When a contracting client offers a project opportunity by way of a competitive bidding system, it requires that all prospective entrants provide a surety bond called a bid bond alongside their bid submission. The client holds onto the bid bond until the lowest bidding party enters into a formal signed agreement. Once contracted, the company provides the client with another surety bond called a performance bond. The client returns the bid bond to the company in return for submitting the performance bond.

Surety Bonds

Surety bonds are promissory documents issued by a third party as part of a business contract. Generally underwritten by banks or insurance providers, surety bonds assure that a client will receive compensation for wrongdoing on the part of the company. Bid bonds and performance bonds are two commonly-used surety bonds.

Bid Bonds

Bid bonds are purchased by prospective contracting companies that take part in a competitive bid for a project. These companies submit a bid for the price they charge as well as a bid bond for that same amount. A bid bond ensures that the contracting client will still receive the lowest price even if the lowest bidding company withdraws without entering into the contract.

How Bid Bonds Work

If a company is chosen as the lowest bidder in a competitive bid for a project, nothing is incumbent upon it until it formally signs a contract with the client. Should the company decline to sign the contract, the client must accept the next-to-lowest bid. In such a case, the bid bond's issuer ensures that the client continues to receive the lowest original bid by paying the difference between the lowest and next-to-lowest bid.

Performance Bonds and the Return of the Bid Bond

Once the lowest bidding company has successfully contracted the client, it is required to submit a performance bond. Similar to the bid bond, the performance bond is provided to protect the client and ensures compensation in the event that the company defaults on its contractual obligations. The client holds the bid bond as collateral until the company submits the performance bond in its place.

Surety Bonds as Insurance

Though surety bonds ensure compensation for wrongdoing, they are not considered insurance policies. If a client in a contract found it necessary to exercise its rights on a bid bond or a performance bond, the bond's underwriter would first compensate the client for the appropriate amount and then solicit the company for the amount of that compensation. In this sense, surety bonds function partially as an incentive for companies to follow through on their obligations.