Since the economic crash and recovery over the past decade, Owner- and Lender-required Payment and Performance (P&P) bonding for construction projects has become more prevalent across the industry. Traditionally, bonding has been associated with public projects in order to protect taxpayer dollars. Additionally, General Contractors are often required to secure bonds on larger projects, as are smaller and less-established subcontractors.
Some contractors are able to “test out” (become exempt) from bonding requirements, often based on their reputation, longevity, and sound financial position, or through their relationship with the Owner/Developer/Financier. Contrarily, some contractors cannot qualify for bonding when evaluated on the same criteria.
Qualifying for a Bond
Qualifying for a bond is similar to applying for a mortgage. Contractors must show the Surety (the Bonding company) that they have experience, sound financials, and can produce a solid resume, in order to qualify for bonding. Applicants are evaluated on three main factors: Capacity, Capital, and Character.
While Capacity and Capital are objective calculations based on a company’s financial data, Character often weighs the heaviest in qualifying and can be a more difficult factor for a Surety to evaluate.
What would you look at to assess a company’s character? Sureties often look to both measurable and subjective indicators, such as job references, supplier references, litigation history, and may also look at the financial (and criminal) records of the company’s key individuals (i.e.: owners, board members, equity partners). Surety providers invest a significant amount of time and resources to research an applicant’s company and background when deciding whether to qualify the company for bonding.
On average, it will take an applicant company 3-6 months to qualify for and establish their bonding capacity with a Surety company. It may take longer if they are a large company, as there is more financial data to review.
New companies that lack any financial and performance history may also qualify for bonding, but must be able to prove they are low-risk contractors. Owner investment into the company will often be counted in their favor, as well as a resume of past work while employed at other bonded companies. A stable workforce and a sufficient backlog of work will also count in their favor and help qualify them with a Surety.
New companies have also been approved for bonds based off of positive relationships with their Surety or Bond Agent. If the owner came from a successful, established contractor with a positive bonding history, they may be able to establish their own bonding capacity based on this pre-existing relationship. An owner with a good relationship with bonding the agent has a much better chance of getting approved than a new company with an owner who has no relationships.
Will You Need a Bond?
If a General Contractor is required to bond a project, typically they will pass on that risk to the Subcontractors. It is also not uncommon for a general contractor on a non-bonded project to still require bonds from some or all of their subcontractors (this is a standard risk mitigation tactic).
Occasionally, general contractors may be required to bond a project, but may not require all of their subcontractors to get bonds. This could occur if the subcontractors are well established companies with secure financials and long histories of successful project performance. For example, if a GC has been using the same subcontractor for 20 years without issue, chances are that the GC won’t want or need to bond them. Ultimately this may be decided by the GC’s Surety and, possibly, the Owner’s bank, who may not have the same confidence in the subcontractor.
Companies who team up with local bonding agents usually have a better chance of approval, and receive them more quickly. This is because the bond agents are able to guide them through the process and ensure that their paperwork is accurate, executed correctly and routed to the correct people for evaluation.
Other positive traits that may contribute to bond approval include:
- Contractors with a positive job history: steady profit margins look great on applications
- Contractors who come from families of successful contractors; they have seen up close what works and what doesn’t
- Contractors who keep the money in the company (re-investing)
Banking and Bonding
When looking to establish bonding capacity, Sureties often look to a contractor’s Banking Support (think: lines of credit). Contractors typically use revolving lines of credit to cover short-term needs such as paying suppliers, covering payroll, and handling other corporate expenses. Most banks require that the company repay the full balance of the line every so often (typically every year).
Banks lend money based on the three C’s: Cash flow, Collateral, and Credit score. Contractors must satisfy all three to qualify for a commercial line of credit, whether Secured or Unsecured. As a part of this process, banks will require a formal ‘Reviewed Financial Statement’ from a reputable construction CPA for a contractor. As contractors grows in size and need more credit, banks will often increase their scrutiny of company financials, resulting in the need for quarterly or monthly financial updates and reporting from the contractor.
The line of credit account is often guaranteed by the owner’s personal signature, the equipment of their company (assets), accounts receivable, and any other assets owned by the company. Because contractors and construction companies are considered a medium-to-high risk account (from a borrowing standpoint), banks are very picky about which contractors qualify for loans and lines of credit.
Because of these qualifications, Surety providers often look at a contractor’s established credit lines, borrowing and payment histories as indicators of potential risk, or confidence in a contractor. Basically, if the bank trusts you with a significant line of credit, this will provide a certain level of confidence to the Surety provider.
At a minimum, contractors should be prepared to send annual financial updates to both their bank and their Surety provider. Depending on the volume and size of the bonds required, this information may need to be sent more frequently to the Surety (quarterly or monthly). High-volume contractors (lots of small bonded projects) will typically need to send updated financial reports more often than low-volume contractors.
Reasons for Denial
Aside from poor financials, lack of work history and questionable character, there are a few other conditions which will typically be used as grounds for denial of a bond application.
Tax Liens are a red flag for Sureties and often will result in a denial of eligibility. A tax lien is imposed for delinquent taxes owed on real property or personal property, or as a result of failure to pay income taxes or other taxes. However, if the contractor can show that the situation was minor and was resolved quickly, then it’s possible they may still be approved.
Other factors that may cause a contractor’s bond application to be rejected include Bankruptcies, Foreclosures, and Maturity Loss.
If a contractor defaults (fails) to either pay or perform on a bonded project, the bond will be ‘pulled’ or ‘exercised’. This means that the Surety will pay out to complete the project. After the project is completed and all debts have been paid, the Surety will return to their contractor to be reimbursed for these costs. A Maturity Loss occurs if the contractor does not repay the Surety for their costs.
With the current increase in projects requiring bonded contractors, having an established bonding capacity is becoming the new industry-standard. Since the approval process can take months, most commercial contractors are now securing their bonding capacity well in advance of needing to use it.
As the old adage says: “Better to have it and not need it, then need it and not have it.”
By knowing what the Surety companies are using to evaluate contractors, it becomes easier for contractors to set themselves up for success. Sound financial reports, positive relationships with other contractors, owners and banks, and a solid work history are key ingredients. Building a relationship with a local bond agent can also increase both the likelihood of surety approval and of a higher bonding capacity.
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