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.
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:
“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.
These are some common types of surety bonds:
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.”
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.
Licensed, bonded and insured may seem synonymous, but they have different meanings:
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.
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:
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.
Surety bonds will cost you money, but there are a lot of benefits to buying one. Gibbs pointed out these upsides:
Kimberlee Leonard contributed to the research in this article. Source interviews were conducted for a previous version of this article.