need to get funded, submit our bid, and hopefully win the contract!

Surety bonds, along with other accounting workflows, can be difficult to manage in a way that maximizes your organization's efficiencies.

Trimble Construction One is a connected suite which connects your office to the field to streamline these workflows with the industries’ leading solutions to give you the right data for your projects. Check out what Trimble Construction One can do for you.