Business owners must meet numerous obligations and legal requirements when they open and operate their companies. Depending on the industry in which a business operates, securing a surety bond might be one of the requirements that must be met.
Many prospective business owners must secure surety bonds before they can get their licenses from the state to operate their businesses. Others might be required to obtain surety bonds as a part of the contracts they enter to perform different types of work. Here is an overview of surety bonds to help you understand what they are, how they work, and when they might be required.
What Is a Surety Bond?
What is a surety bond? A surety bond is a contract between the principal, which is the business seeking the surety bond, the obligee, which is the party requiring the bond, and the surety company, which is the company that issues the bond. Surety companies issue bonds up to a maximum amount to guarantee the principal will fulfill its obligations under its contracts to perform work up to a certain amount. However, the principal retains the responsibility for paying any claims that might be filed against the surety when it fails to perform as promised. The surety will only step in when the principal defaults and fails to pay its claims.
Is a Surety Bond a Type of Insurance?
Surety bonds are not insurance. They do not protect the businesses that purchase them. Instead, they protect consumers. When a claim is filed against a surety for the principal’s failure to perform under a contract or to meet its legal requirements for licensing and other duties, the principal remains liable for paying the claim.
The surety might step in and pay the claim when the principal does not. However, the surety company will seek to recover the amount it has paid by seizing the company’s collateral for the bond or pursuing other means of reimbursement. When a surety bond is issued, the principal will have to sign an indemnification agreement in which the principal will agree to pay any filed claims.
How Do Businesses Get Surety Bonds?
Surety bonds are offered by surety companies. A business owner can apply for a surety bond with a surety company, but approval is not guaranteed or automatic. Instead, the surety company will complete an underwriting process to determine whether or not to issue the bond. Some of the factors a surety company considers when deciding whether to approve an applicant for a surety bond can include the following
- The principal’s available working capital
- The business owner’s and the business’s credit score
- The reputation of the business and the business owner
- The company’s experience in performing projects of a similar size
- The company’s financial statements when the project will be large
- Any history of claims filed against the company or its surety
In general, companies need to have sufficient working capital to cover potential losses. A surety will want to know that you have enough capital available for potential claims. Your credit score and assets will also be important. If you have bad credit, it will be more difficult for you to get a surety bond. If you are able to get one, you will likely have to pay a much higher percentage of the total bond amount upfront than if you have good credit.
If you have had surety bonds in the past with a history of multiple claims or defaulted claims, you might not be approved for a surety bond. This can also cause problems for you in your ability to operate your business at all since state licensing boards for some industries require surety bonds before they will issue business licenses.
When Are You Required to Get a Surety Bond?
Surety bonds can be project-specific or industry-specific. Business owners operating in certain types of industries might be required to secure surety bonds before they can obtain licenses to operate. Some of the types of businesses for which surety bonds are normally required include the following:
- Auto dealers
- Freight brokers
- Licensed contractors
- Will executors
- Estate administrators
- Businesses or individuals working on public construction contracts
- Collection agencies
There are many other businesses for which surety bonds are required by individual states. You can check with the Secretary of State’s office in your state to determine whether you might be required to purchase a surety bond as a condition of obtaining a license.
In some cases, surety bonds are required as a provision contained within a contract. For example, if you want to perform work on a residential construction project, you might be required by the property owner to have a surety bond in addition to insurance and a license. Project-specific surety bonds are common requirements for individuals and businesses when contracting to perform a broad variety of different types of work.
What Are the Types of Surety Bonds?
While there are many different types of surety bonds, three of the most common include the following:
- License/permit bonds – Bonds required of certain professionals before they can legally operate
- Court bonds – Bonds required by courts for a variety of different purposes
- Contractor bonds – Bonds required by the contract for individuals and businesses performing work on public construction projects
How Much Does a Surety Bond Cost?
A principal is required to pay a bond amount upfront when purchasing a surety bond. This amount is set as a percentage of the maximum bond amount. The maximum bond amount is calculated based on the principal’s financial strength.
The percentage that you might have to pay to secure a surety bond will depend on the assessment conducted during the underwriting process. Business owners with good reputations, excellent credit, and a history of no claims will likely be judged to be of minimal risk and be required to pay around 1% to 3% of the maximum bond amount. Those with poor credit and a history of defaulted claims might be turned down for surety bonds or be forced to pay a high percentage of the total bond amount upfront.
Surety bonds are a cost of doing business for many professionals. Depending on the industry in which your business will operate, you might be required to get a surety bond. Concentrating on performing your contractual and legal obligations at all times can help you to avoid being turned down for a surety bond so that you can continue operating your business.