Most contractors will encounter surety bonds in the course of business. If you want to become a general contractor, you will likely be required to purchase a contractor license bond before your state issues a contractor license to you. You might also be required to buy other contractor bonds to bid on public projects or enter into contracts with private project owners for projects over a specific size. Contractor bonds are legally binding contracts between you, the party that requires you to purchase the bond, and the surety company that issues the bond. Before you are given a bond, you must meet the surety company’s specifications. The surety company will want to see that you have good credit, sufficient working capital, experience on similarly sized projects, and a good reputation.
Contractors required to obtain license bonds
Most states require contractors to perform work valued over a threshold amount to purchase surety bonds to get a contractor license. In some states, all licensed contractors must purchase surety bonds as a condition of their licenses. Contractor license bonds guarantee that the contractors will comply with the state’s laws and regulations in which the contractor operates.
Surety bond basics
Surety bonds are legally binding agreements between three parties. A bond guarantees that the party purchasing the bond will comply with the laws that govern the industry and will fulfill its contractual duties. The following three parties are involved in the surety bonding process:
• Principal – The business or contractor that is required to purchase a surety bond and that must comply with all laws and regulations
• Obligee – The government agency or private project owner that requires the bond and can file a bond claim if the contractor fails to perform as promised or violates the law
• Surety – The surety company that issues the bond and provides assurance that the principal will fulfill its legal and contractual obligations
If you purchase a license bond and subsequently violate the law, a claim can be filed against your surety bond. The surety company will then have to pay a valid claim, and you will have to reimburse the surety company. When a bond is issued to you, you will be required to sign an indemnification agreement with the surety company.
Common types of contractor bonds
In addition to contractor license bonds, there are several other types of bonds that you might frequently encounter as a contractor, including payment bonds, performance bonds, and bid bonds. Each of these three types of bonds is explained below.
Payment bonds
If you want to perform work on federal buildings for projects worth more than $100,000, one of the types of bonds you will be required to purchase under the Miller Act is a payment bond. Many private project owners also need general contractors to purchase payment bonds. This type of bond guarantees that you will pay your subcontractors and suppliers for the work that they perform and protects the project owner from mechanic liens that might be filed against the title for nonpayment. Payment bonds similarly protect subcontractors and suppliers by guaranteeing that they will be paid and might make it easier for you to find suppliers and subcontractors who are willing to work for you on your project.
The subcontractors and suppliers can file claims against your payment bond if you fail to pay them on time instead of filing mechanic’s lien claims against the property’s title.
Performance bond
Performance bonds are the second type of bond that contractors must purchase to perform work on public buildings and for other types of public projects. Many private project owners also require contractors to secure performance bonds to protect them from losses caused by default or non-performance. Additionally, performance bonds guarantee that the contractors will perform work according to the contracted specifications.
Project owners can file claims against a contractor’s performance bond if the contractor fails to perform under the contract or completes shoddy work. General contractors might also require subcontractors to secure performance bonds and file claims against their bonds if they fail to perform or complete substandard work.
Bid bond
The Federal Government requires contractors to purchase bid bonds before bidding on public projects. State and local governments also frequently need bid bonds. These bonds guarantee that the winning bidder will contract with the project owner at the bid amount. Bid bonds prevent general contractors from backing out of projects if they learn that other bids were substantially higher or when they forgot to include something when they submitted their bids.
If a general contractor left something out when it submitted a winning bid, it still would be required to enter the contract. A claim can be filed against the bid bond for the difference between the bid amount and the actual amount, but the general contractor will be required to reimburse the surety company.
Why contractor bonds are important?
Significant risks are involved in the construction industry. When a project is large and expected to last for several years, many things can happen and interfere with the contractor’s ability to complete the project on time. Economic downturns and inflation can combine and make the cost of supplies go up while the contractor’s business declines. Because of these types of risks, project owners frequently require contractors to purchase several different types of surety bonds for protection.
In most states, contractors must purchase license bonds to secure licenses to operate legally. In states where contractors on small projects are not required to be licensed, it still makes sense for contractors to get bonded and licensed. Doing so might help you gain access to more projects and accelerate the growth of your business. Once you purchase a contractor bond, ensure that you always comply with the law and meet your contractual obligations to maintain a good relationship with your surety and your clients.
