Surety bonds are a necessary part of business if you're working with a government agency or bidding for construction jobs.
- Surety bonds ensure that businesses complete the work they were hired for.
- Most government contracts and construction jobs require a surety bond.
- The SBA Surety Bond Guarantee Program helps business owners who have a bad credit score or no track record.
- This article is for small business owners who want to know what a surety bond is and if they need one.
Small businesses vying for contracts have to show their worth. One way to do this is through a surety bond. These are legally binding agreements between a small business and another party that ensures the agreed-upon work is completed. They are common for businesses that take on construction projects or want to land a government contract. Surety bonds aren't free, but the benefits usually outweigh the cost.
What is a bond for business?
A surety bond guarantees the terms of a contract will be met. It is an agreement between three parties that ensures everyone holds up their end of the arrangement.
Surety bonds are legally binding and can be used for any type of agreement, but they are most commonly used for government contracts and construction projects. Three parties are involved in a surety:
- The principal is the small business owner who purchases the bond to bid on a contract or perform the work.
- The obligee is the business or entity that requires the surety bond. While government agencies are common obligees, anyone who wants assurance of a job's completion can require a surety bond.
- The surety is the insurance company that guarantees the bond. If the principal fails to complete the work, the surety company has to step in and make sure it's completed.
"Surety bonds are a necessary element to doing business if it's required," Chris Downey, chair of the National Association of Surety Bond Producers' Small & Emerging Business Committee, told Business News Daily. "If you are doing state and federal work, surety bonds are required to protect taxpayer money."
Under the Miller Act, which was established in 1935, contractors providing construction, alteration or repair services for federal buildings must have a surety bond for contracts that exceed $100,000. The Little Miller Act is the state version of the federal rule, requiring companies to have a bond when doing work on state buildings or bidding on state contracts. That rule went into effect in 1967.
Key takeaway: Surety bonds ensure work between a small business and another party is completed and are legally binding. They are common for construction projects and jobs done for federal and state entities.
What are the types of surety bonds business owners might need?
There are many types of surety bonds. These are some common ones:
- Contract bond: A contract surety bond ensures the business owner will meet all the terms of the agreement and perform the work laid out in the contract.
- Fidelity bond: These are bonds a small business owner takes out to protect the business from a financial loss. That could mean protection from the loss of clients' money or equipment or from a financial loss due to an employee who committed fraud.
- Business service bond: If you provide a service and there may be an opportunity for your employees to commit fraud, this surety bond will protect your customers.
Key takeaway: Common types of surety bonds include contract, fidelity and business service bonds.
What is an SBA surety bond?
Small business owners who have poor credit or are just starting out may have a hard time getting a contract surety bond on their own. The Small Business Administration makes it easier by backing most of the risk.
Under the SBA Surety Bond Guarantee Program, the SBA agrees to back 80% to 90% of the surety bond. This gives the surety more incentive to approve bonds they would have normally turned down.
"If you utilize an SBA surety bond, you're not going into a situation blind," said Peter Gibbs, director of the Office of Surety Guarantees. "We do a lot of due diligence on the companies we partner with. They have been helping businesses for 50 years."
Key takeaway: Business owners who might have a tough time getting approved should consider the SBA Surety Bond Guarantee Program.
How do surety bonds work?
If a surety bond is required, a business owner turns to a surety company or agent to purchase the bond. Surety bonds can be bought through an insurance company, online marketplaces, or an insurance agent who specializes in surety bonds.
Before a bond is issued, the surety company does its due diligence. Unlike insurance providers, these companies don't accept liability if a claim is filed, so business owners are put through an underwriting process.
The surety provider reviews the principal's financials – including its history of paying suppliers, subcontractors and other third parties – as well as the business owner's personal credit score. It also weighs the size of earlier projects compared to the one the business is bidding on.
"A big part of this is we analyze risk significantly," said Downey. "If you are a risky endeavor, you're not going to get [a surety bond]. Make sure your personal credit score is good, because most companies will write smaller-sized bonds based on your credit score. "
The SBA has less stringent underwriting rules, but business owners will pay more for those surety bonds, said Downey.
By providing the surety bond to the business owner, the insurance company is guaranteeing there is ample money in the bank to cover any damages that occur if the business owner can't meet the terms of the surety bond.
If the terms of the bond are not met and a claim is filed, the bond provider doesn't lose any money. The principal (the business owner) is on the hook to pay back the surety company.
Key takeaway: Surety bond providers put the business and its owner through an underwriting process before issuing the bond. If a claim is filed, the business owner has to pay the surety company back.
What is the difference between license, bonded and insured?
Licensed, bonded and insured may seem synonymous, but they mean different things.
- Licensed: A business that is licensed is given permission by government agencies to provide specific services. A merchant who is required to have a seller's license is one example.
- Insured: Companies will take out insurance to protect their business, customers and employees. They pay monthly or annual premiums and aren't on the hook if something goes wrong. Liability insurance protects damage to property. Workers' compensation covers lost wages and medical expenses if an employee is harmed on the job.
- Bonded: Business owners buy bonds based on specific contracts. Unlike an insurance provider, the surety is not on the hook if anything goes wrong.
Key takeaway: A licensed business is granted permission by government entities to provide a service, while insurance protects a business from calamities. "Bonded" means the business is approved to bid on specific jobs.
What is an indemnity agreement?
The parties involved in a surety bond turn to the indemnity agreement to protect everyone's interests. This is a contract between the principal and the surety company that guarantees the principal will repay any money the surety company pays out in the event of a claim. An indemnity agreement is required anytime a surety bond is underwritten. If you adhere to state rules and laws, though, the chances of a claim against the bond (and thus a liability) are minuscule.
Key takeaway: An indemnity agreement is between the principal and the surety company, guaranteeing the principal will pay back any money the surety company has to pay out.
How much do surety bonds cost?
The amount you pay for a surety bond depends largely on your credit score and risk, but you can expect to pay 1% to 3% of the contract amount, said Gibbs. It can go as high as 10% if you or the project are considered risky, though. If you need a $100,000 surety bond to start work on refurbishing a government building and are paying 1%, it will cost you $1,000.
The price you pay is based on several factors.
- Credit score: Your personal credit score dictates how much the surety bond will cost. The better your score is, the less you'll pay; the worse it is, the more you will pay.
- Financial statements: A surety company doesn't want to work with a business that has a poor track record of making money and meeting its obligations. Expect the surety to pore over your financial statements, including your balance sheet, income statement and cash flow statement.
- Industry experience: The surety company wants the project to succeed, so it needs proof you're up to the task. It may require a resume or a list of projects your business has completed in the past.
Key takeaway: Surety bonds can cost anywhere from 1% to 10% of the contract size. Your credit score plays a big role in whether you land on the high or low end of that range.
What are the benefits of a surety bond?
Surety bonds will cost you money, but there's a lot of benefits to buying one. Gibbs pointed out these specific benefits:
- Everyone has protection. The obligee isn't the only one a surety bond protects. It also protects all the subcontractors and suppliers, so a surety bond may make it easier to hire subcontractors.
- It boosts client confidence in your enterprise. To get a surety bond, you and your business go through an underwriting process. Customers know that, so they'll know you're accountable.
- It opens up new access to projects. To bid on any federal or state project, you'll need to be bonded. The same goes for many construction jobs. Once you're bonded, you can go after new opportunities like these.
Key takeaway: Surety bonds protect all parties involved in the contract and give clients confidence in your business.