What is a Surety Bond?
A surety bond is a legally binding contract between three parties— the Principal, the Surety and the Obligee—that ensures that the principal will fulfill agreed-upon obligations to the obligee. The Surety is a middleman that guarantees that the principal will adhere to the conditions of the bond and will pay the damages if the conditions of the contract are violated. This type of bond is a way to guarantee that the terms of a contract will be fulfilled, and the Obligee will be compensated if those terms are not fulfilled.
In a surety bond there are three parties:
The principal: This is the party that buys the surety bond. This party can involve business owners or contractors.
The Obligee: This is the party that is protected by the bond. The Obligee may be the government or private companies and the general public.
The Surety: This is usually an insurance company, bank, or other financial institution that issues the bond and guarantees payments.
How Does Surety Bond Work?
Suppose a small or medium-sized contractor bid on a construction project and the project managers, be it a private company or the government, wanted the construction to be carried out in accordance with industry standards. In order to ensure this and also protect themselves from loss due to poor construction, the project managers may require the contractor to take out a surety bond with its conditions being that the contractors do their job in a timely manner and in keeping with industry standards. In this case, the contractor is the Principal, the project managers is the Obligee, and an insurance or bond company is the Surety.
Is Surety Bond Right for My Business?
Depending on your type of business and the sector within which you operate you may find your business as either the Principal or the Obligee of a surety bond. In the United States, contractors going into business with the government are required to take out a surety bond. In this case, your business would be the Principal of that bond. If you are seeking to protect your business from the actions of an employee, then your business would be the Obligee. Generally, you would need a surety bond if your business is a:
- Construction company bidding on a government project or any project above $100k
- Dealership i.e. cars and even some consumables like Alcohol
- Brokerage firm
- Law firm etc.
When to Get Surety Bonds
A surety bond is usually gotten before bidding on a project for contractor bonds, or hiring a new employee for fidelity bonds. Usually, a surety bond is taken out before the contract for which it was issued commences.
The Costs of a Surety Bond
The cost of a bond depends on the insurance company or bond broker but is usually between 1%- 4% of the total amount of the bond per year for businesses with a credit score higher than 700, and between 5%- 15% for businesses with lower credit scores. The credit scored used may be business, personal or both, depending on the surety and the type of bond. The principal incurs all the cost of a surety bond.
For example, a $20,000 bond at a rate of 2% spanning a 3-year period would see the principal paying a yearly amount of $400 as “bond premium”.
How to Get a Surety Bond
- Apply for a bond from an issuer.
- Get evaluated and get a quote depending on your business’ credibility and past financial records.
- Sign an indemnity form stating that you will pay the bond issuer the total amount of the bond if a claim is made and the issuer pays on your behalf.
- Pay for the bond.
If the principal does not default on the terms of the contract then only pay the bond premium.
Requirements for a Surety Bond
- A credit score above 550.Sureties do not usually grant bonds to businesses with credit scored below 550, but this is not a guarantee. A good credit score i.e. one above 700 is the safest bet.
- Financial statements for the past three years.
- A small business line of credit.
- Experience in industry. This includes past performance of the business seeking a bond.
Types of Surety Bonds
- Contract bond: Protects project owners from damages from construction companies. Makes sure the contractor carries out the project as agreed.
- Commercial surety bond: This is to make sure dealerships and businesses catering to the general public in some sectors follow agreed upon terms.
- Fidelity surety bond: Used to protect companies against malpractice by an employee.
- Court surety bond: Used to protect lawyers in situations where they don’t win court cases. The bond makes sure they still get paid.