As a project manager in construction I’ve learned that not everything is in your control, so be prepared for anything. The same goes for the owner of a construction project. Things happen and unforeseen issues arise, so to protect themselves they obtain a construction surety bond.
When I refer to “things” I am referring to if a contractor in unable to fulfill their contractual obligation to the project. This could be missing deadlines/causing delays to performing low quality work that they can’t correct.
With a performance bond in place, the owner can make a claim which will provide them with a financial compensation. The money they receive can go toward hiring a new contractor to correct the poor quality work. A payment bond will protect the contractor, should the owner fail to pay for the work completed.
So, the bond has been paid out to the project owner. Now the contractor that purchased the bond will need to pay the surety company back. The amount will be the total of the contract value for the contractors work.
I should also mention that as a project manager in construction, bonds are not something that I personally deal with. Most construction companies will have administrators that handle the paper work involved with obtaining a bond. Having this information is still valuable as it can be a critical step in the construction process.
Let’s look at what a construction bond really is about.
Construction Surety Bonds
When it comes to surety bonds, there’s typically three parties involved. You have the principal (contractor), the owner (obligee), and the surety bond company.
The surety company will be responsible for collecting the fees from the principal to create a bond. They’re also responsible for paying the obligee should they file a claim on the bond.
There are various types of bonds that we will cover in this article. You should know how the different bonds work to understand if you may require one for your job.
Work with a surety company to determine the options that you might have for your project. Just know that a bond is not always required but provides some protection for the job.
Before we move forward, I want to cover the difference between a bond and insurance.
Difference Between a Bond and Insurance
You should know that there’s a difference between a surety bond and insurance. The surety bond is designed to usually protect the owner. An insurance policy is in place to protect the contractor should there be an accident on the job site.
If there’s accidental damage or an injury in a construction project, the contractor involved must make a decision. Pay for the repairs or hospital bills out of pocket, or have insurance cover the costs. Of course when you choose to go with insurance this will result in a higher premium, so this is where you need to weigh your options.
Insurance is not meant to payout the owner should these issues occur. Only case where insurance will payout the owner of a job is if their property is damaged during the work. But again, this is the decision of the contractor to pay the repair expense out of pocket.
Three Major Construction Bonds
Being in the construction industry, you will mainly encounter three types of bonds.
1. Performance Bond (Also known as a contract bond)
2. Payment Bond
3. Bid Bond
Each one of these bonds serve a different purpose, but they protect the contractor and owner in some way. When looking at these bonds, just know that performance and payment bonds usually go together. The owner is required to pick up the payment bond, and the contractor pays for the performance bond.
The project owner is required to obtain a payment bond because it guarantees that the contractor will get paid. Where the performance bond protects the owner from any issues with workmanship in the project.
Performance Bonds & The Miller Act
Know that bonds are not required for all jobs. On private jobs, it’s at the owners discretion if they would like to have the project bonded. It comes down to the size of the project in this case.
On federal jobs, a performance bond is only required if the contract value is greater than $100k. This is due to something called the Miller Act of 1935. This was enacted to protect the federal government should the contractor fail to perform.
With the Miller Act there eventually was the development of the Little Miller Act. This basically modifies the requirements for bonds between the states. You can use the links below to learn more about how the Little Miller Act applies to your state laws.
When the general contractor is awarded the project, they work to obtain the performance bond right away. The bond amount will be between 1-3% of the contract value.
The rate of the bond can vary based on a few parameters.
1. Contractor Financial Standing
2. Work History/Performance
3. Credit Score
4. Contract Value
The best analogy I could use it when buying a house, the lender will pull your credit history. When they know your credit score and history they can determine how risky it will be to give you the loan. The more risky the loan the higher the interest rate so the lender can guarantee they get something from the deal.
I should also mention that in my experience, the federal government paid for the performance bonds. But, this payment was not direct from the government to the surety company. Our company had to cover the cost initially and bill the government once we provided proof of payment.
So, this means the cost for the bond needs to be accounted for in your estimate. The cost for the bond will be your first item in the schedule of values submitted when you send in the invoice.
I believe the reason the government covered the cost was because it provided additional incentive to take on the work. For large construction projects, the cost of the bond can become expensive. This would become a financial burden if the contractor had to cover it out of pocket.
Last on this list is the bid bond. When a project has finished the design phase in a design-bid-build job, the owner will need to issue an RFP. Contractors create proposals based on the RFP and submit it for the owners review.
The contractor will need to obtain a bid bond when they submit their proposal (bid). This guarantees they will remain faithful to their price and will carry out the work.
Surety companies will all vary when it comes to the cost of the bid bond. They may not charge anything for the bond or it could be a marginal flat rate.
Bid Bond Penalty
If the contractor decides to back out after they’ve been awarded the job, there will be penalties.
When you obtain the bid bond, you will need to request for a certain amount. The bid bond amount will vary between 5-10% (20% for federal jobs) of the bid price. This amount will be paid to the owner when they make the bond claim.
The money is meant to cover the cost difference for the next bid on the list. If the money has to be paid out, the surety company will be coming for the contractor to collect on the costs.
Other Types of Construction Bonds
What is it?
Also called a warranty bond, this covers the owner from any defects they may experience with new equipment. If the equipment fails and the contractor is unable to correct the issue, then the owner will need to find someone who can fix it. The surety company will compensate the owner to cover the cost for repairs.
This bond is only valid for as long as the defined warranty period. On construction projects this period is typically one (1) year long.
When is it required?
The maintenance bond is not required by law like the performance and payment bonds. This may be included in the terms of the contract with the owner so this needs to be carefully reviewed.
Additionally, project specifications will make references to any warranty required for a project. When a construction company enters into a contract they agree upon doing the work to meet the project plans and specifications.
A guarantee will be made to the owner in the form of a warranty letter. The letter will state the warranty period along with what is covered.
The amount for the maintenance bond varies on your credit score, bond amount, work record, and financial standing.
What is it?
Retention on a project is money that is withheld during the monthly progress billings. This money is usually held from owner to general contractor (GC) or GC to subcontractor. The amount will be either 5% or 10% of every invoice.
This is a standard practice in construction as it provides the company releasing the funds with some leverage. If the contractor does not fulfill their part on the project to closeout, they will not get paid the retention.
Now, if the construction business does not want retention to be held against them, they can obtain a retention bond. This way they can get paid the full amount during every billing period. If the contractor fails their duty, then the surety company will payout the obligee as compensation.
When is it required?
A good application for this type of construction bond would be if your work occurs in the very beginning. The retention does not get paid out until the project is completed and the owner pays up. Depending on the contract value, that could be a significant sum of money sitting.
Instead of waiting, obtaining this bond will allow you to claim that money. The nice part is that some jurisdictions require that owners for public projects must accept the retention bond. Unless they can provide a good reason for denying it then you’ll get your retention.
How much does it cost?
This depends on the contractors standings and the surety companies pricing. One company I found charge a fixed price per thousand dollars of the retention amount.
What is it?
This guarantees that the principal (contractor or vendor) will provide materials, equipment, supplies as required by the project plans & specs.
When is it required?
The supply bond requirements vary from state to state. The Miller Act does not specifically state that a supply bond is required for a project as well. However, the owner can make the decision to require supply bonds for their project.
The amount for the bond depends on the contractors standings.
Site Improvement Bond / Subdivision Bond
What is it?
This is a type of performance bond, but with one key difference. The project developer is the principal for this bond. And the obligee is the government agency working with the developer.
This bond is required when planning a new development. It guarantees that the developer will also consider the existing site conditions around the project. Any sidewalks, gutters, roadways, etc.. need to be accounted for during the project.
The extent to which the repairs/improvements need to occur are dependent on the subdivision codes. Also, it’s important to know that the site improvement bonds are used for existing buildings. Subdivision bonds are used for new construction.
The amount for this bond is similar to a performance bond.
Contractor License Bond / Permit Bond
What is it?
The contractor license bond ensures that the contractor will complete the work to meet local code and licensing requirements. This goes hand in hand with the permit bond. The contractor will need to show their license is in good standings, then obtain a permit bond for the permit to the job.
When is it needed?
Requirements for contractors bond varies from states to state. In Hawaii, every contractor is required to be bonded. This can cost them a minimum of $5,000 per year but I recommend looking up your states local requirements.
Bond amount is dependent on the contractors standings, the rates vary from 1-5%.
Material Payment Bond
This is another type of payment bond that needs to come from the owner. It guarantees that the contractor will get paid for material used on a job site. You can also see this being referred with a labour and material bond.
What is it?
This is required for contractor that have violated their local code and have had their license suspended. If they would like to keep working on construction projects, they must carry this bond to get their license back.
The bond cost can vary. In the state of California, the minimum amount is $15,000. In other states, the amount can be up to ten times the contractors license bond cost.
As you can see, there’s many different types of construction bonds. You will need to work with your bonding company to determine the rates that you’re eligible for. Your company may have to show some level of financial security, but that just the cost to do business in construction.
Construction contracts will vary between projects. Carefully review any contracts issued to your company and look out for the bond requirements. As a business owner or project manager, it’s important to understand these requirements to save you from financial hardship.
Thank you for reading.
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