What you need to know about surety bonds and whether you need one
As a small business owner, you may have heard the term ‘surety bond,’ or you may have heard other businesses describe themselves as ‘bonded and insured.’ But what does it mean to be ‘bonded,’ and how do you know if your business needs a surety bond?
Here’s what you need to know about what a surety bond is and whether or not you need one.
What is a surety bond?
A surety bond is a contract between three parties – the principal, which is the company presenting the bond (your business), the obligee, which is the company or entity requiring the bond (your client), and the surety (the company you purchase the bond from). In the contract, the surety guarantees that the principal will perform the duties and activities required by the obligee.
The principal pays a fee to the surety, who then assumes the risk, up to a certain dollar amount, if the obligee maintains that the principal did not adequately perform the duties in an implied or specific contract.
You may need a bond in order to conduct business in your line of work, or you may need one for a specific project.
Surety bonds for certain types of businesses
Bonds – called commercial bonds - may be required for some types of businesses, and these requirements are dictated by the state in which you operate. For example, in Massachusetts, you need to have a surety bond if you are an auctioneer, a private detective, or a used automobile dealer. In Texas, you need a surety bond if you collect debts for a third party. In California, you need a surety bond if you are a tax preparer or a process server.
To determine if a surety bond is required for your business, check with the national association for your type of business, if there is one. For example, the National Association of Professional Process Servers can tell you if your state or municipality has licensing laws and surety bond requirements. Your state Real Estate licensing board will have requirements for the surety bonds that real estate brokers must maintain.
Surety bonds for specific projects
Bonds issued for specific projects, typically construction projects, are called contract surety bonds. When a contract to build a project is awarded, the company which won the contract (the principal) obtains a surety bond that will compensate the project owner (the obligee) in the event that the contractor defaults on the contract or causes a financial loss of some kind.
There are four types of contract bonds.
- A bid bond protects the project owner if the winning bidder doesn’t sign the contract or provide the payment and/or performance bonds required by the contract.
- A performance bond guarantees that the surety will ensure the contract is completed, if the contractor defaults. This guarantee may include the costs associated with identifying and hiring a new contractor and the cost of any delays.
- A payment bond guarantees payment to subcontractors and suppliers as stipulated in the contract.
- A warranty or maintenance bond provides a guarantee that material defects in the construction will be repaired within the warranty period.
What is the cost of a surety bond?
A surety bond is priced based on the amount of risk the surety is assuming, and the likelihood that they will have to pay out on the bond – in other words, the likelihood that the principal will default. For this reason, companies with good credit and no record of default may pay less for their surety bonds than companies that are new, or that have a history of default.
The type of business has some bearing as well. For example, the standard bond for a real estate broker covers their handling of deposits and escrow payments. The typical requirement is a $5,000 bond, and a real estate broker can usually obtain one for six years for about $50. For a large-scale construction project, the surety bond would need to be for a significantly higher amount – perhaps $1,000,000 or more – and would be significantly more expensive.
The best way to determine your cost for a surety bond is to get quotes from at least three surety bond companies. Many companies will provide a quote online when you answer a few questions.
Does a surety bond replace insurance?
A surety bond does not replace general or professional liability insurance. A surety bond protects only the obligee, or the customer or owner of a project. In order for a small business to be fully protected, business insurance is also required.
Likewise, small business insurance does not negate the need for a surety bond. Surety bonds are often required by federal, state or local government entities, professional organizations, and contract owners. Not having or obtaining a surety bond and insurance may disqualify you from being awarded certain contracts.