Construction bonding is a risk management tool used to protect project owners and developers. A bond constitutes a legal guarantee that the project will be completed as expected. In instances where a bonded contractor fails to perform, the bonding company will provide some form of restitution to the owner. While bonds are not required on all projects, there are strict bonding standards on government work. Many private owners and developers might also require bonds to protect the interests on various projects.
Three types of bonds are used in construction. Bid bonds are issued during the bidding process. They constitute a guarantee that a company will sign a contract for their specified bid price if they are the low bidder. Performance bonds ensure that the contractor will complete the job according to the contract. If they fail to perform, the performance bond guarantees that no money will be lost in bringing in another contractor to complete the work. Payment bonds guarantee that all suppliers and subcontractors will be paid for work performed.
Bonding offers a number of benefits to project owners, who often face enormous financial risks. A company must be thoroughly investigated before they are issued a bond. By requiring bonds, the owner is getting a guarantee that the company is financially qualified to take on the project and has a solid performance history. Jobs that are bonded are much more likely to be completed without incident because of the huge financial and legal penalties contractors face for failing to perform.
However, construction bonds present several drawbacks for owners and contractors. The bonding premium might range from 1 percent to 2 percent of the project price. This cost is passed on to the owner in the form of higher bids. For contractors, bonds can be difficult to obtain. New companies might not have the required performance history to qualify and those that do will have limited bonding capacity.
Bonds are issued by organizations known as surety companies. Once a contractor becomes aware of bid requirements on a job, he will contact a surety company to arrange a bond. The surety company will evaluate the contractor as well as the risk associated with the project before determining the bond rate. Once the contractor pays this premium, he is issued a bond certificate, which must be submitted along with the bid. Once the contractor fulfills all obligations associated with the bid or the project, his bond premium is refunded.
Since the Miller Act of the early 20th century, payment and performance bonds have been a requirement on all government projects over $100,000. In 1994, the act was amended to require bonds on all projects valued over $25,000. The 1994 amendment also specified that a bid bond should be submitted on all jobs that require payment and performance bonds. Jobs valued under $100,000 must allow contractors to submit a cash deposit rather than a bid bond. This gives less-established companies an opportunity to bid.