Major construction projects can be risky, especially those being paid for with taxpayer dollars. There's a chance the project may cost more than expected or that it will take longer than planned. That's why many government agencies and other organizations require contractors to obtain construction bonds, which help ensure the project will be completed according to plan.
What are Construction Bonds?
When a company or an organization needs a new building, they'll first put out a request for proposals from construction companies. Once they've selected the winning proposal, they want some assurance that the project will actually be completed as planned and that the contractor will follow all applicable laws and rules. That's where construction bonds come in.
Construction bonds help ensure that the contractor performs the work as agreed upon. In many cases, bonds are required by government agencies using public funds for construction work or other projects. Bonds are like insurance policies that help protect the government and its citizens from fraud, misconduct, business failures and other liabilities.
Generally, there are three parties involved in bonds: the company or organization that requested the construction work (the obligee), the company managing the construction work (the principal) and the company financially guaranteeing the bond (the surety).
How Do Construction Bonds Work?
When a contractor or a construction company is selected to perform work, they may be required to obtain surety bonds, especially if they're doing work for a government agency. Working with a surety company, the contractor can determine which types of bonds are needed for the project.
In general, the surety company will analyze the size of the job, the type of work being performed and the contractor's credit and financial statements to determine the risk associated with issuing bonds. This risk is how the surety company determines the cost of the bonds, which is typically 1-percent- to-3-percent of the overall project cost.
After issuing bonds, the surety company will then require the contractor to sign an indemnity agreement, which is a legal document that requires the contractor to pay for any claims that arise up to the full bond amount. The surety company will pay the claims first but then expects to be reimbursed by the contractor.
If a contractor fails to complete a project as agreed upon, the organization that requested the work may make a claim against the bond. The surety company will make sure the organization is made whole by finding another contractor for the job, making a financial payout or through some other means. Ultimately, however, the bonded contractor is responsible for the cost of any claims.
What Types of Construction Bonds are There?
There are several different types of construction bonds available.
A bid bond serves as a guarantee that the proposal a contractor submitted is accurate and that the job can be performed as described. If a contractor backs out after winning a job or if their proposal is inaccurate, a claim can be made against the bid bond.
After a contractor is selected to perform work, he'll likely be required to obtain performance bonds, which are required by law for all public work contracts over $100,000. A performance bond is a promise that the work will be performed according to the contract.
A payment bond guarantees that a contractor will pay all sub-contractors, laborers and specialists for their work on the job.
A contractor may also be required to obtain a maintenance bond, which acts as a warranty for a designated time period after the work is completed.