- 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 learn about surety bonds.
Small businesses vying for contracts have to show their worth. One way to do this is through a surety bond, a legally binding agreement between a small business and another party that ensures the agreed-upon work is completed. Surety bonds are common for companies 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 surety bond?
A surety bond is an agreement that guarantees that the terms of a contract will be met and ensures that 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 usually involved in a surety bond:
- 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 must step in and make sure it’s completed.
“Surety bonds are a necessary element to doing business if it’s required,” said Chris Downey, president of independent insurance agency Downey and Co. and chair of the National Association of Surety Bond Producers’ Small and Emerging Business Committee. “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 law, requiring companies to have a bond when doing work on state buildings or bidding on state contracts. That rule went into effect in 1967.
Surety bonds ensure work between a small business and another party is completed. 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?
These are some common types of surety bonds:
- 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 because an employee committed fraud.
- Business service bond: If you provide a service and there may be an opportunity for your employees to commit fraud, this type of surety bond will protect your customers.
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 (SBA) 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 insurer more incentive to approve bonds they normally would have turned down.
“If you utilize an SBA surety bond, you’re not going into a situation blind,” said Peter Gibbs, president of Foundation Surety & Insurance Solutions and former director of the SBA’s 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.”
Artificial intelligence is transforming underwriting and the insurance industry by helping insurers assess an applicant’s risk.
How do surety bonds work?
If a surety bond is required, a business owner turns to an insurer 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 other 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 previously completed projects compared with the one the business is now bidding on.
“A big part of this is, we analyze risk significantly,” Downey said. “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.
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 might 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) must pay back the surety company.
What is the difference between licensed, bonded and insured?
Licensed, bonded and insured may seem synonymous, but they have different meanings:
- Licensed: A business that is licensed is given permission by government agencies to provide specific services. A merchant that is required to have a seller’s license is one example. [Read related article: Your Guide to Getting a Business License]
- Insured: This refers to companies that take out insurance to protect their business, customers and employees. They pay monthly or annual premiums and aren’t responsible if something goes wrong. For example, liability insurance protects against property damage, and workers’ compensation insurance covers lost wages and medical expenses if an employee is harmed on the job.
- Bonded: In this case, business owners buy bonds based on specific contracts, as required by the client. Unlike a typical insurance provider, the surety is not on the hook if anything goes wrong.
What is an indemnity agreement?
The parties involved in a surety bond use an 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 liability) are minuscule.
Pair a surety bond with insurance coverage to better protect your business from the many risks it faces.
How much do surety bonds cost?
The amount business owners pay for a surety bond depends largely on their credit score and risk, but you can expect to pay 1% to 3% of the contract amount, according to Gibbs. For instance, if you need a $100,000 surety bond to start refurbishing a government building and are paying 1% for the bond, it will cost you $1,000. However, the rate can go as high as 10% if you or the project are considered risky.
The price of a surety bond 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’ll 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 insurer to pore over your financial statements, including your balance sheet, income statement and cash flow statement. [Use the best accounting software to stay on top of your business’s finances.]
- Industry experience: The surety company wants the project to succeed, so it needs proof you’re up to the task. The insurer may require a résumé or a list of projects your business has completed in the past.
Surety bonds can cost business owners anywhere from 1% to 10% of the contract size. Your credit score plays a big role in whether you land on the low or high end of that range.
What are the benefits of a surety bond?
Surety bonds will cost you money, but there are a lot of benefits to buying one. Gibbs pointed out these upsides:
- 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 to help you complete the job.
- 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 more opportunities like these.
Kimberlee Leonard contributed to the research in this article. Source interviews were conducted for a previous version of this article.