Types of Bonds in Construction Contracts

Bonds in construction contracts are frequently used to enhance industry regulations and are particularly common in construction. Until a contractor knows their obligations, it is not uncommon for them to know little about construction bonds.

Construction professionals should familiarize themselves with the types of bonds that are often requested, and assist in controlling the industry so that their business runs easily and they can land new projects, driving additional revenues. This article highlights the most common categories of construction bonds.

Parties to Bonds in Construction Contracts

There are three main parties to a construction bond:

Principal: This is the person or company that purchases the bond – usually the general contractor or subcontractor for most projects.
Surety Company (or Bank): This party provides the bond to the project, and is in charge of paying any claims that are made.
Obligee (Owner): This is the person or company who will get paid if there is a problem with the job. The identity of this party varies based on the type of construction bond. The obligee for a payment bond is typically a subcontractor or supplier, while the obligee for a performance bond is usually the owner.

Types of Bonds in Construction

1.Bid Bonds

A bid bond is a guarantee that, once a project bid has been awarded, the bonded contractor will commit to the contract. Bid bonds remove uncertainty from contractors who are not willing to take up a job. This is a process for three parties: the surety company or bank, the owner, and the contractor. Bid bond costs vary, but usually, a flat fee is paid.

2.Performance Bonds

A performance bond guarantees the contractor’s ability to finish and fulfill project construction and installation. It ensures that the project is completed in the way described in the contract and that the deadline assigned to finish construction works is also met.

The owner may claim the bond if the project lasts longer than expected or is finished unsatisfactorily. If the contractual terms of the contract have not been met, the bond can be utilized to compensate the owner.

3.Payment Bonds

Payment bonds are used to guarantee that contractors and suppliers are paid upon the delivery of construction work and materials. They ensure that subcontractors are paid for their contributions to a project and that the project owner does not accept these costs unless the contractor can pay.

4.Supply Bonds

These bonds ensure that contractors can get supplies or materials in a reliable way. If the supplier fails to deliver the items according to the contract, the bond is used to reimburse the purchaser for the resulting loss.

5.Maintenance Bonds

Maintenance bonds are one of the most common construction bonds. They become effective after the contract is completed and generally cover 1 to 2 years after completion of the work. This relationship protects owners against flaws in labors and materials.

6.Retention Bonds

Retention bonds replace retention on a construction project. Instead of letting the General Contractor hold 5-10% of every payment, the subcontractor can purchase a retention bond to guarantee that all work will be completed at the end of the project.

A retention bond will help a subcontractor obtain their full progress payment on time without waiting for retention until completion of the project.

Depending on the cost of the bond, there may be significant savings for the General Contractor over the life of the project. The owner of the project is responsible for making any claims for work that has not been completed.

7.Site Improvement Bonds

Site improvement bonds ensure that the improvements made to projects are finalized. These bonds tend to be used exclusively for renovation projects.

Advantages of Construction Bonds

1. Signals Financial Strength

Typically, the financial requirements for obtaining a guarantee bond are stringent. Bonding agents need to see positive net income with adequate margins, positive operational cash flow and shareholder equity growth to minimize risk.

Bonding agencies seek fairly low debt, a credit line for financing working capital and modest aging on receivables. In addition, agents prefer a robust pipeline of past, current and pending jobs. In a construction firm, therefore, the existence of bonding signifies financial strength.

2. Aids Pursuit of Public Contracts

Even in down-markets, a government must maintain its buildings at all levels. Government entities require bonding for projects over a certain dollar amount, often $1 million, to protect taxpayer dollars and to ensure timely completion of the project.

A large project can hire a general contractor who subcontracts to smaller bonded specialty companies, and a small project may directly hire subcontractors. However, both types of projects will specify a minimum amount of bonding and will require documentation of that bonding.

Unbonded construction companies do not meet the minimum requirement level, and thus cannot seek such contracts.

3. More Attractive to Employees, Subcontractors and Suppliers

Many types of construction companies have low entry barriers. Such organizations often go bankrupt as soon as they are established, leaving unpaid staff, suppliers and independent contractors, who are then wary of companies that they have not previously worked with.

However, if a bonded construction company fails to pay, these individuals and entities have a high-quality remedy which adds a payment security layer. Knowing a company is bonded therefore makes it more appealing to the individuals and companies you need to build your business.

4. Avoids Contract Disputes

A general contractor or developer will sometimes dispute percentage of completion, cause of delay or another performance parameter that is covered by contract. The developer can withhold a payment as part of the dispute.

The main remedy for a contractor without insurance is lawsuits or liens. When bonded, the guarantee of the building company has an overarching interest in dispute resolution until it reaches the stage where the bond is used.

The protection company thus usually intervenes in order to prevent expensive delays and resolve the dispute before it escalates.

How Do Contractors Qualify for Construction Bonding?

The contractor must provide their resume, important official information, personal finances (in some cases), financial statements, and contractor qualifications in order to qualify for a construction bond. Past performance data is also essential in order to ensure that there are no prior default problems.