Performance bonds guarantee that contractors will complete projects according to contract terms. Understanding performance bond requirements is essential for contractors pursuing public works and many private construction projects.
What Is a Performance Bond?
A performance bond is a surety bond that guarantees the contractor will perform the contract according to its terms. If the contractor defaults, the surety is obligated to remedy the situation.
The Surety Relationship
Three parties are involved:
| Party | Role | Obligation | |-------|------|------------| | Principal | Contractor | Complete the contract | | Obligee | Owner | Protected against default | | Surety | Bond company | Guarantee performance |
How Performance Bonds Work
- Contractor obtains bond from surety
- Bond guarantees contract performance
- If contractor defaults, owner makes claim
- Surety investigates claim
- If valid, surety remedies default
- Surety seeks recovery from contractor
Performance Bond Requirements
When Performance Bonds Are Required
Mandatory (Miller Act):
- Federal contracts over $150,000
- 100% of contract value
- Payment bond also required
State and Local:
- Most public works projects
- Typically over $25,000-$50,000 threshold
- Amount varies by jurisdiction
Private Projects:
- Often required by lenders
- Large commercial projects
- Project-specific requirements
Typical Bond Amounts
| Project Type | Performance Bond | Payment Bond | |--------------|------------------|--------------| | Federal | 100% of contract | 100% of contract | | State/Local | 100% of contract | 100% of contract | | Private | 50-100% of contract | 50-100% of contract |
Performance Bond vs. Payment Bond
Performance Bond:
- Guarantees work completion
- Protects owner from default
- Covers completion costs
Payment Bond:
- Guarantees payment to subs/suppliers
- Protects unpaid parties
- Prevents liens on project
Both are typically required together on public works.
Qualifying for Performance Bonds
Underwriting Criteria
Sureties evaluate contractors on the "Three C's":
1. Character
- Business reputation
- Personal integrity
- Industry references
- Credit history
- Claims history
2. Capacity
- Technical expertise
- Project experience
- Equipment and resources
- Personnel capabilities
- Backlog management
3. Capital
- Financial strength
- Working capital
- Net worth
- Bank relationships
- Cash flow
Financial Requirements
Key Financial Metrics:
| Metric | Typical Requirement | |--------|---------------------| | Working capital | 10% of bond capacity | | Net worth | 10-15% of bond capacity | | Current ratio | Greater than 1.25 | | Debt to equity | Less than 3.0 |
Financial Statement Requirements:
- CPA-prepared statements
- Reviewed or audited (for larger limits)
- Current (within 12 months)
- Construction-specific format
Experience Requirements
Sureties look for:
- Completed similar projects
- Successful track record
- Experienced key personnel
- Relevant project references
Performance Bond Costs
Pricing Structure
Performance bonds are typically priced per $1,000 of contract value:
| Contract Amount | Rate Range | |-----------------|------------| | First $500K | $15-25 per $1,000 | | Next $2M | $10-20 per $1,000 | | Next $2.5M | $7-15 per $1,000 | | Next $2.5M | $5-10 per $1,000 | | Over $7.5M | $4-8 per $1,000 |
Rates vary significantly by contractor profile
Factors Affecting Rates
| Factor | Impact on Rate | |--------|----------------| | Financial strength | Higher strength = lower rates | | Experience | More experience = lower rates | | Project type | Complex projects = higher rates | | Claims history | No claims = lower rates | | Indemnity strength | Better indemnity = lower rates |
Example Cost Calculation
$5 Million Project:
| Tier | Amount | Rate | Premium | |------|--------|------|---------| | First $500K | $500,000 | $20/1000 | $10,000 | | Next $2M | $2,000,000 | $15/1000 | $30,000 | | Next $2.5M | $2,500,000 | $10/1000 | $25,000 | | Total | | | $65,000 |
This is 1.3% of contract value
Building Bonding Capacity
Capacity Calculation
Sureties typically calculate capacity as multiples of:
| Metric | Multiplier | Example | |--------|------------|---------| | Working capital | 10-15x | $500K WC = $5-7.5M capacity | | Net worth | 10-20x | $750K NW = $7.5-15M capacity |
Actual capacity is the lower of the two calculations.
Strategies to Increase Capacity
1. Strengthen Balance Sheet
- Retain earnings in business
- Minimize distributions
- Build working capital
- Reduce debt
2. Build Track Record
- Complete projects successfully
- Document performance
- Maintain good references
- Avoid claims and disputes
3. Develop Surety Relationship
- Communicate regularly
- Provide timely information
- No surprises
- Build trust over time
4. Professional Financial Statements
- Use experienced construction CPA
- Consider reviewed or audited statements
- Provide comprehensive notes
- Include proper schedules
Managing Work in Progress
Sureties monitor work-in-progress (WIP):
Key WIP Metrics:
- Underbillings vs. overbillings
- Backlog vs. capacity
- Profit fade analysis
- Cost to complete accuracy
Best Practices:
- Accurate job costing
- Timely billing
- Proper revenue recognition
- Regular WIP review
The Bonding Process
Getting Started
1. Find a Bond Producer
- Construction-focused agent/broker
- Strong surety relationships
- Industry knowledge
- Responsive service
2. Complete Application
Required Information:
- Company history and structure
- Owner background
- Financial statements
- Banking references
- Project history
- Current work in progress
3. Underwriting Review
- Surety evaluates submission
- May request additional information
- Site visit possible
- Interview with principals
4. Approval and Terms
- Bonding line established
- Single and aggregate limits
- Rate schedule
- Indemnity agreement
Obtaining Bonds for Specific Projects
Once approved:
- Request bond for specific project
- Provide contract and project details
- Surety reviews and approves
- Bond issued for submission
Surety Claims
When Claims Occur
Default triggers may include:
- Failure to complete on schedule
- Abandonment of work
- Bankruptcy or insolvency
- Failure to pay subcontractors
- Failure to meet specifications
Claim Process
1. Owner Declares Default
- Written notice to contractor
- Opportunity to cure
- Declaration of contractor default
2. Owner Makes Claim
- Formal claim to surety
- Documentation of default
- Statement of damages
3. Surety Investigates
- Reviews circumstances
- Evaluates claim validity
- Assesses options
4. Surety Response Options
- Finance contractor completion
- Take over and complete
- Tender new contractor
- Pay damages (up to bond amount)
Avoiding Claims
Best Practices:
- Communicate problems early
- Work with surety on solutions
- Maintain adequate resources
- Honor contract obligations
- Document everything
Special Bonding Situations
Joint Venture Bonds
For JV projects:
- Both partners may provide bonds
- Proportional bonding possible
- Cross-indemnification typical
- Clear JV agreement needed
Subdivision Bonds
For development work:
- Site improvement guarantees
- Warranty bonds
- Maintenance bonds
- Often required by municipalities
Supply Bonds
For material supply contracts:
- Guarantee delivery
- Quality assurance
- Less common than performance bonds
SBA Surety Bond Guarantee Program
The SBA helps small contractors obtain bonds.
Program Overview
- Guarantees up to 90% of bond losses
- Reduces surety risk
- Enables bonds for marginal applicants
- Available through approved sureties
Eligibility
- Small business (SBA size standards)
- Unable to obtain bonds otherwise
- Contracts up to $6.5 million (standard)
- Up to $10 million (federal)
How to Apply
- Work with SBA-approved surety or agent
- Apply through normal bonding process
- Surety requests SBA guarantee
- SBA reviews and approves
Working with Your Surety
Building a Strong Relationship
Communication Best Practices:
- Regular financial updates
- Project status reports
- Early warning of issues
- Honest and transparent
Meeting Expectations:
- Timely information submission
- Accurate financial statements
- Professional presentation
- Consistent performance
What Sureties Want to See
Growing contractors should demonstrate:
- Improving financial metrics
- Successful project completions
- Controlled growth rate
- Strong management team
- Professional operations
Common Bonding Challenges
Challenge 1: Insufficient Capital
Problem: Working capital limits bonding capacity.
Solutions:
- Retain more earnings
- Secure line of credit
- Reduce debt
- Consider equity investment
Challenge 2: Limited Experience
Problem: Lack of relevant project history.
Solutions:
- Build experience gradually
- Partner with experienced firms
- Document all project experience
- Develop key personnel
Challenge 3: Financial Statement Quality
Problem: Statements don't meet surety standards.
Solutions:
- Use construction-specialized CPA
- Upgrade to reviewed/audited
- Improve financial reporting
- Provide detailed WIP schedules
Challenge 4: Claims History
Problem: Past claims damage bonding prospects.
Solutions:
- Document claim circumstances
- Show corrective actions taken
- Demonstrate improved performance
- Consider alternative sureties
Next Steps
Ready to strengthen your bonding position?
- Assess your current capacity - Understand your limits
- Review financials - Identify improvement areas
- Build relationships - Connect with surety partners
- Document experience - Maintain comprehensive records
- Plan growth - Align project pursuit with capacity
Related Articles
- Understanding Bid Bonds in Construction
- Pre-Qualification Requirements for Government Contracts
- How to Write Winning Construction Bid Proposals
Frequently Asked Questions
What's the difference between bonding capacity and credit? Bonding capacity is the maximum value of bonded contracts you can have outstanding. It's based on financial strength and experience, not borrowed money.
Can I get bonds with bad credit? Personal credit matters, but business financials are more important. Work with a bond producer experienced in placing accounts with credit challenges.
How quickly can I get a performance bond? With an established bonding relationship, bonds can be issued in 24-48 hours. New relationships take 2-4 weeks for underwriting.
What happens if I can't finish a bonded project? Communicate with your surety immediately. They may provide financial or technical assistance to help you complete. Default triggers serious consequences.
Do I need a bond for every project? Not always. Many private projects don't require bonds. Public works usually do. Review contract requirements carefully.
