Performance bonds are financial instruments that will help you ensure that a large project is completed within a stipulated time. A Performance bond is more relevant in the construction industry. For instance, if you are hiring a contractor, a performance bond would help safeguard your financial interests.
But what are performance bonds?
Performance bonds are issued to guarantee to the obligee (customers, clients, or government) that the work done by the issuer (in many cases, they are contractors or construction companies) will meet the conditions and terms agreed upon. It is also framed to promise a certain level of performance and timely delivery of projects to the obligee.
Financial institutions such as banks and insurance companies act as intermediaries and charge a fee from the issuer to frame a performance bond. You cannot write the terms on a piece of paper and call it a performance contract or bond. But, you have to go through the proper channels to get a performance bond.
While there are various use-cases of a performance bond, they are primarily required in construction. In construction work often gets delayed, which could cause a loss for the parties involved. So, having a performance bond helps to safeguard the interest and cover losses.
Parties involved in performance bonds
Usually, three parties are involved in a performance bond; a principal, an obligee, and the surety.
The principal is commonly the contractor or any other person or company providing a service or a commodity. An obligee is a client entitled to timely deliverables by the contractor. The obligee could be anyone; an individual could get a performance bond for constructing their home or a government institution getting a performance bond for constructing a bus stop.
The surety is the middleman or, in this case, a financial institution that would provide the performance bond.
Many people tend to confuse a performance bond with insurance, but that is not the case. The issuer only has to pay the fees to the surety, and the rest falls on the shoulders of the surety only. So, if the contractor has failed to do the job on time, then the obligee may raise a claim, and the surety would have to deal with them.
However, the financial institution does not just provide a performance bond to every company or individual. Instead, they look into the company’s history and financial position before proceeding with the bond.
What is a payment bond?
When two parties are involved in a transaction, one party pays for the commodity or the services while the other party provides them. At its most authentic form, a performance bond only protects the buyer’s interests or the client.
Sod, a payment bond is usually required along with a performance bond. It is an agreement between the three parties, as mentioned earlier, wherein the contractor ensures timely payments to any of the sub-contractors, suppliers, and laborers.
How does a performance bond work?
In most cases, performance bonds are more commonly used for government projects, but they are being widely used by private companies these days. For a performance bond to be enforceable, it must have specific details about the work that a contractor must deliver, along with the completion dates and the final expected output.
Not only does a performance bond protect the obligee in case of delayed work or inferior quality of work, but it also safeguards them if the contractor declares bankruptcy during the project.
In case of any failure, the payment will only be made to the obligee; as per the surety’s terms and policies, they might cover the cost of hiring a new contractor or directly pay the obligee a sum required to complete the job.
What is the cost of a performance bond?
There is no fixed cost of a performance bond as the fee charged by the surety from the principal depends upon various factors. However, it is usually one percent of the total contract value under one million dollars.
For contracts over one million dollars, the surety may charge even a two percent fee.
Benefits of a performance bond
- It protects the obligee as the legally enforceable performance bond is essentially a guarantee that their work will be completed no matter what. So, if the contracting company goes under or any other such thing happens, the surety will ensure the project is completed. This hedges the obligee’s interests from uncertainty.
- The obligee will not have to spend more money if the contractor fails the job, and this helps the obligee to get the work done within the predetermined budget.
It is a financial instrument that will safeguard a client’s interest and makes it the contractor’s responsibility to fulfill their promise.
