Understanding Surety Bonds for Small Business
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A surety bond is a legally binding agreement that holds people accountable for fulfilling an obligation to someone else. Within the agreement, one party guarantees the actions of another party to follow through on promises made.
There are different types of bonds that can be useful in business, such as bonds that hold contractors responsible, provide protection against employee theft or cover losses from court cases. In some circumstances, your state or local government may mandate that you obtain a surety bond to legally operate.
Continue reading to understand how surety bonds could affect your small business.
- What is a surety bond?
- 5 different types of surety bonds
- How to get a surety bond
- State-level differences to keep in mind
What is a surety bond?
A surety bond involves three parties that create an agreement to carry out specific obligations.
The principal: The party obliged to complete a task.
The obligee: The party for which the task is performed and is protected by the bond against loss.
The surety: A third party providing the bond to guarantee the work of the principal.
The obligee typically requires the bond as part of the business arrangement, and the principal must purchase it. The surety issues the bond and promises to be liable for the default or failure of the principal if the agreement is broken. Surety bond companies, which usually act as sureties, would then pay the obligee if the principal does not follow through on a contractual agreement. Surety companies can also assist principals in competing for contracts, as the surety bond would guarantee their work. Surety companies may also be referred to as surety bond producers.
An example of a surety bond would be a bond guaranteeing the work of an independent builder or contractor. The surety bond would act as an assurance that a builder would properly complete projects, complying with regulations such as building codes and safety regulations.
There are various surety bonds that exist to address specific situations, but most share basic characteristics, such as:
- Bonded amount: Sureties typically cap the amount that can be bonded for a single project. The maximum amount is usually between 10 and 15 times the principal’s equity.
- Bonded capacity: The total bonded amount that a principal can obtain for multiple bonds is also capped, based on a combination of the business’s equity and working capital.
- Bond premium: A fee — typically between 1% and 15% — that the principal pays annually to the surety as the surety bond cost.
- Bond term: A term of one to four years is common for surety bonds, though some may not have an end date.
- Working capital: Sureties often prefer principals to have working capital that equals at least 10% of the bonded amount.
Non-business uses for a surety bond: Surety bonds also appear outside the business world. For example, notary surety bonds are available to ensure that notaries don’t cause financial harm when performing their professional duties.
In some instances, you may be able to substitute a surety bond for a car title. Georgia residents who do not have proof of ownership documents could obtain a Georgia car title on the basis of a surety bond.
5 different types of surety bonds
Surety bonds typically fall into two basic categories: contract surety bonds and commercial surety bonds. You may have heard of a security bond, but that term is often mistakenly used when discussing surety bonds. And although cities, states and other government entities often issue municipal bonds, these are simply just debt securities used to fund projects.
Contract bonds relate to our earlier surety bond example, as they guarantee the work of a contractor to complete a specified job. Commercial surety bonds generally have a broader purpose, and businesses could be required to have one through federal, state or local regulations or ordinances.
Below, we’ll dive into more detail about contract and commercial bonds, as well as other surety bonds you may come across.
Contract surety bond
A contract surety bond is often in the form of a construction surety bond to guarantee the completion of a construction project. The contractor purchases the surety bond and if the contractor defaults on the project, the surety company would either compensate the project owner for the financial loss or find another contractor to finish the job.
You could find contract surety bonds in a variety of forms:
- Bid bond: Provides financial protection to the project owner that a contractor has entered into an agreement in good faith at the price bid and will post the appropriate performance bond.
- Performance bond: Guarantees the surety would provide another contractor to complete the project if the original contractor defaults.
- Payment bond: Guarantees payment to subcontractors and suppliers.
- Warranty bond: Ensures that any faulty construction will be repaired during the warranty period.
If you own a construction company, obtaining different types of surety bonds could help you establish trust with your customers. Conversely, requesting a surety bond any time your business hires construction contractors would ensure they hold up their end of an agreement.
Commercial surety bond
Government entities require commercial surety bonds to make sure certain entities perform as they should and comply with regulations and codes. Other business entities could also require that a business obtain a commercial surety bond before entering into an agreement. The many different types of commercial surety bonds include:
- License and permit bonds: Required to obtain a license or permit for various fields and professions.
- Mortgage broker bonds: Holds mortgage brokers to state-specific regulations.
- Other professional surety bonds: Specialized bonds available to a range of companies, including liquor companies, utilities businesses, car dealers and travel agents.
Commercial surety bonds are typically in place to protect the well-being of the general public. If your business is related to public interests, you could be required to obtain surety bonds.
SBA-guaranteed surety bond
Surety bonds are a form of credit, and small businesses may not have the collateral or capital needed to qualify for one; without the necessary bonds, companies may not be able to compete for certain projects. The U.S. Small Business Administration guarantees surety bonds from select surety companies, which then encourages those companies to issue the bond when it otherwise might not. As with an SBA loan, small business owners may have an easier time obtaining a surety bond that has an SBA guarantee.
To be eligible, small businesses must have a small contract – the SBA guarantees up to $6.5 million for non-federal contracts and up to $10 million for federal contracts. The business also must meet the surety company’s requirements. If approved, business owners would owe a fee of 0.6% of the bond price to the SBA.
SBA surety bonds guarantee full completion of a contractual obligations, as well as payment to suppliers and contractors and completion of ancillary project requirements.
Fidelity surety bond
A fidelity bond protects a business against employee theft. Purchasing a fidelity bond may be useful if you assign any of your employees to handle cash or other business assets. Three types of bonds are usually available:
- Business services bonds: Protects against loss of a customer’s money, equipment supplies or personal belongings because of your employee’s dishonest acts while on the customer’s premises.
- Standard employee dishonesty bonds: Protects your business against financial loss resulting from fraudulent employee activity.
- ERISA bonds: Bonds required through the Employee Retirement Income Security Act of 1974, protecting retirement plan participants or beneficiaries from dishonest acts of those who manage the plan.
Court surety bond
A court surety bond, which is a type of commercial surety bond, would protect a person or company from losses during a court case. Plaintiffs, defendants and estate administrators commonly use court surety bonds. Types of court bonds include:
- Cost bond: Guarantees payment of court costs during appeals.
- Administrator bond: Protects estate administrators when estate owners die without a completed will.
- Attachment bond: Courts need an attachment bond before seizing property, as it guarantees that defendants will receive payment from any resulting damages.
Surety bond vs. insurance
Surety bonds are not a form of insurance, even though both reduce risk. A surety bond protects the obligee if the principal doesn’t follow through on an obligation, but losses are not covered as they would be with an insurance policy.
For instance, the surety would pay the obligee, or the project owner, if the principal, or contractor, doesn’t finish the job. But the contractor would likely be on the hook to reimburse the surety for the payment. The contractor would’ve had to pay a fee to obtain the surety bond, but that fee would not be designed to cover their losses.
On the other hand, insurance policies require the payment of premiums on a regular basis. If you incur any losses as the contractor, the insurance policy would likely cover those, minus any deductibles. Insurance companies may provide insurance policies as well as surety bonds.
How to get a surety bond
Surety bond companies are subsidiaries or divisions of insurance companies that issue surety bonds. Those companies, also referred to as surety bond producers, must be authorized through state insurance commissioners in the state where they do business. State insurance departments regulate surety bonds, much like traditional insurance policies.
When seeking a surety bond, you’d need to go through an underwriting process that mirrors a loan approval process. A surety company would analyze many aspects of your business — for example, when obtaining a contract surety bond, the company may review the following information about the contractor:
- Credit history
- Financial strength
- Work experience
- Any works in progress
- Management ability
- Personal character
The surety would expect you to carry through with your obligation. If you don’t, you’d need to reimburse the surety for the amount they paid to the project owner. Based on the underwriting process, the surety company would decide whether you’re reliable enough to work with, and the bonded amount they’ll offer.
Large insurance companies, like Travelers and Nationwide, provide surety bonds for business owners. You may be able to work with an SBA-backed surety bond agency in your area as well.
State-level differences to keep in mind
In many states, certain types of businesses must acquire a surety bond in order to operate. For instance, real estate brokers are often required to be bonded before getting a professional license.
Here’s a look at how a few states handle surety bonds.
Surety bonds in Texas: The Texas Department of Insurance requires construction and contract bonds before a project begins. Either state law or municipal ordinances mandate that many Texas businesses obtain license and permit bonds before engaging in business activity. Grain warehouses, health spas, insurance agencies and notaries are among the other types of businesses that need surety bonds to operate in the state.
Surety bonds in California: The California Secretary of State provides forms for the number of businesses that need surety bonds. California businesses required to get surety bonds include auction companies, dance studios, employment agencies and fitness and wellness centers. The forms cost $30 to file with the California Secretary of State’s office.
Surety bonds in Florida: The majority of bonds required in Florida are commercial bonds for businesses such as auto dealers, collection agencies, mortgage brokers and telemarketers, according to the state’s Division of Consumer Services. Contract bonds are also necessary for construction work for public entities, such as the state or cities or counties.
But even if your state does not require your business to purchase a surety bond, you may still encounter one of the various surety bonds that exist. Whether you request that a contractor purchase a surety bond before working with your business, or you buy your own bond to protect your company against dishonest employees, a surety bond could prove beneficial.