Bonding Basics: Bonding Can Increase Profitability and Add Value to Your Company

by David Arch, Gulfstream Insurance Group

Contractors who have the ability to obtain surety bonds for their work can gain substantial benefits.  They have the opportunity to bid for and win public contracts.  In addition, in some private bid situations the ability to provide a “letter of bondability” or a “good guy letter,” even though a final bond may not be required, can sometimes make the difference between winning and losing a project.  Having a relationship and a bonding line with a surety demonstrates to outside parties that the contractor has the character, capacity and capital necessary to successfully undertake and complete a project.

What is a bond?

A bond is not insurance.  A bond is the financial guarantee of a third party (known as the surety) that the contractor (called the principal) will deliver to the owner or general contractor (known as the obligee) a project completed to the specifications of the contract.  If the contractor does not deliver the project as required by the contract, the surety must step in and ensure that the project is completed and the contract is fulfilled.
Sureties charge a premium for their services, but unlike insurance, these premiums do not anticipate any losses.  The premium is charged for the surety’s service and evaluation of the contractor.  If a loss occurs, the surety will seek to recoup all of its losses, expenses and costs from the contractor’s corporate and personal assets.

When are bonds required?

A federal law, called the Miller Act, requires that contractors who obtain contracts in excess of $200,000 in public works must post two bonds to protect the taxpayer.  These bonds are called a performance bond and a labor and material bond:

»A performance bond guarantees that the project will be completed at the contract price and to the specifications of the contract.

»A labor and material bond guarantees that the subcontractors and material suppliers will be paid so as to guarantee delivery of a lien-free project to the taxpayer

Most states have adopted similar requirements and these requirements have become the norm for the majority of public projects throughout the United States.  In some circumstances, private owners also require surety bonds for their projects as an additional assurance that the project will be completed and delivered lien-free.

What qualities are necessary for bonding?

Surety companies look for three principal qualities in a contractor to determine if they are eligible for bonding:

»Character – Does the contractor have a good reputation in the business community?  Does he have a history of performing quality work? Does he pay his suppliers and his subcontractors faithfully and promptly?  Does he have a good relationship with his banking institution and do they find him a worthy credit risk?

»Capacity – Does the contractor have the experience, track record, equipment and personnel necessary to complete the job at hand?

»Capital – Does the contractor have the financial wherewithal and bill paying ability to complete the project?  Various ratios and tests are used by the surety to judge the contractor’s financial position.

How does a contractor prepare himself to demonstrate he is worthy of bonding capacity?

A contractor must first identify professionals who are familiar with the surety underwriting process and can assist him throughout the process of obtaining and managing a surety relationship.  He should identify a professional surety agent, a construction CPA, a banker familiar with the needs of contractors and a construction attorney.
These professionals will assist the contractor in putting together the following items which are generally necessary to make a full submission to a surety:

»CPA prepared year-end corporate financial statements for the last three years.  Audited or reviewed percentage of completion statements are preferred, though compiled statements may be acceptable for lower single job and total program limits

» Personal financial statements for all owners, based on the same date as the corporate financial statement

» Schedule of equipment available to perform the work

» A schedule of projects in progress

»Resumes of key personnel

»A contractor questionnaire which requests general information on the contractor’s previous work and relationships

»A reference letter from the contractor’s bank outlining credit currently available to the contractor and the terms and conditions of the credit

»Reference letters from satisfied owners/general contractors, suppliers and subcontractors

How will the surety determine how much bonding capacity I am eligible for?

As a surety works with a successful contractor, the level of confidence grows and the surety will become more comfortable in extending the contractor’s bonding capacity.  In order to reach this level with a surety, a good contractor will:

»Show a history of performing good quality and profitable work
»Strong, timely & accurate  financial reporting and controls
»Remain profitable over a number of years
»Maintain an acceptable level of capital within the business

Once a contractor has demonstrated his ability and willingness to meet the above standards, sureties use a variety of ratios and tools to determine bonding limits for eligible contractors.  Each surety is a little different, but here are some general ratios and rules of thumb that sureties use for contractors with whom they have established a good relationship:

»“Net Quick” is a very important factor to a surety.  A contractor’s net quick is determined by calculating the following:
•Current Assets (cash + accounts receivable no more than 90 days old) + costs and estimated earnings in excess of billings) – All Current Liabilities = Net Quick

»Sureties are generally willing to extend a total bonding program of 10 times Net Quick.
•For example, if Net Quick is $100,000 the surety would be likely to extend no more than $1,000,000 in bonding capacity
• Single job limits would likely be much lower. Contractors can expect the surety to limit single bonds to two times the size of the contractor’s largest completed project

What can a good bonding relationship do for you?

A good relationship with your surety can help you in a number of ways:

»You will be able to show owners or general contractors that you have been pre-screened and will be therefore able to bid for (and potentially win) more public and private work

»Demonstrate to outside parties that the surety has qualified your financial strength and ability to complete projects satisfactorily

»Working closely with a surety can be of tremendous benefit to a contractor in today’s uncertain economy.  Sureties have broad experience with all trades and with in various geographical areas and market conditions.  Using a surety as a resource may help you to better assess your financial position as well as offer you valuable benchmarking against other successful contractors to measure your success.

»Ultimately, establishing a relationship with a surety and assembling a professional team comprised of a knowledgeable surety agent, construction oriented CPA, proactive banker and a construction attorney can help you manage your risk and better compete in today’s uncertain marketplace.

For further insight on how to navigate this uncertain marketplace, I recommend reading Bill Platzer of Platzer & Associates’.  He has some valuable recommendations that will assist contractors to cope with and thrive in today’s marketplace.  For a copy, email me at david@gulfstreaminsurance.net