How Does a Surety Bond Work With Respect to a Receivable?

Surety bonds protect the public or private owner from financial loss in the event the contractor does not perform according to the contract. This protection impacts the contractor financially and results in the placement of a number of restrictions on the bonded contractor. One of the primary restrictions is that placed on a contractor's receivables.

A surety bond guarantees a contractor’s full execution of a construction contract for bid, payment or work performance. The surety is a third party guarantor, similar to a bank that provides a letter of credit. The surety promises to pay out the amount of the bond to the project's owner or developer in the event the bonded construction firm does not adhere to the contract. If an owner forces the surety to pay, the surety will immediately pursue restitution from the bonded construction firm.

To ensure there are adequate assets to pursue, the surety bonding firm places a lien against all receivables related to its bond. These “bonded receivables” are account receivables, A/Rs, generated from the contract that required the bond. The bonding company is in first position with these A/Rs. If you have a business line of credit, a bank will exclude any bonded receivables from consideration since the bank would be in second position for the asset, behind the bonding company.

Often when bonds are required, owners or developers pay contractors on a percentage of completion. If the developer's project manager or architect deems you completed 40 percent of the project, you will be paid for 40 percent, even if you actually spent and submitted for reimbursement of 50 percent of the project costs. Therefore, the conversion of your bonded receivables to cash payments could lag significantly if you do not closely follow your contract. This is one reason why bonding companies focus so much on a construction company's past performance and financial strength when deciding whether or not to bond.

Fortunately, as your construction firm performs the work, generates the A/Rs and pays suppliers and contractors, you continually decrease your exposure on that bond. For example, on a $1 million bond, you may have completed nearly half the work and received payment for 40 percent. Now your true bond exposure is closer to $600,000. Although this does not change the relationship to the bonded receivables, the overall risk to your company has decreased.